Inverse Head and Shoulders: What the Pattern Means in Trading

In the dynamic world of trading, the inverse head and shoulders chart pattern stands as a notable indicator for identifying bullish reversals. Characterized by three (3) distinct troughs: a lower "head" between two (2) higher "shoulders", this pattern signals a potential shift from a bearish to a bullish trend when the price breaks above the "neckline".

Traders tend to often enter the position at this breakout point, set stop loss orders below the right shoulder, and use technical analysis indicators such as the moving average, the Relative Strength Index (RSI), and the Moving Average Convergence Divergence (MACD) for additional confirmation, thereby creating a multifaceted approach to capitalize on these trading opportunities.

What Is the Inverse Head and Shoulders?

The inverse head and shoulders chart pattern is a bullish chart formation that signals a potential reversal of a downtrend. It is the opposite of the head and shoulders chart pattern, which is a bearish formation.

The inverse head and shoulders chart pattern consists of three (3) troughs: the first and third troughs are roughly equal in depth and are known as "shoulders", while the second trough is deeper and is called the "head".

A Description of the Inverse Head and Shoulders Chart Pattern

This chart pattern formation is commonly used in technical analysis to predict the reversal of a downtrend. It is a bullish signal that is essentially the reverse of the regular head and shoulders chart pattern, which is a bearish indicator. The structure of the inverse head and shoulders chart pattern is described as follows:

• Left Shoulder: After a downtrend, the price of the respective asset makes a low and then rallies to a higher point, forming the left shoulder.
• Head: Following the formation of the left shoulder, the price declines to a point lower than the left shoulder and then rallies again, forming the head.
• Right Shoulder: Finally, the price declines again but not as low as the previous decline or the head, and then rallies one more time, forming the right shoulder. The right shoulder is typically roughly equal in depth to the left shoulder.
• Neckline: A trendline is drawn connecting the high points (or "peaks") after the formation of each shoulder and the head. This line serves as a level of resistance that the price must break through to confirm the pattern.

The Psychology Leading to the Formation of the Inverse Head and Shoulders Chart Pattern

The psychology behind the formation of the inverse head and shoulders pattern can be understood through the changing sentiment among traders and investors during its development.

On the left shoulder, the overall sentiment is pessimistic. The sellers are still in control. Then, a minor rally begins to occur as some traders think the security is oversold. However, this rally is short-lived as the dominant sentiment is still bearish.

Next, with the formation of the head of the inverse head and shoulders pattern, the sentiment moves from extremely pessimistic to cautiously optimistic. The price of the respective asset drops even lower than the left shoulder, indicating strong selling pressure. The drop to a new low may trigger panic selling. However, this extreme point often attracts value investors who consider the asset significantly undervalued, leading to a rally.

The right shoulder now begins to form. The sentiment is cautiously optimistic to optimistic. The price declines again but not as low as the head, indicating waning selling pressure. The shallower low suggests that sellers are losing steam and buyers are starting to gain confidence. The sentiment starts to shift from bearish to bullish.

Finally, with the breaking of the neckline, optimism turns into bullishness. The price breaks above the neckline, often on higher volume. The break above the neckline confirms the bullish reversal, leading to more traders who had previously been on the sidelines stepping into the market. This often fuels a strong upward move.

Understanding trader psychology is crucial in technical analysis. Behavioral finance studies suggest that chart patterns like the inverse head and shoulders can be explained by cognitive biases such as herd behavior and representativeness heuristic.

How to Trade the Inverse Head and Shoulders Chart Pattern

Trading the inverse head and shoulders pattern involves several key steps, each with its own set of considerations. Below is a guideline on how to approach trading this chart pattern:

Identification:

• First Step: The trader should identify the pattern formation on the chart, which includes a left shoulder, a head, and a right shoulder. A point to note is to ensure that the pattern follows a downtrend. For a reversal to occur, there must be something to reverse.

Confirmation:

• Neckline: The trader should then draw a trendline connecting the peak of each shoulder and the head.
• Volume: If volume data is available, the trader would look for increased trading volume during the breakout above the neckline as a confirmation signal.

Entry:

• Buy Signal: The trader could enter a long position when the price breaks above the neckline, preferably on high volume, or when price returns to test the neckline.

