Technical Analysis: Inverse Head & Shoulders Pattern

Last update - 29 August 2019 By Rivkin

An inverse head and shoulders reversal pattern are perhaps one of the most well observed patterns in technical analysis. As the name suggests, the pattern resembles that of a person’s upside down bust with the head of the pattern surrounded by adjacent shoulders on each side a valid formation signals the high probability of a reversal.

The pattern is comprised of three distinct valleys, each of which forms a shoulder or head of the pattern which are connected by two horizontal trend lines. Firstly to identify this pattern we need to locate an downtrend, following which the three valleys form with the middle valley bottoming below the two on either side (shoulders). These three valleys and two peaks (peaks between valleys) should be well-defined minor highs and lows.

There is generally a very clear symmetry to the pattern, with the left and right shoulders being similar distances from the head (middle valley) and both side valleys (shoulders) also forming near the same price (connected by a horizontal trend line). As with most patterns we tend to find that volume recedes as the pattern forms however this is a general rule of thumb. Finally the two armpits (peaks) also top around the same level and are connected by a second horizontal trend line which is used as confirmation of the pattern once the price closes above this level.

The chart below shows the ASX200 index which has formed a large inverse head and shoulders pattern. Following a strong downtrend from April 2015 the price reaches a low in September at 4,918 (1) before bouncing sharply higher over the next month. The price pushes to a high of 5,384 in October (2) at which point traders holding long positions see this as a good opportunity to exit any long positions while some traders will look to initiate short positions hoping for a continuation of the downtrend. This selling pressure managed to push the price to a new low in February 2016 at 4,706 (3) at which point buyers step in seeing this new low as a bargain while short sellers may look to cover their positions.

This new buying momentum pushes the price higher once again to form the right hand shoulder in May at 5,425 (4) until selling pressure emerges once again as targets are reached. This time the selling pressure is not sufficient to push the price to a new low and it only goes down to 5,051 in June (5) at which point traders recognise the downtrend is ending. Short sellers will look to cover their positions while buyers will enter hoping for a continuation as dips are quickly bought. The pattern is confirmed as valid at (6) when the price closes above the neckline and looks set to reverse the downtrend from April 2015.

The psychology behind this pattern is the struggle to buy at the lowest possible price, following the initial decline into the pattern a price target is reached where buyers see a bargain thinking the downtrend is overdone and are able to push the price higher initially before sellers emerge looking to enter short positions and traders who had bought previous look to exit long positions at the best possible price to minimise losses. This then drives the price lower to the middle valley or head of the pattern, where another short seller price target is reached and buyers emerge again seeing this as an ever better bargain and pushing the price higher.

Short sellers view this rally as another opportunity to enter new short positions hoping for a continuation of the prior downtrend and buyers who bought at the head of the pattern look to take profit. While this manages to drive the price lower the pressure is not strong enough and it does not go to a new low. This encourages buyers to enter long positions and short sellers to cover short positions and this forms a higher low on the right hand side of the pattern (right shoulder). Sensing the downtrend has now run out of momentum, bulls become even more eager driving the price higher until it breaks above the neckline and confirms the pattern.

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