Trading the Inverse Head-and-Shoulders Pattern

Chart depicting the share price of SCHW.

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.

Key Takeaways

  • The inverse head-and-shoulders pattern is a common downward trend reversal indicator.
  • You can enter a long position when the price moves above the neck, and set a stop-loss at the low point of the right shoulder.
  • The height of the pattern plus the breakout price should be your target price using this indicator.

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 moves back 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: the left shoulder, head, and right shoulder.

Inverse head and shoulders
Inverse head and shoulders.

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) below the right shoulder's low point.

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 (it's too high). In that case, buy or enter long when the price moves above the high of the second retracement (between the head and right shoulder).

inverse head and shoulders chart pattern - ES one minute chart
Inverse Head and Shoulders Chart Pattern - ES One Minute Chart. Thinkorswim

You also can 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. That gives you the height of the pattern.

For example, if the head's low 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 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 pattern's height 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.

Frequently Asked Questions (FAQs)

What happens after the head and shoulders pattern completes?

The head and shoulders pattern typically marks a reversal on a longer-term timeline. Therefore, after the pattern has played out and followed through, it might be expected to continue trending in the direction of the follow-through. For example, an inverse head-and-shoulders pattern can mark the bottom of a crash before the price resumes an uptrend. A regular head-and-shoulders pattern, on the other hand, can mark the top of a bull run before a bear market starts.

When is a head and shoulders pattern invalidated?

If the right shoulder is formed and then broken before the neckline breaks, that invalidates the head-and-shoulders pattern. That's why, in the example above, the stop-loss order is placed just below the right shoulder. If the price rises from the right-shoulder support line, approaches the neckline, but is rejected before crossing the neckline, and breaks back down below the right shoulder, the inverse head-and-shoulders pattern won't be a viable play anymore.

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