Risk Management:

• Stop Loss: In order to manage risks, the trader should place a stop loss order slightly below the right shoulder or the neckline to minimize potential losses.
• Position Sizing: The trader would also determine the size of the trade based on their risk tolerance and the distance between the entry point and the stop loss.

Profit Target:

• Target Price: The trader should calculate the target price by measuring the vertical distance from the neckline to the lowest point of the head. This value will be added to the distance at the breakout point at the neckline.

Exit:

• Take Profit: The trader should exit the position when the price reaches the target level or shows signs of reversing.
• Trailing Stop: Alternatively, the trader could use a trailing stop to capture additional gains while protecting their position.

Additional Considerations:

• Confirmation Indicators: Traders would use technical indicators like the RSI or MACD for additional confirmation on the inverse head and shoulders chart pattern.
• Time Frame: The chart pattern is generally more reliable on longer time frames like daily or weekly charts.

An Example of a Inverse Head and Shoulders Chart Pattern

On a 15-minute chart spanning from July 19th at 11:15 to August 24th at 10:00, the Invesco QQQ Trust Series (QQQ) showcased the inverse head and shoulders chart pattern following an 8.57% decline from a higher of $387.98 to a low of $354.76.

The pattern's right shoulder was marked by lower highs at $365.94 and $3263.03, bottoming out at $360.68. The head was distinctly formed at a low of $354.70. Subsequently, the ETF rallied to a high of $362.59, constituting the the top of the right shoulder, which had a low point at $359.17.

The critical neckline was delineated by lower highs of $354.76 and $354.70. On August 21st at 13:15, QQQ broke above this neckline, setting a bullish target of $370.66. This target was subsequently met with a rally on August 24th at 9:30.

The Significance of Volume in the Inverse Head and Shoulders Chart Pattern Formation

Volume plays a critical role in confirming the validity and strength of an inverse head and shoulders pattern.

During the formation of the left shoulder, volume generally decreases as the left shoulder forms, reflecting waning selling pressure. For the head of the inverse head and shoulders chart pattern, volume may spike at the low point of the head as panic selling ensues, but it often picks up again during the subsequent rally, indicating renewed buying interest. For the right shoulder, volume is usually lower compared to the head, signaling that selling pressure is diminishing.

During the breakout of the neckline, a significant increase in volume as the price breaks above the neckline is a strong confirmation signal. It indicates that the market participants are in agreement about the asset's bullish prospects. High volume during the breakout suggests that the upward trend is more likely to be sustained, as it shows strong buyer commitment.

Why Volume Matters in the Inverse Head and Shoulders Chart Pattern Formation

There are several reasons why volume matters in the case of an inverse head and shoulders chart pattern. One reason is the confirmation of the chart pattern. High volume confirms that the pattern is not a false breakout, thereby increasing the reliability of the trade signal.

Another reason why volume matters is from the perspective of momentum. A volume supported breakout often leads to a stronger and more rapid price movement, making it easier to reach the profit target.

Finally, volume can help with risk management. Low volume during a breakout can be a red flag, signaling that the pattern may not be as reliable, which can aid in risk assessment.

Volume is often considered an essential second dimension to price in technical analysis. Studies in market microstructure theory suggest that volume contains information about traders' beliefs and intentions, making it a valuable tool for confirming chart patterns.

The Significance of False Breakouts in the Inverse Head and Shoulders Chart Pattern

False breakouts in the context of the inverse head and shoulders pattern can have significant implications for traders. A false breakout occurs when the price moves above the neckline but quickly reverses, failing to sustain the upward momentum.

Traders who enter long positions based on the initial breakout may incur losses if the breakout turns out to be false. These false breakouts can shake investor confidence and can lead to emotional decision making, such as premature exits or disregarding stop loss levels.

Also, a false breakout may indicate that the asset is not yet ready for a bullish reversal, suggesting that the bearish sentiment still prevails. Moreover, the occurrence of a false breakout often necessitates a re-evaluation of one's trading strategy, including risk management techniques.

How to Mitigate the Risks False Breakouts in the Inverse Head and Shoulders Chart Pattern

There are several ways to mitigate the risks of false breakouts in the inverse head and shoulders chart pattern. One way is volume confirmation. Traders would look for high trading volume during the breakout of the neckline as a confirmation signal on the discussed chart pattern.

