The inverse head and shoulders is one of the most common patterns traders use to begin their journeys in the trading world. However, it’s also known that traders with little experience focus on the head and shoulders formation, not its inverse variety. In this FXOpen guide, we will tell you how to spot the inverse head and shoulders formation and build effective strategies.
What Is an Inverse Head and Shoulders Pattern?
The inverse head and shoulders, or inverted H&S pattern, is formed at the end of a downtrend. Is the inverse head and shoulders bullish or bearish? It’s a bullish pattern that predicts a reversal from a down to an uptrend. It’s the opposite of the head and shoulders setup, which appears at the end of an uptrend and signals a coming price decline. Similar to the head and shoulders formation, the inverse consists of two shoulders and a head, but they are reversed.
It’s vital to remember that the inverse head and shoulders pattern can’t appear in an uptrend, and the head and shoulders formation can’t exist in a downtrend.
How to Spot the Inverse Head and Shoulders
To identify this formation on the chart, you need to find a downtrend, which is close to a reversal. To determine whether the trend is becoming weaker, you can use trend strength indicators like ADX. Another sign of a weakening trend is its length. You can identify the average length of a trend on a timeframe you trade and compare it to the one you plan to trade in. Once you find a weakening trend, you can draw the inverse head and shoulders formation.
The price should rebound from a low to form a left shoulder (1). Next time, in the inverse head and shoulders pattern, selling volumes should increase, so the price will break below the previous low and form another one (2). This will be a head. The price should rebound again. In the third attempt, bears will pull the price down but won’t be able to reach the previous low (3), and the price will rebound almost at the same level as the left shoulder. This will be the right shoulder. After it has formed, bulls are likely to push the price above the resistance level. The resistance level, in its turn, is drawn through the peaks between the head and shoulders (4).
The construction is simple – you need to find two troughs at almost the same level with a lower one in between at the end of a downtrend. The pattern can be found on the chart of any asset and of any timeframe; this is why there are inverse head and shoulders stock patterns, as well as those for forex and other markets.
The Inverse Head and Shoulders: Trading Rules
There are some common inverse head and shoulders pattern rules that you can use; however, you can still develop your own trading strategy and try other entry and exit points.
The rules slightly differ for aggressive (risky) and conservative approaches. You can open an FXOpen account to test both approaches.
Entry. In a conservative approach, traders usually open a buy position only after at least a few candlesticks close above the neckline. This helps them limit the risks of a false breakout*. Another option is to use a buy limit order at or slightly below the neckline. It’s very often that the price rebounds to the neckline after a breakout. By placing a buy limit order, traders can reduce the slippage. However, the price may continue to rise without a retracement to the neckline, so a trader will miss a trade.
*A false breakout occurs when bulls don’t have enough strength to push the price further up.
Stop loss. A stop-loss order is placed below the neckline. However, it’s not easy to identify its size. If the level is too close to the resistance point, the trade can be closed early due to a short-term price pullback. If the level is far from the neckline, there is a risk of increased losses in case of an unsuccessful trade.
Therefore, traders usually use a risk/reward ratio of 1:2 or 1:3, depending on the market conditions and the trading approach.
Take profit. An inverse head and shoulders target usually equals the distance between the head and the neckline. A trader can trail the profit target, considering the trend's strength and fundamental factors affecting the price direction.
Entry. In an aggressive approach, traders prefer to enter the market when the price breaks above the neckline; usually, they place a buy stop order above that point. This approach allows traders to open a trade early in a new trend. However, it's risky because of the possibility of a fakeout and increased slippage.
Stop loss. In case of a failed inverse head and shoulders pattern, a stop-loss order is placed according to the same rule as in the conservative approach. However, traders usually consider narrower stop-loss areas because the risk is higher.
Take profit. A take-profit target will equal the distance between the head and the resistance counted from the neckline.
The Inverse Head and Shoulders Pattern: Trading Example
Let’s consider how to trade the inverted head and shoulders in the forex market.
On the daily chart of the EUR/USD pair, the price formed an inverted H&S pattern. A breakout is always followed by an increase in trading volumes. To confirm the price breakout (1), a trader could have used a volume indicator. In the reverse head and shoulders chart above, the volumes rose when the price broke above the neckline (2). However, this wasn’t enough to confirm a trade. A trader could have used a moving average crossover. The 14-day moving average rose above the 21-day MA before the breakout (3). This was a signal of a trend reversal.
Note: Although traders usually use longer-term moving averages on a daily chart, they provide lagging signals and confirm a solid trend direction. Short-term MAs are more sensitive to price fluctuations, so they reflect even short-term movements within a strong trend.
The entry point would have depended on the trader’s approach. The take-profit target would have equalled the distance between the head and the neckline (4). As the trend was strong, the trader could have used a trailing take-profit order and lifted the target. The stop-loss level could have been placed according to the risk/reward ratio and changed accordingly if there had been a trailing take profit.
The Inverse Head and Shoulders Pattern: Limitations
The upside-down head and shoulders formation is an approach that can be used easily by traders with any level of experience. However, it has some limitations that should be considered before entering a live market.
- False breakout. As with other chart patterns whose signals are based on a breakout, you may face a false breakout. To limit the risks, traders commonly use stop-loss orders and confirm breakouts with other trading tools, including volume and trend indicators.
- False trend reversal. Sometimes, the price breaks above the resistance level and moves the distance predetermined by the common H&S rules but turns around. This may happen in a solid long-term trend when the market needs a break.
The inverse head and shoulders pattern is simple, meaning you can spot it on charts of different financial instruments. If you have traded with the head and shoulders formation, you will quickly learn how to use it; however, it’s worth practising before you enter a live market. For this, you can use the TickTrader platform for free.
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