Contrary to the head and shoulders pattern, the inverse head and shoulders pattern occurs after an extended move down. It represents a possible exhaustion point in the market, where traders can begin to look for buying opportunities as the market establishes a bottom and starts to climb higher.
To kick things off, let’s take a look at the characteristics of an inverse head and shoulders pattern.
The illustration above shows the five characteristics of an inverse head and shoulders pattern. In order of occurrence, those characteristics are:
The inverse head and shoulders pattern begins with a downtrend. This is the extended move down that eventually leads to exhaustion and a reversal higher as sellers exit and buyers step up. That downtrend is met by minor support, which forms the first shoulder. As the market begins to move higher, it bounces off of strong resistance and the downtrend resumes. This resistance level forms what is called the neckline.
After the market makes a lower low, it finds strong support which forms the head of the pattern. The market finds resistance at the neckline once more, which forms the second shoulder. At this point the inverse head and shoulders is taking shape but the pattern isn’t confirmed just yet.
One area where a lot of traders go wrong is thinking that the pattern is confirmed as soon as the second shoulder forms. Although the pattern begins taking shape at this stage, it isn’t confirmed until the market closes above neckline resistance.
A close on which time frame, you ask?
That depends on the time frame that is best respecting neckline resistance. The example we’ll get to shortly shows an inverse head and shoulders that formed on the 4 hour chart. In that case, we would need to see a 4 hour close above the neckline.
The illustration below shows the point at which the pattern is confirmed.
Notice how the market is now trading back above the neckline. This break and close confirms the inverse head and shoulders pattern and also signals a breakout opportunity.
Note: The break of the neckline is only confirmed on a closing basis. So if the pattern forms on a 4 hour chart, you would need to wait for a 4 hour close above the neckline in order for it to become a tradable pattern.
Now that you have a good understanding of the characteristics that form an inverse head and shoulders, let’s see how this pattern looks on a price chart.
The AUDUSD chart above shows an inverse head and shoulders pattern that formed on the 4 hour chart. The pattern has a clear head and neckline as well as two shoulders.
You can see that the first shoulder has a steeper rise back to the neckline than the second shoulder. This is okay. In fact most times these patterns will not be perfectly symmetrical.
Based on the chart above, at what point was the inverse head and shoulders confirmed? See if you can identify the exact 4 hour candle before moving on to the next section.
The first 4 hour close above the neckline confirmed the pattern. As soon as this candle closed, the pattern was confirmed and we could therefore begin watching for buying opportunities.
Now it’s time for the really fun part – how to trade (and profit) from this pattern. But before we do that, let’s recap what we’ve covered thus far.
So far you’ve learned the five characteristics of the inverse head and shoulders. You know how to identify the pattern as well as how to determine when the pattern is confirmed. Now let me turn your attention to how you can actually profit from this pattern.
There are two schools of thought when it comes to trading the inverse head and shoulders. The first says to use a buy stop order just above the neckline. The idea here is to catch the market as it breaks through neckline resistance.
The problem with this approach is that there is an increased likelihood that you will experience a false break. By using a buy stop order above the neckline, you aren’t waiting for the market to close above resistance. This close is extremely important as it is what confirms the pattern. Without it, the pattern is untradable.
Without waiting for the close it’s possible for the market to spike above the neckline, trigger your buy order, and then settle back below the neckline without ever closing above it. Now you have a losing position right from the start.
The second school of thought, and the one I use and teach, is to wait for a close above the neckline. This ensures that the rest of the market is on-board with the breakout, which means you are less likely to experience a false break.
When using this approach, you have two options as to how and where you will enter the market. The chart below shows both entry strategies.
The first option in the chart above illustrates what would be a market buy order as soon as the 4 hour candle closes.
Why the 4 hour time frame? Remember that it’s all about which time frame is respecting our key level. In this case it’s the 4 hour chart.
The second, and preferable, entry strategy shows a pending buy order on a retest of the broken neckline as new support. Remember, “trading 101” says that old resistance becomes new support and vice versa, and that’s exactly what happened in the AUDUSD chart above.
Measured objectives are one of my favorite ways to identify profit targets. But as much as I like them, they pale in comparison to using simple support and resistance levels. Which is why I’d like to start this last section by saying that you should always think of a measured objective as a guide and never a rule.
This method for finding profit targets can be extremely effective, but it isn’t without flaw. Nor should it be used in place of key technical levels. Instead it should be used in combination with key support and resistance levels.
With that out of the way, let’s get into how to identify a profit target using a measured objective.
The first thing to understand is that there is a difference between the measured objective and what’s called the measured move. A measured move is simply the distance a market travels to reach the objective.
So how exactly do we find this objective? Let’s take a look…
Notice in the chart above, the distance from the head to the neckline is 175 pips. Once we know this distance, we simply project 175 pips above the neckline to find the objective.
In the case of the AUDUSD 4 hour setup above, the market moved 200 pips higher after confirming the inverse head and shoulders. This would have made a take profit set at 175 pips above the neckline the ideal place to book profits.
Although using a measured objective can be quite accurate, it should never be used alone. The best way to identify a profit target is by combining a measured objective with simple support and resistance. Only then can you be sure a profit target is accurate.
We have covered a lot of material in this lesson. To wrap things up, let’s recap some of the more important points for you to keep in mind when trading the inverse head and shoulders pattern.
The very first thing to remember about it is that it is a reversal pattern. It often occurs after the market has made an extended move down. It signals a point in the market where buyers may begin to outweigh sellers and thus push prices higher.
The pattern is made up of five parts:
Remember that the pattern can only be confirmed once the market makes a close above neckline resistance. The time frame required for this close depends on which time frame is best respecting the neckline. In the AUDUSD example above, the 4 hour chart was respecting the level and also displayed the most accurate rendition of the pattern, therefore we needed a 4 hour close above the neckline to confirm the pattern.
One method of finding a profit target is to use a measured objective. To find the objective, you simple measure the distance in pips from the head to the neckline. You then project that same distance from the neckline to a higher point in the market. The measured move, on the other hand, represents the distance traveled from the neckline to the objective.
Although a measured objective can be a great way to identify a profit target, it isn’t the only way. Nor should it be used alone. The very best way to identify a profit target for an inverse head and shoulders pattern is through the combined use of a measured objective along with key support and resistance levels.