Trading the Inverse Head and Shoulders Pattern
Traders use charts to study different types of patterns in market trends, including the inverse head and shoulders pattern. The pattern is characterized by three troughs (the upward head and shoulders have peaks), with the middle trough being the lowest.
An inverse head and shoulders pattern occurs in all markets, on all time frames, and is associated with the reversal of a downward trend.
Identifying Inverse Head and Shoulders Patterns
The inverse head and shoulders pattern is used as an indicator. This pattern is associated with a reversal of a downward trend in price. It is one of the more common reversal indications.
As price progresses downward, it hits a low point (a trough) and then begins to recover and swing upward. Market resistance then pushes it back down into another trough.
Price drops to a point where the market cannot support lower prices and the price begins rising again. Again, market resistance forces the price back down, and the price drops one last time. If the market can't support a lower price, it doesn't reach the prior low. This causes a higher low before prices rise 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, or resistance line.
How to Trade This Pattern
Since the inverse head and shoulders are a bottoming pattern when it completes you should focus on buying, or taking long positions (owning the stock). The pattern completes when the asset's price rallies above the pattern's neckline, or breaks through the resistance line.
On the pictured chart, the price rallies above the neckline following the right shoulder. Traders call this a 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 (trade stop at a set point) just below the low point of the right shoulder.
The neckline works well as an entry point if the two retracements (the short intervals in the trend, or the smaller trough) 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.
Pattern Height and Target Price
Chart patterns provide price targets or an approximate area 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, if the low of the head is $2,059.50, and the retracement high was $2,063.50, the height of the pattern would equal four ($2,063.50 - $2,059.50 = 4).
Add the height to the breakout price to attain a profit target. If the breakout price was $2,063.25, the target is $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-to-reward ratios for trading.
Recapping 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 a downward trend to an upward trend.