Inverse Head and Shoulders
The Inverse Head and Shoulders pattern or sometimes called the Head and Shoulders bottom is a bullish bottom reversal pattern that according to Bulkowski's (2005) research has an averaged maximum rise of 38%. The head and shoulders pattern consists of three "V" bottom, with the first and third bottoms being roughly equal in height and the second or middle bottom being lower than the first and third bottoms. An inverse head and shoulder pattern has two peaks that are high prices between the first shoulder bottom and the middle head bottom and the middle head bottom and the last shoulder bottom.
Upward Sloping Neckline
A line drawn between the two peak highs is called the neckline. There are three variations of the inverted head and shoulders pattern as it relates to this neckline: First, if the second peak is higher than the first peak, it is an upward sloping neckline.
Downward Sloping Neckline
Second, if the second peak is lower than the first peak, then it is a downward sloping neckline; and third and most rarely, when both peak highs are even in price it is a horizontal neckline.
Psychology of Inverse Head and Shoulders Pattern
The psychology of the inverse head and shoulders pattern is explained next: The head and shoulder bottom pattern occurs during a downtrend, with the left shoulder being an additional lower low for the downtrend. The first peak after the left shoulder is just another expected short-term retracement up in a downtrend. From there prices continue moving downward and make yet another lower low (creating the head). So far the inverse head and shoulders pattern is not a head and shoulders pattern at all; it is just a lower low, with a short retracement upward and a second lower low in a downtrend. However, problems begin to arise either at the second retracement peak or the right shoulder bottom.
For an upward sloping neckline, the second peak created by the retracement after the head's lower low is far higher than expected. Since the second peak is a higher high and one definition of a downtrend states that prices make lower lows and lower highs, technically the downtrend is over and a new uptrend could be beginning. The right shoulder bottom being higher than the head bottom confirms the potential end of the downtrend because now there is a higher high and a higher low, one of the main definitions of an uptrend.
However, for downward sloping neckline inverse head and shoulders pattern, the second peak created by a retracement up from the head bottom is still a lower high and suggests that the downtrend is still intact. Not until the right shoulder fails to make a lower low do traders begin to worry. When the neckline is broken above on a downward sloping neckline on the inverse head and shoulders pattern, essentially the downward sloping resistance line of the prior downtrend has been broken.
Buy Signal and Price Targets
Kirkpatrick and Dahlquist (2010) state that prices breaking through the neckline trigger the buy signal but warn never to trade in anticipation of the neckline breaking signal because the "risk of failure is too great"; they also suggest a price target as the height of the pattern (high price of the highest of the two peaks minus the low of the head bottom) added to the breakout price (p. 329). However, Bulkowski (2008) suggests a smaller price target:
Traits that Increase the Inverted Head and Shoulders Pattern's Effectiveness
Traits of the inverted head and shoulders pattern that increase its profitability (Bulkowski, 2008):
- Larger the price decrease prior to pattern, greater the price reversal
- Patterns with downward sloping lines perform best
- Patterns with upward sloping lines perform best
- Higher left shoulder than right increases performance
Complex Inverted Head and Shoulders Pattern
A variation on the inverse head and shoulders pattern is the complex inverse head and shoulders pattern. Essentially, there are multiple left and/or right shoulders and/or multiple heads as opposed to just one left shoulder, one right shoulder, and one head.
In addition, the opposite of the inverse head and shoulders pattern is the head & shoulders pattern which is a bottom reversal pattern.
Inverse Head and Shoulders Chart Example (Downward Sloping Neckline)
The chart above of the Gold ETF (GLD) shows an inverted head and shoulders pattern with a downward sloping neckline. All the gaps are mainly because the Gold futures contract trades 24 hours whereas the chart above of GLD trades during regular Wall Street hours. Notice that the first four important pivot prices of an inverse head and shoulders pattern: the left shoulder – a new low, the first retracement peak – a lower low, the head – another lower low, and the second retracement peak – another lower high correspond to a continuation of the downtrend. Only when the right shoulder creates a higher low, has any signal been given by the market that the downtrend has ended. Once prices penetrate past the upside resistance neckline, then a second signal has been given, that the next high is a higher high rather than a lower high as the prior two retracement peaks were.
Inverse Head and Shoulders Chart Example (Upward Sloping Neckline)
The chart example above of the Russell 2000 ETF (IWM) shows an inverted head and shoulders bottoming pattern with an upward sloping neckline. This chart shows a downtrend with lower highs and lower lows. The left shoulder makes another new low and the first retracement peak is a lower high. Thus far the downtrend is intact. Prices move lower making yet another new low (the head). The trend still has not changed to positive, even though the inverse head and shoulders pattern is halfway complete. Only when the retracement above the head's lowest low creates a peak that is higher than the first peak does a warning signal go off that the downtrend is in trouble. A higher low (the right shoulder) confirms that the downtrend is in trouble because now there is a higher high and a higher low – one of the definitions of an uptrend. Once prices break above the neckline resistance area, a buy signal is given and prices rise.
Inverse Head and Shoulders Chart Example (Horizontal Neckline)
The chart above of the Energy SPDR ETF shows an inverse head and shoulders pattern with a horizontal neckline where the retracement peaks between the shoulders and head are both equal.
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