Inverse Head and Shoulders Pattern: A Beginners Guide to Improve Investment Outcomes

Summary

The inverse head and shoulders pattern is a chart pattern that is popularly used by traders as a technical indicator. However, it is important to understand the intricacies of this pattern before venturing into trading. This article aims to provide you with an understanding of this pattern and highlight its key characteristics. 

Today, let's talk about the Inverse Head and Shoulders pattern, a favourite among traders for its reliability.  It will surely be yours too if you follow the steps outlined in this guide. 

So, if you're eager to kickstart your trading journey with the inverse head and shoulders pattern then you’ve come to the right place.

Let's dive right in!

What is an Inverse Head and Shoulders Pattern?

It is the opposite of the head and shoulders pattern. The inverse head and shoulders pattern signals a bearish to bullish trend reversal. This means it gives you an opportunity to seek buying positions as the market forms a bottom and begins its ascent. 

Identifying the Inverse Head and Shoulders Pattern

Let's break down the characteristics of the inverse head and shoulders pattern in the order they occur:

• Left Shoulder: This pattern commences with a downtrend as the asset's price moves lower eventually leading to exhaustion and subsequently rallies upward.
• Head: As prices climb higher, they encounter and rebound from a strong resistance level. Prices then dip, falling to a level even lower than the left shoulder, forming the head. After this, the prices move upward once again.
• Right Shoulder: Prices once again decline at the resistance line, but not as steeply as during the previous downtrend. They then rally once more, shaping the right shoulder, which closely mirrors the depth of the left shoulder.
• Neckline: The resistance line connecting the high points after each shoulder and the head is referred to as the neckline. For the pattern to be confirmed, the price must break through this neckline and close above it.

Things to consider when trading the inverse head and shoulders pattern

Before diving into the key steps, let’s first look at the things to consider while trading using this pattern:

• When it comes to the time frame, it is useful to keep in mind that longer time frames such as daily or weekly charts, often boost the pattern's reliability.
• Volume plays an important role in confirming the validity and strength of an inverse head and shoulders pattern. When the neckline is breached during a breakout, there’s a substantial surge in trading volume as the price surpasses the neckline. This serves as a strong confirmation signal.
• A successful retest of the neckline strengthens the pattern's reliability and confirms a bullish reversal. Additionally, this retest gives you a second chance to get in in case you have missed the first breakout. You can then use a closer stop-loss order to reduce risk.
• Be careful to not make the same mistake made by many traders and assume that the pattern is confirmed as soon as the second shoulder develops. While the pattern does begin to take shape at this stage, its confirmation only occurs when the market closes above the neckline resistance.

So, follow the key steps below to begin trading using this pattern effectively.

Trading using Inverse Head and Shoulders Pattern

When trading always remember to manage risks and protect your capital. Also, it is advisable to use other technical indicators like the RSI or MACD to enhance the reliability of the trading signals.

Now for the fun part - Time to learn to actually profit from this pattern. 

Step 1: Identification and Confirmation

Now that you know how to identify an inverse head and shoulders pattern, you know how crucial it is to identify it and determine when it's confirmed. Also, keep an eye out for increased trading volume during the breakout for added validation.

Step 2: Entry and exit

Trade only when the price breaks above the neckline, preferably one that is accompanied by a substantial trading volume. Begin with a long-position trade. Another option is to enter when the price retraces to test the neckline.

Step 3: Set target price

Calculate the target price by measuring the vertical distance from the neckline to the lowest point of the head. Add this value to the breakout point's distance on the neckline.

Step 4: Mitigate risks 

To manage risks effectively, place a stop-loss order just below the right shoulder or the neckline. Also, gauge the trade's size by considering your risk tolerance and the gap between the entry point and the stop loss.

Exit strategy

Aim to close your position once the price reaches the designated target level or shows signs of a potential reversal. Alternatively, you can employ a trailing stop to secure additional profits while safeguarding your position.

To sum it up

An inverse head and shoulders pattern is basically a reversal pattern. It often occurs after the market has moved downward for a prolonged period. The pattern is made up of four parts - left shoulder, head, right shoulder, and neckline. However, investors should remember that only when the market closes above the neckline resistance, is the pattern confirmed. For more information on such market patterns, investors can choose to consult a financial advisor.