Key Questions Answered
- The inverse head and shoulders chart pattern can help you time the bottom of a downtrend and buy into an asset at the perfect time.
- There are three parts of the inverse head and shoulders: Left shoulder, Head, and Right shoulder
- One way to identify a buy signal’s strength is to observe how long it took for the inverse head and shoulders pattern to form. A smaller inverse head and shoulders pattern may not be sufficient, especially when preceded by a long downtrend.
In stock or cryptocurrency trading, you may have heard of the term “inverse head and shoulders.” Also known as the “head and shoulders bottom” formation, the inverse head and shoulders chart pattern can help you time the bottom of a downtrend and buy into an asset at the perfect time. This is part of technical analysis, which relies on studying recent price patterns to predict future market movements. Methods like this help not only traders looking to make quick gains, but also value investors seeking long-term growth assets.
What Is the Inverse Head and Shoulders Pattern?
An inverse head and shoulders pattern is the inverted version of a standard head and shoulders pattern.
What is a standard head and shoulders patterns?
A standard head and shoulders pattern features three peaks, with the first and third peaks being close in height and the middle peak being the highest. The two external peaks are respectively called the left shoulder and right shoulder, while the middle peak is called the head. They are connected by the market support level which forms the neckline. This pattern is used to predict a bullish-to-bearish trend reversal.
What is the inverse head and shoulders patterns?
The inverse head and shoulders pattern is the reverse. It consists of three troughs, with the external two troughs being close in height and the middle trough being the deepest. The market resistance level forms the neckline. An inverse head and shoulders pattern signals a bearish-to-bullish reversal.
An inverse head and shoulders pattern (Source: The Balance)
How to read the Inverse Head and Shoulders Chart Pattern?
Here’s how to break down the inverse head and shoulders pattern:
1. The Left Shoulder
This indicates that there is a sell signal and the market is bearish. The price falls due to aggressive selling, but then recovers due to buying pressure, thus forming a trough.
The market continues to be bearish. Sellers push the price aggressively downwards, as they believe that the price will continue to decrease. Eventually, they are unable to push the price any lower as buyers aggressively drive the price upwards towards recovery once more. This forms the second, deeper trough.
3. Right shoulder
The price dips once more as sellers continue to drive the price down. However, they are unable to push the price down as much as they did in the second trough. Aggressive buyers drive the price up once more to the neckline, while sellers become more passive. The price eventually breaks through the neckline. This signals that the buyers are in control and that the downtrend is being reversed.
A complementing indicator is that buying volume will likely spike towards the end of the pattern as sellers become more passive and buyers become more aggressive. This can sometimes signal an upcoming bearish-to-bullish market reversal even before the price breaks through the neckline.
Example of an Inverse Head and Shoulders Pattern
Let’s look at a few examples of how an inverse head and shoulders pattern may look on a real-life chart.
A real-life example of an Inverse Head and Shoulders Pattern in traditional stock market
One such example is the Aurobindo Pharma (AUROPHARMA) stock. In March 2018, the stock price dropped from about $625 to $544 and then rebounded to $623 in April 2018. This formed the left shoulder of the chart pattern.
The price was then pushed downwards to an even lower dip at $526, forming the lowest point of the head. Eventually, the market recovered, and the price hit the neckline at $630.
This is followed by the last trough, which consists of a final smaller dip to $565. Finally, the stock price breaks through the neckline slightly at $635.
A real-life example of an Inverse Head and Shoulders Pattern in the crypto markets
Another example of an inverse head and shoulders chart pattern can be seen recently from the Bitcoin market. In May 2021, the cryptocurrency’s price dropped from about $57,500 to below $54,000, forming a small left shoulder. It then recovered to about $57,000.
Following that, Bitcoin’s price dipped to a deeper trough of $48,000, with plenty of volatile fluctuations along the way as bears and bulls fought for control over the market. The price then rose to about $55,000 again, before dipping to $53,000, forming the right shoulder. Finally, the price broke through the neckline, completing the inverse head and shoulders chart pattern.
