Inverse Head & Shoulders: Definition & How to Trade

inverse head and shoulders

Among the hundreds of technical indicators and tools, some of the best performers are patterns and shapes that form on a chart. The great thing about patterns is that they are visually recognizable straight from the chart at a glance. These features apply to the inverse head and shoulders pattern.

Patterns of any type are not conclusive on their own and should preferably be used with other technical indicators such as RSI, MACD, or ADX. However, some patterns offer an extremely reliable prediction tool for the next price trend or direction.

The inverse head and shoulders pattern is one of the few patterns that has a high degree of accuracy. The pattern marks the end of a downtrend. The longer the asset has traded downwards the more likely this pattern indicates a trend reversal. At other points in the downtrend, the pattern may simply indicate a price retracement.

The inverse head and shoulders pattern is useful to swing traders and trend traders in particular, but also has its application for day traders

Let’s have a closer look at how to recognize this pattern and how to trade it.

Inverse Head & Shoulders Pattern

Recognize the Pattern

First of all, we need to know how to define and determine an inverse head and shoulders pattern straight from the chart. The pattern is the same as the head and shoulders pattern but upside down. This actually makes things a little more complicated.

After all, we are used to seeing someone’s head and shoulders the right way round. From left to right a shoulder, the head slightly higher, and a shoulder slightly lower. That configuration is something that is easy to recognize as we can assimilate it to real life.

To spot an inverse head and shoulders you must turn the above picture upside down. Now the shoulder on the left is higher than the head, and the next shoulder is also higher. Below is a diagram to show what an inverse head and shoulders looks like in a stylized manner.

inverse head and shoulders

The Neckline

In the diagram above you can see how each shoulder is higher than the head. However, for you to consider the inverse head and shoulders pattern as successful, some features must be respected. 

Each time price retraces from the shoulder low to a new temporary high, these highs must be subsequently lower. We can see that in the picture of the inverse head and shoulders the pattern was successful. The black trend line shows how each retracement was lower than the previous one. 

This characteristic gives the pattern what is known as a neckline, as represented by the black line. The neckline must appear as a downward sloping line for the inverse head and shoulders pattern to be considered valid.

Also, the second shoulder on the right of the diagram should be lower than the first shoulder. This gives a downward slope to the lows of the shoulders. Without the two features mentioned above, the pattern you may see on the chart is not an inverse head and shoulders, although it may seem similar. 

Inverse Head & Shoulders Breakout

This is when you get the buy signal. When the price of the market closes above the neckline, it’s called a breakout. This means that the following price action is likely to rally upwards. Notice I specified “market closes”, this is important because the market may attempt a breakout but fail. 

The failed attempt may lead to further downward price action before a successful breakout is completed. Or the failed attempt to break the neckline may lead to other chart patterns that invalidate the inverse head and shoulders.

The diagram below shows a stylization of the concept of breakout. The red line shows price action breaking through the neckline, indicating further upward price action may follow.

inverse head and shoulders breakout

Once the market closes above the neckline you may want to consider taking a long position. However, also analyze other metrics to determine if the market may be running into an overbought area. Or if other trend indicators are also signaling a possible reversal in price action to consolidate the breakout.

Consider how many bars or candles it took the pattern to establish itself. The more candles in the pattern the more significant the breakout signal. With a higher number of bars in the pattern, you might have a deeper through from the neckline to the bottom of the head.

This is the height of the inverse head and shoulders pattern and is important in determining how profitable your trade might be. We will see a bit more on this later.

How to Trade Inverse Head & Shoulders

Just to be clear, the fact that price action closes above the neckline, and you have a valid buy signal, does not mean that you automatically have a winning trade. Risk management always needs to be applied, on every trade, and on the inverse head and shoulders breakout too.

We have already explained the parameters for entry, now we can have a look at the parameters for a winning trade and a losing trade. 

