Trading the Inverse Head and Shoulders Chart Pattern
Entries, stops and targets for the Inverse Head and Shoulders chart pattern
The inverse head and shoulders is a type of chart pattern. When the pattern has fully formed it means the prior downtrend is over, and an uptrend is underway. This is why the inverse head and shoulders is called a reversal pattern. Inverse head and shoulders occur in all markets and on all time frames.
Identifying an Inverse Head and Shoulders Chart Pattern
The head and shoulders pattern is a reversal pattern that signals a downtrend is over.
As the price is progressing lower it creates 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 (creating a higher low) before rallying again. This movement creates three troughs (low points), called the left shoulder, head and right shoulder.
There are two rallies or pullbacks that occur during the pattern--one occurs after the left shoulder and one after the head. The high points of these pullbacks are connected with a trendline, which extends out to the right. This trendline is called the "neckline."
The attached chart shows an inverse head and shoulders chart pattern.
Ways to Trade an Inverse Head and Shoulders Chart Pattern
Since the head and shoulders is a bottoming pattern, when it completes the focus should be on taking long positions (buying)
The pattern is "complete" when the price rallies above the neckline.
On the attached chart, the price rallies above the neckline following the right shoulder. This is called a chart pattern breakout, and signals a completion of the inverse head and shoulders.
The traditional method of trading the inverse head and shoulders is to enter a long position when the price moves above the neckline.
Place a stop loss order just below the low 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 is slightly lower than the first.
If the 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, 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 is much lower than the first. In other words, if the neckline is gradually descending, use it as an entry point. If the neckline is steeply angled, either up or down, use the high of the second retracement as an entry point.
Chart patterns provide price targets--an approximate area where the price could run to based on the size of the pattern. Subtract the low of the head from the high of the retracements. This gives you the "height" of the pattern. For example, the attached charts shows an inverse head and shoulders in the ES futures market. The low of the head is 2059.5 and the retracement high is 2063.5 (use the lower retracement so the target is more conservative, and more likely to be reached).
The height of the pattern is therefore 2063.5 - 2059.5 = 4.
Add the height to the breakout price to attain a profit target. The breakout price was 2063.25, so the target is 2067.25. Price targets are only a guide; there's no guarantee the price will reach the target or that the price will stop rising near the target.
Focus on trading patterns where the reward to risk on the trade is greater than 2:1, based on the target and stop loss. In the case of the attached chart, the target is 4 points above the entry price, while the stop loss is 3.25 away from the entry price (if placed at 2063, just below the right shoulder). Therefore the reward to the risk isn't that great, yet the pattern stills shows a transition from a short-term downtrend to a short-term uptrend. Patterns where the right shoulder low is well above the low of head produce more favorable risk/reward ratios for trading.
Inverse Head and Shoulders Chart Pattern - Final Word
The inverse head and shoulders pattern occurs during an downtrend and marks its end. The chart pattern is composed of three lows, with two retracements in between. The pattern is complete--and provides a potential buy point--when the price rallies above the neckline or second retracement high. A stop loss traditionally goes just below the right shoulder and a target is established based on the height of 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 uptrend.
There is a also a head and shoulders pattern (not inverse). It's an upside down version of the above, and marks the end of an uptrend.