How to Trade Inverse Head and Shoulders

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Contributor, Benzinga
October 31, 2023

According to the century-old Dow Theory, the trend in the price movement persists until a reversal occurs. Since those tops and bottoms mark a maximal point of success between the trends, it is easy to see how they present the siren’s call for traders who try to catch them.

Still, reversal chart patterns do exist, and this article will explain inverse head and shoulders — arguably the most popular reversal forex pattern.

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What is the Inverse Head and Shoulders?

The inverse head and shoulders pattern is a bullish reversal forex chart pattern. These patterns are graphical formations appearing on charts, giving clear indications for entry, profit and stop-loss placements.

They’re fractal because they’re equally as actionable on any time frame, and they can be either bullish or bearish.

What Does an Inverse Head and Shoulders Indicate?

The inverse head and shoulders pattern indicates that the market might be bottoming after a prolonged downturn. Along with a double-bottom pattern, it is arguably the most popular reversal pattern.

An inverse pattern indicates that the trend has been exhausted. In this case, the price is struggling to break into new lows, and by making a higher low, it indicates it is ready for a reversal.

Identifying the Inverse Head and Shoulders Pattern

The inverse head and shoulder pattern appears when the price declines but subsequently rallies to resistance before declining again and establishing a new low.

This process forms the three key components of the pattern: left shoulder, head and neckline.

Eventually, the price declines again but fails to reach the previous low, establishing a higher low — or the right shoulder of the pattern. This pattern is one of the more visually appealing patterns, and novice traders learn to identify it quickly.

How Do You Trade an Inverse Head and Shoulders Pattern?

One of the greatest virtues any trader can have is patience. Regardless of the time frame, the head and shoulders pattern takes time to form so it might take a while between spotting and trading it.

The key information about any head and shoulders pattern is the height between the neckline and the peak because this gives the trader a take-profit projection point. Many traders use the height of the right shoulder as a stop-loss measure. Depending on the market structure, it can be smaller, but it should always be at least 10% of the average true range (ATR).

Trading Aggressively

An aggressive inverse head and shoulders entry would take the trade immediately after the neckline break.

Inverse head & shoulders, GBP AUD 15-min chart, Source: TradingView

The chart above has all the conditions for a proper reversal pattern. The price is in a strong downtrend that eventually starts fading. It puts a clear lower low in place and then fails to make it, creating a higher low.

An aggressive entry would enter immediately upon the price’s closure above the neckline, with a stop loss below the right shoulder and a take profit target equal to the height of the formation.

This higher-risk approach sometimes results in fake breakouts stopping the trader out. Aggressive traders should pay attention to the breakout volume because the proper breakout should have above-average volume.

Trading Conservatively

A conservative entry will always have a lower risk but a lower strike rate —  it will not always present itself. In the example above, a low-risk entry is on the pullback to the neckline once the price already tags the 1.71800 level.

Along with a lower number of opportunities, a conservative entry will have a worse risk-reward ratio since an average entry will usually be closer to the take-profit level. Still, it might be worth it for traders with larger accounts who want to take only the best opportunities.

Inverse Head and Shoulders vs. Head and Shoulders

Head and shoulders patterns can be either normal or inverse, but they serve the same purpose — to signal a potential reversal in the market.

Regular head and shoulders patterns appear after a prolonged bullish run with the neckline acting as a support, not resistance. Compared to an inverse pattern, its head is not a lower low but a higher high.

Otherwise, it trades like the regular pattern with recommended stop loss above the right shoulder and takes a profit target equal to the distance between the neckline and the peak.

A Battle-tested Pattern

Head and shoulders, either in its normal or an inverted form, is unquestionably one of the most popular chart patterns. It is simple, reliable and actionable.

It takes some time to form, so it leaves traders plenty of time to prepare for entry and plan for the exit because it gives clear guidelines and, most importantly, avoids ambiguity.

Although very popular, this pattern can still fail about 20% of the time. Traders should refrain from overcommitting to a single opportunity and follow a sound risk-management plan.

Frequently Asked Questions 

Q

Is inverse head and shoulder bullish?

A

Inverse head and shoulder is a bullish pattern. It is a reversal pattern that indicates a high probability of a market turnaround and is the exact opposite of the classic head and shoulders pattern.

Q

Why is head and shoulders so effective?

A

Head and shoulders pattern is one of the most reliable patterns. Statistically, it works about 83% of the time for a proper setup. It shows an exhaustion of the trend, giving a clear horizontal level that, once broken, provides a trading setup.

Q

What invalidates a head and shoulders pattern?

A

Head and shoulders pattern needs to have two highs and a higher high in between them. For an inverse head and shoulders pattern, it is two lows with a lower low in between.

If the price rises above the higher high or falls below the lower low before breaking the neckline, then the pattern is invalid, and it shouldn’t be traded upon the future break of the neckline.