How To Trade In Inverse Head And Shoulders Pattern
Formation of the head and shoulders pattern in trendline indicates a reversal in uptrend. Similarly, an inverse head and shoulders pattern appearing in a downtrend is indicative of bearish to bullish reversal. Like head and shoulders pattern, the inverse head and shoulders also appear in all time frames and is easy to spot.
An inverse head and shoulders pattern forms when the price of an asset falls to a trough, then rises, falls for the second time, but this time the fall is steeper than the first. The price rises again and drops for the final time.
Key Takeaways
- The inverse head and shoulders formation is similar to head and shoulders formation, but only reverse
- It shares many characteristics with head and shoulders – of three troughs with the first and second being shallower than the middle one
- Inverse head and shoulders pattern appears in the downtrend
- The formation signals a bull market and traders enter a long position once the formation is complete
- Traders look for a steep price rise once the third rise breaks through the neckline
How To Read An Inverse Head And Shoulders Pattern
Inverse head and shoulders pattern indicates the end of bearish phase and onset of an uptrend. Traders enter a long position when the up breaks through the resistance line. They would look for a rise in volume to confirm the trend change. Inverse head and shoulders pattern appears frequently in the trendline, and since it shares many characteristics with the head and shoulder in an uptrend, it is also interpreted the same way.
Inverse head and shoulders is a robust pattern that allows traders to visualise the new resistance and stop-loss. Traders measure the distance between the bottom of the head and the neckline to set a suitable profit target while they trade. Some aggressive traders will place a stop-loss just below the right shoulder of the inverse head and shoulders, although the most practised method is to place it below the second trough.
When an inverse head and shoulders appears
- Inverse head and shoulders appears after a long bearish trend
- It indicates a trend reversal when accompanied by an increase in the volume of trading
- During the formation, new lows form, indicating that the market tried to fish for the floor
- The price drops to the point when the market can’t support it; so, it rises again
- Traders also take into account the ongoing trend. If the inverse head and shoulders doesn’t appear in a downtrend, it is not a trend reversal pattern
When the inverse head and shoulders pattern forms, traders enter a long position. But before we discuss in detail about trading strategy, let’s discuss each component of the formation in detail.
The left shoulder: The first trough forms the new low in the current trend. The market then rises again to break at the resistance level.
The head: The second trough forms a new low, lower than the first one. Sometimes the high in the rise also break the downtrend line.
The right shoulder: The third low ends above the second low, creating the right shoulders. It is usually in the line of the left shoulder or symmetrical. While symmetry is preferred, it is not guaranteed. When the right shoulder breaks through the neckline, the formation gets complete.
Resistance or Neckline: The neckline is a line conjoining the high 1 and high 2. High 1 is a point that marks the end of the left shoulder rise and the beginning of the head. And, high 2 is the point where the head ends, and right shoulder begins.
Volume: Volume is critical to confirm the reversal. Expansion in volume isn’t imperative for the head and shoulders pattern, but it is mandatory for the inverse formation. If it isn’t accompanied by an expansion in volume, it isn’t a reversal pattern.
Support line: Once the resistance line is broken, it becomes the new support. The pattern isn’t complete until the trendline breaks the neckline. Often in an uptrend, the price will once again drop to the support line to give traders a second chance to buy.
Price target: Inverse head and shoulders pattern lets traders calculate a suitable profit target by measuring the gap between the head to the neckline. It is then placed against the opposite side of the neckline, in an uptrend, to set a profit target.
Trading In Inverse Head And Shoulders
Inverse head and shoulders is a popular formation and indicates major trend reversal when appearing in a downtrend. Traders enter a long position when the pattern appears in price line, but there are more than one ways to trade in inverse head and shoulders.
Aggressive trading
Some aggressive traders would jump on the first opportunity to buy when the trendline breaks the resistance by placing a stop buy just above the inverse pattern’s neckline. The problem with this strategy is that it can be a false break, and price can slip down again.
Conservative trading
Traders can wait for the pattern to complete and validate the reversal when the price closes above the neckline. It can result in nullifying any chance of price retrace and minimise slippage. Alternatively, he can place a limit order just below the broken neckline point. However, there is one flip side to it. Waiting for a retrace can lead to missing out buying opportunity if the pullback never happens.
Summarising the inverse head and shoulders
Inverse head and shoulders pattern indicates volatility in the market. It suggests that bull is trying to take over the market when the bear is resisting by pushing the asset price down. The pattern completes when the price drops for the third time and then rises to break the neckline, confirming that bull has finally taken over. However, there must be a significant increase in the volume of trade during the phase to confirm trend reversal. Without a rise in volume, the pattern isn’t a reversal formation.
Conclusion
Inverse head and shoulders is a confirmed trend reversal pattern. The pattern completes when the asset rallies through where the right shoulder breaks the neckline. Traders take a long position given the fact that bull has taken control of the market and established an uptrend. It is a definitive format that allows traders to successfully plan an entry just above the neckline of the formation and place stop-loss below the right shoulder. But one should be prompt enough to identify the pattern to take a position. Although a price drop in the uptrend is commonplace, allowing a second chance to traders to buy, it is not guaranteed.
Learn Free Stock Market Course Online at Smart Money with Angel One.
