How to Trade the Inverse Head and Shoulders Chart Pattern

Inverse Head and Shoulders Chart Pattern - Es One Minute Chart
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Traders use charts to study different types of patterns in market trends, including the inverse head and shoulders pattern. When this pattern has fully formed, it indicates the end of the prior downtrend and the beginning of an uptrend.

This has lead traders to refer to the inverse head and shoulders pattern as a reversal pattern. An inverse head and shoulders patterns occur in all markets and on all time frames. Other types of chart patterns include the triangle and flag.

Identifying Inverse Head and Shoulders Chart Patterns

The head and shoulders pattern works as a reversal pattern that signals the end of a downtrend. As the price progresses downward, it hits a low point and then pulls back to the upside. The price then drops to a lower low and pulls back again. When the price drops again, it's unable to reach the prior low, thereby creating a higher low before rallying again. This movement creates three troughs, or low points, called the left shoulder, head, and right shoulder.

You will see two rallies or pullbacks occur during this pattern. One occurs after the left shoulder and one after the head. The high points of these pullbacks connect with a trendline, which extends out to the right. This trendline is called the "neckline." The pictured chart shows an inverse head and shoulders chart pattern with a trendline added to show the neckline.

How to Trade This Pattern

Since the head and shoulders is a bottoming pattern when it completes you should focus on buying, or taking long positions. The pattern completes when the asset's price rallies above the pattern's neckline.

On the pictured chart, the price rallies above the neckline following the right shoulder. Traders call this a chart pattern breakout, and it signals a completion of the inverse head and shoulders.

Traditionally, you would trade the inverse head and shoulders by entering a long position when the price moves above the neckline. You would also place a stop loss order just below the low point of the right shoulder.

The neckline works well as an entry point if the two retracements in the pattern reached similar levels, or the second retracement hit slightly lower than the first.

If the right shoulder is higher than the first, the trendline will angle upwards, and therefore won't provide a good entry point (too high). In this case, buy or enter long when the price moves above the high of the second retracement (between the head and right shoulder).

Also, use this entry point if the second retracement high comes in much lower than the first. In other words, if the neckline trend gradually descends, use it as an entry point. If the neckline shows a steep angle, either up or down, use the high of the second retracement as an entry point.

Chart patterns provide price targets or an approximate area to where the price could run based on the size of the pattern. You can subtract the low price of the head from the high price of the retracements. This gives you the height of the pattern.

For example, the pictured chart shows an inverse head and shoulders in the ES futures market. The low of the head is $2,059.50, and the retracement high is $2,063.50. You would use the lower retracement to make the target more conservative, and more likely to be reached. The height of the pattern therefore equals $2,063.50 - $2,059.50 = 4.

Add the height to the breakout price to attain a profit target. The breakout price was $2,063.25, so that makes the target $2,067.25. Price targets serve only as a guide; they offer no guarantee that the price will reach the target or that the price will stop rising near the target.

Focus on trading patterns that offer trades with a reward to risk ratio of greater than 2:1, based on the target and stop loss. In the case of the example, the target is 4 points above the entry price, while the stop loss is 3.25 away from the entry price (if placed at $2,063, just below the right shoulder).

Therefore the trade doesn't offer a very good reward-to-risk ratio, yet the pattern still shows a transition from a short-term downtrend to a short-term uptrend. Patterns where the right shoulder low hits well above the low of head produce more favorable risk/reward ratios for trading.

Recap the Strategy

The inverse head and shoulders pattern occurs during a downtrend and marks its end. The chart pattern shows three lows, with two retracements in between. The pattern completes and provides a potential buy point when the price rallies above the neckline or second retracement high.

You would traditionally use a stop loss and price it just below the right shoulder and establish a target based on the height of the pattern added to the breakout price. Ideally, the trade should provide a better than 2:1 reward to risk ratio; if it doesn't, the pattern still provides useful information, showing the transition from downtrend to an uptrend.

A head and shoulders pattern (not inverse) also exists. It's an upside-down version of the above and marks the end of an uptrend.