Today we’re going to look at the inverse head and shoulders pattern
It’s the easiest of all the patterns, and it’s also one of the most common ones.
In fact, if you’ve been trading for any length of time, then you’ve probably already come across it.
The inverse head and shoulders pattern is one of the most powerful trading patterns there are.
But in order to make it work you need to trade it in a very precise way.
And in this post, I’m going to show you how you can easily add it to your trading analysis.
Let’s dive in.
What is an Inverse Head and Shoulders Pattern?
The Inverse Head and Shoulders pattern is a classic bullish reversal pattern.
It’s characterized by a break of the neckline of an inverse head and shoulders formation, which can be seen in any time frame.
As the name suggests it’s the inverse, or opposite, of a normal head and shoulders pattern that is found at the top of trends.
It’s a very powerful chart pattern that can indicate a high probability reversal to the upside.
What does an Inverse Head and Shoulders Indicate?
So the inverse head and shoulders meaning are that the market participants are shaking off the last series of sell orders and bullish momentum is building.
Even though the price action pattern is easy to see, it’s important you understand why this forms so it can give you a greater understanding of the current market strength.
This is seen in the pattern as the market creates a low, then pulls back to a recent high.
It then creates a lower low, then pulls back to a recent high.
Then finally, it creates a higher low that is a similar distance as the first low, then pulls back to the recent high.
This suggests that the sellers in the market are not strong enough to hold the price any lower as the buyers have bought them out to the highs, 3 times.
This is a strong indication that the weakness in the short side is undone and the buyers are looking to take the price higher whilst they have strength.
Is Inverse Head and Shoulders Bullish Only?
Yes, this is a bullish reversal chart pattern – so you should only look for taking long/bullish trades only.
For the bearish version, you need to find the regular head and shoulders pattern.
How to Identify The Inverse Head and Shoulders Pattern
Now we are on to the core of the guide, let’s break down some of the patterns first:
Inverse head and shoulders
Identifying the inverse head and shoulders it’s easy.
Here is a chart example:
As you can see there are 3 parts to the pattern.
The 2 shoulders and 1 head.
It’s important that the shoulders trade around the 50% level of the head part of the pattern, as this will provide a valid signal of the weakening in sellers.
Here’s an extra tip too:
Most of the time, the head part of the pattern is more volatile (has extra push down faster) because sellers are trying to push lower harder.
So when we see the right shoulder form at the 50% mark, it’s safe it acknowledge that the previous low (the head) was the seller’s last attempt.
Inverse head and shoulders neckline
The neckline is the area of recent highs that the market has pulled back to after trading lower the previous three times.
As you can see, it’s basically a resistance level.
However, sometimes necklines can be sloped – this is fine:
Necklines are essentially the area of the head and shoulders pattern we look for price to break out from.
So it doesn’t matter if it’s slanted or straight.
The key aspect of the inverse head and shoulders is the actual pattern formation.
Inverse head and shoulders probability
Nothing is guaranteed in trading.
Even the most successful systems in the world fail from time to time.
However, an inverse head and shoulders probability of success is quite high.
Inverse head and shoulders target
To create an inverse head and shoulders target for a profit should be used by simply taking the range of the pattern (from the neckline to the low of the head) and then using that distance as pips to place a take profit level.
Now, this doesn’t mean it’ll work out all the time like this, but it does set up a good projection.
However, there are other factors that you should consider too such as looking at the previous market structures for areas where a take profit level might be more realistic.
You should look out for supply and demand zones just in case.
Inverse head and shoulders pattern in an uptrend
You can find an inverse head and shoulders pattern in an uptrend or at the bottom of a downtrend.
Both play the same role as a bullish reversal pattern.
When they form in an uptrend it’s usually a signal that the sellers have entered the market OR the market has hit resistance with a lot of taking profit orders.
This is a good sign for you to enter a current uptrend but also a cautious one as sell orders were able to halt the current uptrend for a short while.
How to Trade the Inverse Head and Shoulders Pattern Step by Step.
With all that being said, it’s time to learn how to trade the inverse head and shoulders pattern step by step.
So, how do you find inverse head and shoulders?
Simple, they most commonly form at the end of a trend.