As seen from this example, real-life inverse head and shoulders patterns may not always follow the textbook version. Bitcoin’s price fluctuated heavily even while it was forming the chart pattern, instead of having straightforward dips or rises. There was also a pullback after the initial break through the neckline. This is why it’s important to study the wider context and trends of the market, and hone your acumen on whether to enter a trade.
How Can I Trade the Inverse Head and Shoulders Pattern?
There are three main approaches you can follow when using the inverse head and shoulders pattern:
The conservative approach
The most conservative strategy would be to wait for the price to close above the neckline after the right shoulder. This can be taken as validation that the price has now broken through the neckline and will likely continue to rise. At this point, the trader can set a buy order when the market next opens. The downside to this is that the trader may wind up paying more for the asset than if they had set an earlier buy order.
The slightly-less-conservative approach
Set a buy order at a slightly lower price than the neckline, banking on the assumption that there will be a pullback after the initial breakthrough. With this strategy, traders can monitor whether the pullback stops and the price continues in a general uptrend, instead of jumping into the trade immediately. However, such conservative traders risk missing the trade if the price only moves in the breakout direction and does not hit their buy order price.
The aggressive approach
Simply set the buy order just above the neckline. This means that once the price breaks through the neckline, traders will enter the trade and quickly ride the uptrend. This is a riskier strategy, as the rise may not turn out to be a true breakthrough. In some cases, it is only a false buy signal and the price will quickly dip again.
How to Identify a Strong Buy Signal with the Inverse Head and Shoulders Pattern?
As mentioned, there can be false buy signals from an inverse head and shoulders pattern. One way to identify a buy signal’s strength is to observe how long it took for the inverse head and shoulders pattern to form. Some experts state that it’s best if the pattern takes more than 100 bars to form. Alternatively, you can simply look at the time period. The pattern should play out over a span of time with significant build-up. A smaller inverse head and shoulders pattern may not be sufficient, especially when preceded by a long downtrend.
As mentioned above, it is also a good sign if buying volume increases, showing that buyers are in control of the market.
How to Set Your Profit Targets
We have established that an inverse head and shoulders pattern signals an impending uptrend. But how much can we expect the price to increase?
Profit Target Calculations
A common estimate is to take the price difference between the high point of the head (either after the left shoulder or before the right shoulder), and the low point of the head. Then, add this to the current breakout price to get the ideal profit target. In other words:
High point of head – Low point of head + Breakout price = Profit target
For example, consider a hypothetical cryptocurrency for which the breakout price is $120, the price of the high point after the left shoulder is $115, and the low point of the head is $70.
You can use $115 – $70 + $120 to get the profit target of $165. This means that you expect a $45 increase in price from the breakout point.
Pros and Cons of Using the Inverse Head and Shoulders Pattern to Trade
Trading always comes with its share of risks and rewards. A good trader carefully monitors the situation for a long time before deciding to make a trade. Chart patterns take time to form, and as mentioned above, it’s safest to observe the pattern over a longer span.
Pro: The inverse head and shoulders pattern is fairly reliable in predicting a trend reversal
One of the main pros of using the inverse head and shoulders pattern is that it’s considered by traders to be fairly reliable in predicting a trend reversal. It is a classic pattern often seen in both stock and cryptocurrency markets. In addition, you can profit massively if your analysis is accurate and the markets move the way you predicted.
Con: It happens in an overall downtrend
However, a potential con is that by nature, an inverse head and shoulders happens in an overall downtrend. This means that there’s a high probability the downtrend will simply continue. If you act on a false buy signal, you will face a continuous downtrend with very little opportunity for capital recovery.
Technical analysis is a good way to examine and predict market movements, and chart patterns are an important part of technical analysis. The inverse head and shoulders pattern is one of many chart patterns you can use to inform your trading decisions. However, it is essential to take note of wider trends and market context before entering the trade. Over time, as you hone your knowledge and experience in trading, your chances of profiting will improve.