What is an inverse head and shoulders pattern, and how does it work?
What is an inverse head and shoulders pattern?
An inverse head and shoulders is a trading chart pattern that can signal a bullish reversal after a sustained downtrend. It forms when price action creates three consecutive troughs: a lower low termed the 'head', flanked by two higher lows ('shoulders'), with each low separated by short-term rallies. The highs between these troughs form a horizontal resistance level called the ‘neckline’.
In technical analysis, this pattern serves as an early signal that selling pressure may be diminishing and buying interest could be emerging. The psychology behind the setup reflects seller exhaustion at new lows, followed by increasing buyer interest as the pattern develops.
The pattern is complete when the price breaks above the neckline, which may indicate a shift in market sentiment from bearish to bullish, followed by sustained upward price action.
Past performance isn’t a reliable indicator of future results.
How do you identify an inverse head and shoulders on a chart?
To spot an inverse head and shoulders, look for a distinct sequence of price movements that create a recognisable pattern on your chart:
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Preceding downtrend – seek a preceding bear market, with a sustained downtrend. This establishes the context for a potential bullish reversal.
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Three troughs – identify three visually distinct swing lows within a downtrend. The first forms the left shoulder, the second is the head (the lowest point), and the third is the right shoulder, typically higher than the head and approximately in line with the left shoulder.
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Neckline – draw a horizontal or gently sloping neckline by connecting the swing highs between the shoulders and head. This acts as a potential area of resistance while the pattern develops.
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Head – a low trough should drop lower than either the left or the right shoulder, which it sits between, making the pattern easy to distinguish at a glance.
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Breakout (and confirmation) – the inverse head and shoulders is considered complete when price closes decisively above the neckline. This breakout is often used as a potential entry signal, sometimes accompanied by rising volume.
Is the inverse head and shoulders pattern bullish or bearish?
An inverse head and shoulders pattern is viewed as a bullish reversal setup that forms after a downtrend, signalling that selling pressure may be fading and buyers might be starting to regain control. A line is drawn across the swing highs between the shoulders and head (the ‘neckline’) which acts as resistance while the pattern develops.
A break above this neckline – ideally on increased volume – helps to confirm the potential bullish reversal and suggests that buyers are confident enough to propel the price beyond recent highs, indicating the potential start of a new uptrend.
Learn more about technical analysis with our 12 chart patterns for traders article.
How to trade the inverse head and shoulders pattern
1. Wait for a decisive breakout
An inverse head and shoulders pattern completes when the price closes firmly above the neckline. Look for a clear, sustained breakout rather than entering on the first touch. An increase in volume on the breakout is widely regarded as an important confirmation, though some set-ups may still be valid without a volume shift.
2. Entry strategies
Potential entry points for the inverse head and shoulders pattern will depend on market conditions, alongside individual preferences and risk tolerance. Here are some common entry points:
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Breakout entry – enter a long position once the price closes above the neckline. This approach aims to capture early momentum but can be prone to false breakouts in choppy markets.
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Retest entry – wait for the price to pull back to the neckline after breaking out, then enter if this former resistance appears to act as support. This method can help filter out failed moves but may result in missed opportunities if the market doesn’t retest.
3. Stop-loss placement
Stop-loss and take-profit orders are risk management tools that help you limit potential losses and protect potential gains. Where you place them may depend on your trading strategy. For example, you could set a stop-loss just below the right shoulder – or beneath the lowest point of the pattern. Note that placing a stop below the head might increase risk due to the wider distance.
This helps manage downside if the pattern fails and the price reverses lower. Adjust stop distance for market volatility and instrument characteristics – too tight a stop can see trades closed prematurely.
Although a stop-loss is not guaranteed, a guaranteed stop-loss (GSL) is available on our platform for a fee.
4. Set a profit target
Stay on track with your chosen strategy and set a profit target. One approach is to measure the vertical distance from the lowest point of the head to the neckline, then project this same distance upward from the breakout level. Some traders use additional reference points, such as nearby resistance zones or technical levels, to determine potential exit levels.
5. Use volume and confirmation tools
Assess volume dynamics to help validate pattern signals, alongside additional technical analysis. Rising volume on the breakout can support the reversal signal, but volume confirmation is not always essential. Use indicators – such as the RSI or MACD – for additional confirmation, particularly on higher time frames. This can help assess the strength of the potential move and avoid false signals.
6. Monitor your trade
Monitor evolving market conditions, including your underlying asset’s price movements and volume data – adjusting and refining your approach as necessary, in line with your trading strategy. Key variables include position sizing and risk management tools – such as stop-loss or take-profit. Remember that trading chart patterns don’t guarantee specific outcomes.
Past performance is not a reliable indicator of future results.