Another type of confirmation is waiting for the price to close above the neckline and even retest it as support before entering a trade. Additionally, traders would employ technical analysis indicators like the RSI or MACD for further confirmation.

Finally, traders would set stop-loss orders to manage their downside risk, especially when trading on these types of pattern breakouts.

The Significance of the Testing of the Neckline in the Inverse Head and Shoulders Chart Pattern

The testing of the neckline in an inverse head and shoulders pattern is a crucial phase that can offer valuable insights into the pattern's reliability and the market's sentiment on the respective asset.

After breaking above the neckline, the price often retraces back to the neckline level, testing it as new support before resuming the upward trend. A successful retest of the neckline strengthens the validity of the pattern and provides additional confirmation for a bullish reversal.

Also, the retest offers a secondary entry point for traders who missed the initial breakout, often with a tighter stop loss order, thus reducing risk. Another significance of the testing of the neckline is market sentiment. A successful retest indicates that market sentiment on the asset has shifted from bearish to bullish, as the previous resistance level (neckline) now acts as support.

Finally, if the price fails to hold the neckline and falls below it, a false breakout could be signaled, necessitating a strategy re-evaluation.

The Profit Targets of the Inverse Head and Shoulders Chart Pattern

Profit targets in an inverse head and shoulders pattern are typically targeted using the vertical distance between the neckline and the lowest point of the head. This distance is known as the price objective and serves as a guidance for potential upward movement after the breakout.

The profit target of the inverse head and shoulders is measured by calculating the vertical distance from the neckline to the lowest point of the head in the pattern. This distance is added to the point where the price breaks above the neckline during the breakout.

Traders find it crucial to know the profit target of this chart pattern. It helps in assessing the risk-reward ratio of the trade, aiding in decision making. Also it provides a logical exit point where traders can take profits, reducing the emotional aspect of trading. Moreover, the profit target can be aligned with other trading objectives and strategies, such as trailing stops, to maximize gains.

The Combining of the Inverse Head and Shoulders Pattern with Technical Analysis Indicators

Combining the inverse head and shoulders pattern with other technical analysis indicators is likely to enhance the reliability of the trading signals. Some commonly used indicators that traders consider are as follows:

Moving Averages:

• Purpose: To identify the overall trend direction.
• How to Use: A crossover of a short-term moving average over a long-term moving average can confirm a bullish reversal.

RSI:

• Purpose: To gauge overbought or oversold conditions.
• How to Use: An RSI value above 70 may confirm the bullish momentum, especially if it coincides with the neckline breakout.

MACD:

• Purpose: To help identify momentum and trend direction.
• How to Use: A bullish MACD crossover can serve as an additional confirmation signal.

Volume Oscillator:

• Purpose: To help confirm the strength of the trend based on volume.
• How to Use: A rising volume oscillator can confirm the bullish breakout, adding credibility to the pattern.

Fibonacci Retracement:

• Purpose: To help identify potential support and resistance levels.
• How to Use: The 50% or 61.8% retracement levels can act as additional confirmation points or targets.

Bollinger Bands:

• Purpose: To measure volatility and potential reversals.
• How to Use: A price movement that touches the upper Bollinger Band can confirm the bullish trend.

Stochastic Oscillator:

• Purpose: To help identify overbought or oversold conditions.
• How to Use: Generally, a stochastic value above 80 can confirm bullish momentum.

The Bottom Line

 The inverse head and shoulders pattern is a powerful tool in the arsenal of traders and investors
alike. Serving as a bullish reversal indicator, this pattern is characterized by three troughs: a lower "head" flanked by two higher "shoulders." The pattern is confirmed when the price breaks above the "neckline," signaling a potential change in trend from bearish to bullish. To enhance the reliability of trading signals traders often combine this pattern with other technical indicators such as moving averages, the MACD, the RSI and the volume oscillator.

This chart pattern is a comprehensive trading strategy when used correctly. By understanding its structure, applying sound trading rules, and using complementary technical indicators, traders can make more informed decisions, manage risk effectively, and improve their odds of success in the market.