Unfortunately, as there are many other chart patterns that can form from the same base, it’s not as crystal clear until the first shoulder and head (swing lower low) has been formed.
Now you can find them, how do you trade inverse head and shoulder patterns?
It’s really easy.
And I’ll teach you the techniques I use to trade them more accurately.
In this guide, I will show you a side by side comparison of trading these patterns, and how my way can give you a little more edge vs. the same way other people teach you.
This is how:
Step 1: Identify the pattern
You can find this pattern by looking out for three attempts of the markets creating new lows.
They can appear in many different forms, so I’m going to show you one that is unorthodox to help conjure the image that you’re never going to get the perfect looking set-up every time.
You can use a charting tool such as TradingView‘s Head & Shoulders tool to draw them quickly.
Like so:
As you can see highlighted in the red square box is the tool I used to generate the pattern on the chart.
This is good for most people, and how most people learn to trade them.
It’s a very simple approach but I’m going to show you how to go deeper and improve on the entry and the overall results.
When you think you have found a pattern, switch to the line chart.
Then use the drawing tools to identify the pattern like so:
As you can see, the patterns are different, plus the line chart shows a sharper move and the neckline is flat vs. slanted using highs of candlesticks in the other example.
Both ways work, but I have found this simple filter has made my trades better in terms of accuracy, risk and execution.
In this example, the line chart offered a signal line 4 pips before the candlestick.
I get 4 pips doesn’t sound a lot but when 4 extra pips could be $400 extra dollars, not bad eh?
You will also see why the line chart beats the other analysis when it comes to managing the trade in the next few steps.
Step 2: Wait for a candlestick breakout from the neckline
Now switch back to the candlestick chart.
You want to see the breakout candlestick close above the neckline, and ideally other previous highs around the neckline.
Just like this:
This gives you a clear indicator that the pattern has been completed and the buyers want to go higher.
As you can see here, the line chart breakout candlestick triggered 8 pips before the candlestick chart.
Step 3: Place a buy order on the high of the breakout candlestick
As per my Best Execution Method rules, place the buy order 2-5 pips above the breakout candlestick’s high.
Like this:
Line Chart Version
Candlestick Version
Step 4: Place a stop loss at the
Place the stop at the low of the right shoulder.
This is to allow your trade the enter and has enough room for any potential profit-taking and any last-minute sellers to enter.
As your trade increases in profit, it is wise to track it using a trailing stop loss to lock in the profits.
Check it out:
Line chart version
Candlestick chart version
Step 5: Place a take profit level
This is where you can use the range of the neckline and the low price of the head part of the pattern to give you a potential trading range.
This works out well, but you must be cautious of the market structure on the left too.
To find the range using your trading platform, select the measure tool and find the number of pips within the pattern’s range.
Then add this to the neckline price like so:
Line chart set up
Candlestick set up
This will give you a good breakout range from the formation.
As you can see the candlestick shows a larger potential profit range by 5 pips, so the difference may seem insignificant, but we are looking for precise timing and accuracy.
In the last section, you will see the difference in the quality of the signal generated by the line chart vs. the candlestick chart.
The Results:
Line Chart Setup Results
The line chart version struggled to hit the target TP of 19 pips, but it didn’t take long (a couple of hours) before it was closed in a profitable position.
As you can see, the neckline reacted like a great support level too.
Candlestick Chart Setup Results
As you can see it was also a profitable trade, but it took longer and the risk reward ratio is less.
But it did achieve 5 more pips.
So there is pros and cons with both, and it’s down to you which to trade with.
Go test it out and see which suits you more.
Keynotes:
- The neckline is not always a 180 degree straight horizontal line. Sometimes it’s sloped, which is also a good sign.
- The pattern is invalidated if the right shoulder is not symmetrical to the left shoulder. This means if it’s a very slight pullback, and not at a similar level as the left shoulder, then this can make the inverse head and shoulders pattern a poor signal.
Conclusion
I hope that you found the information in this article helpful.
By now, you should have a good understanding of what an inverse head and shoulders pattern is and how to trade it.
I’ve also shared with you some extra tips to ensure you can validate and take full advantage of these chart patterns.
Go and practice them and I know you’ll succeed with them!
And if you want to learn more about the stock market, visit our blog for more trading tips.