What is a failed inverse head and shoulders pattern?
When an inverse head and shoulders doesn’t deliver the expected outcome, it’s called a failed inverse head and shoulders pattern.
A failed inverse head and shoulders may occur when price breaks above the neckline, but quickly loses momentum and either stalls around or falls back below the breakout level. Rather than confirming a new uptrend, the market either returns to sideways action or resumes the preceding downtrend.
The inverse head and shoulders does not guarantee a bullish reversal. Although widely used to signal potential price reversals, it cannot predict future price movements.
Signs the pattern has failed
A few common signs suggest an inverse head and shoulders has not played out as expected:
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Lack of follow-through: after the breakout, the price fails to hold higher levels and drops back below the neckline.
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Weak volume: a breakout occurring on low or declining volume is more likely to reverse, as buying interest may be insufficient to drive a new trend.
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Swift rejection: the market may briefly trade above the neckline before reversing sharply, trapping breakout traders.
Why failures happen
Failed patterns can arise for several reasons. Broader market sentiment may remain bearish, or a false breakout may be triggered by short-term volatility. The neckline might be poorly defined, or the right shoulder may be too shallow, indicating weaker support from buyers. Interpretation is subjective and can vary among traders.
The reliability of the pattern can also vary across asset classes. Forex and cryptocurrency CFD markets, for example, are prone to volatility and potential false breakouts, particularly around key news releases or during periods of thin liquidity.
Managing risk
Effective risk management is key. Some traders place a stop-loss beneath the right shoulder or the lowest point of the pattern to limit downside if the setup fails. However, stop-loss placement ultimately depends on individual risk tolerance and prevailing market conditions. Others seek confirmation from additional indicators or wait for a retest of the neckline before entering a position.
Best indicators to use with the inverse head and shoulders
Although the inverse head and shoulders pattern is widely recognised, many traders employ technical indicators to add confirmation before taking a position. Appropriate indicators can help validate a potential reversal, identify momentum shifts and reduce the risk of false breakouts. Below are some effective tools to use alongside this pattern:
Moving averages
Moving averages, such as the 20- or 50-period simple moving average (SMA), can provide additional confirmation. A close above a key moving average at the same time as the neckline break adds weight to the bullish signal. After entry, these averages may provide support in a new uptrend; however, this is not guaranteed.Relative strength index (RSI)
The RSI is a popular momentum indicator that measures whether an asset is overbought or oversold. When trading the inverse head and shoulders, many look for the RSI to move above 50 as price breaks the neckline – this signals strengthening bullish momentum. Some also monitor bullish divergence (where the RSI traces higher lows while price makes lower lows), which can suggest the downtrend is weakening.Volume
Volume is a key confirmation indicator for the inverse head and shoulders pattern. A breakout above the neckline accompanied by rising volume may enhance the reliability of the reversal signal.
Moving average convergence divergence (MACD)
The MACD helps traders identify shifts in trend. A bullish MACD crossover (when the MACD line rises above the signal line) near the neckline breakout is a common confirmation signal. It is also useful to note if the MACD histogram shifts from bearish to bullish, as this may lend additional support for a trend reversal.Stochastic oscillator
The stochastic oscillator is another momentum tool that can help confirm the pattern. Traders often look for the oscillator to rise above 50 at the point of neckline breakout, indicating increasing bullish momentum. A bullish crossover or a move out of oversold territory may also provide further confirmation.Common mistakes when trading the inverse head and shoulders
Even experienced traders can misread inverse head and shoulders patterns, leading to false signals or missed opportunities. Here are some common pitfalls:
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Misidentifying patterns: the inverse head and shoulders pattern shares visual similarities with other formations characterised by multiple troughs, such as a double-bottom formation. To identify an inverse head and shoulders pattern, look for the middle trough (the head) – which should be lower than both shoulders – and a defined neckline, either horizontal or gently sloping.
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Entering before confirmation: chart formations such as the inverse head and shoulders can fail or behave unpredictably. After the breakout – but before you enter a CFD position – validate the signal with additional technical indicators such as RSI or moving averages, monitor trading activity, and wait for confirmation of a sustained follow-through.
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Ignoring the wider market context: inverse head and shoulders patterns are a technical indicator of potential price action, but they’re not the only factor. Broader market sentiment and trends can significantly influence an underlying asset’s price moves. Their influence can be gauged by observing fundamentals, such as economic data releases, volatility and geopolitical conditions.
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Setting inappropriate stop-loss levels: sub-optimal stop-loss placement is another common issue. Stops set too close to the right shoulder may be triggered by routine price swings, while stops set too far away can lead to larger losses. Placing a stop below the head might increase risk due to the wider distance. Adjust stops to reflect current market conditions and volatility.
