Using the Inverse Head and Shoulders Pattern in Trading

The inverse head and shoulders pattern is a technical indicator that signals potential bullish trend reversals early. It occurs when the price falls and rises rapidly, three times, before finally settling into an uptrend. The inverse head and shoulders pattern could be a valuable tool to add to your trend and reversal trading strategies.

How to Recognise the Pattern

The inverse head and shoulders pattern is formed when the price forms three consecutive lows:

1. The first trough, also called the left shoulder, is a steep (steeper than the usual in the ongoing downtrend) decline in price. After this, the price rises back up to a resistance level. This is known as the initiation phase, and this resistance level is the neckline of the pattern.
2. The price retracts into a second, deeper trough, and then surges back to the neckline. This is the head of the pattern. Head formation is an early sign of a potential reversal.
3. Finally, the price forms the last trough, i.e., the right shoulder, with a low similar to the one in the initiation phase. This signals that the bulls are taking over, driving the price beyond the neckline into an uptrend.

Things to Keep in Mind When Looking for Pattern Formation

• The retractions happen at a resistance level. This neckline could be a horizontal or sloping line.
• This pattern forms during a downtrend.
• The pattern works better for longer timeframes, such as a few days or weeks.
• High trading volume during the breakout helps build momentum, indicating a sustainable uptrend.

Confirming the Inverse Head and Shoulders Pattern

The inverse head and shoulders pattern is a leading indicator. However, confirming its signals helps avoid falling prey to false positives. Here are a few ways to confirm the signal:

• The pattern shows a clear price breakout from the neckline, usually with a sharp surge. 
• As the market retests the neckline, it gets established as the support level after the initial breakout.
• The trading volume surges right before the breakout and stays high throughout the retest and beyond. You can use technical indicators, such as on-balance volume (OBV) and accumulation/distribution (AD), along with volume-weighted average price (VWAP) to determine trading volume.

Timing Your Entry and Exit

Timing your entry and exit is crucial to optimising your trading experiences. Using additional indicators can strengthen your trading strategy.

Identifying Entry Points

The best time to enter a trend is right before it starts. This could be right after the price returns to the uptrend after retesting the neckline as the support level. This is a time to open a buy position. 

If you do not want to wait for the retest, you can use technical indicators to confirm whether the market is in the oversold region. Oversold conditions also indicate potential bullish reversals. The completion of the inverse head and shoulder pattern under oversold market conditions forms a strong signal for a reversal into an uptrend. Indicators, such as the Relative Strength Index (RSI) and Stochastic Oscillator (SO), are useful to determine if the asset is oversold or overbought.

Timing Your Exit

Whichever asset you are trading, risk management remains paramount. A useful feature of the inverse head and shoulders pattern is that the pattern itself shows risk and exit price points. You don’t have to perform any additional calculations.

A potential stop loss could be just below the neckline. However, this can easily get triggered if the market retests the neckline multiple times. Stop loss prevents losses from accumulating, in case the trend reverses again before you can lock in gains. Therefore, while trading highly volatile markets, traders tend to use the low of the right shoulder as a stop-out level.

A take profit order automatically locks profits and closes the position. A profit target can be placed at the same distance from the neckline as the low of the head. When traders observe a higher surge potential than that, they can use the Fibonacci indicator to determine consecutive profit target levels.

To determine the position size, check your risk tolerance levels. A popular rule of thumb is to invest only 1%-2% of your trading capital in a single trade.

Limitations of the Inverse Head and Shoulders Pattern

A few things to keep in mind while using this pattern are:

• The wait time from the first shoulder to pattern completion can be too long for some traders. Patience is key.
• The inverse head and shoulders pattern is not immune to false signals. Confirming the signal with another indicator helps.
• The pattern may not be suitable for high-speed trading strategies, such as scalping.
• The pattern may be difficult to recognise when the neckline is sloping instead of horizontal. With practice, you can master identifying the pattern.

Use a demo account to practise identifying and appropriately taking positions to refine your trading strategy before trying it out in the live markets.

The inverse head and shoulders pattern can be used across multiple assets, including commodities, indices, stocks and forex. It is important to consider other factors that influence your asset of choice to make informed trading decisions when the pattern forms.

To Sum Up

• The inverse head and shoulders pattern is a leading bullish reversal indicator.
• The pattern is formed when the price makes three troughs from an existing resistance level.
• Confirming the signal with other technical indicators can strengthen your trading strategy.
• The pattern simplifies identifying entry, stop loss and take profit price levels.
• Practicing on a demo account can improve your trading experiences.

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