Target Profit 

The target profit price is potentially the distance between the low of the head and the neckline, plus the breakout price. The chart below shows a vertical green arrow from the bottom of the head to the neckline. You can then place this arrow on the neckline, where the breakout occurs. You now have your profit target price.

inverse head and shoulders profit target

Notice that your target price will be higher, giving you a potentially more profitable deal, when the trough from the neckline to the bottom of the head is deeper. If the green arrow, which illustrates the height of the inverse head and shoulders pattern is small, your potential profit target is also small. 

Remember, that if after 20 bars the market price has not reached the profit target you may need to start thinking of another exit strategy. Also, be aware of any other patterns that may have formed in the meantime. 

If another pattern has formed before the market price reached the target profit, then the signal from the inverse head and shoulders is no longer valid. Check that other trend indicators you may use are also still in line with the position. 

Stop Loss

The stop loss on this type of trade is just below the right shoulder. Some traders use the bottom of the head. However, that area may be a lot lower, and more expensive if you are stopped. That would be the case especially if the inverse head and shoulders has a very large height.

inverse head and shoulders stop loss

The diagram above shows how a possible breakout of the pattern occurred, and presumably got you into a trade long of the market. However, the market price then turns south before reaching your profit target.

As with all trades, risk management will define how much you can lose on a trade. The green dotted line below the neckline determines the stop price. If the trade goes wrong, and you defined your stop loss at the market entry, you won’t lose more money than planned. 

Failed Inverse Head & Shoulders

The diagram below shows a stylized version of a failed head and shoulders pattern. The market price moves towards the neckline but fails to break above it. The price then heads south and goes lower than the right shoulder. Once the market price has closed below the right shoulder you have confirmation that the pattern has failed.

inverse head and shoulders failure

Risk & Reward

Before setting up your trade you need to establish if the reward outweighs the risk. Traders use varying risk-reward ratios, let’s use a simple 2:1. The ratio establishes that you want to potentially make twice the amount you could potentially lose.

Bearing this in mind, you should measure the height of the inverse head and shoulders to compare it to the height between the right shoulder and the neckline. The height between that head and the neckline should be at least twice that of the height of the right shoulder to the neckline. If the head is too close to the neckline, your ratio might be lower than 2:1.

You might be absolutely convinced it is the right timing to enter the market long, and that the price will increase from the current levels. However, you should not use the parameters dictated by the inverse head and shoulders in the above case. In this case, you should look for another strategy to define your exit point as the pattern does not give you the ratio you predefined.

Chart Time Frame

As with all technical tools and indicators the longer the time frame the more accurate the indicator or tool. You may spot an inverse head and shoulders on any time frame, including a 5-minute candle chart, for example.

However, the inverse head and shoulders pattern takes many bars to complete. Whereas the validity of the pattern is for 10 to 20 bars following the breakout. If you are using this pattern on a 5-minute chart, the price of the market will rarely move that much in 50 to 100 minutes.

While the market price can move considerably over 10 to 20 days. A larger price movement after the breakout gives your trade a higher chance of making money and gives you a better risk-reward ratio. It makes more sense to use this pattern on a day chart for the above reason and to have a chance of offsetting the risk you must necessarily take when putting on the trade.

Strategy Summary

The inverse head and shoulders pattern indicates that the downward price trend may have come to an end. It may indicate a trend reversal, usually when the downtrend has extended itself for a long period. Or it may indicate that the market price is about to pause its downtrend and retrace higher.

You can assume a buy signal from the pattern when the last bar closes above the downward sloping neckline. The profit target price is the height between the low of the head and the neckline plus the breakout price. While your stop loss price is just below the low of the right shoulder.

Wrapping Up

Traders use the inverse head and shoulders pattern profitably when they consider all aspects thoroughly. Together with other technical indicators, the pattern has shown a reliable track record. However, trading can be a complicated business with a steep and costly learning curve. 

You can get some help from various firms that specialize in providing signals to improve your win/loss ratio. They can also help when it comes to trading education. And having some experts on your side can be the trick to successful and profitable trading. You can check out our reviews on the top stock trading newsletters here. 

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