The inverse head and shoulders is exactly what you think it is – the head and shoulder pattern is on the bottom rather than the top and subsequently is used to predict reversals in downtrends. There are a few key characteristics that confirm the appearance of the inverse head and shoulders pattern:
- The price needs to fall to a trough but then pick itself back up again
- The price must then fall through that previous trough and rise once again
- The final indication is the price falling but not as low as the previous movement
The price should then rise through the resistance line and significantly more trading volume is typically observed at this time. That final movement over the neckline or resistance is crucial. It signals the completion of the reversal and the large spike in trading volume confirms the validity of the signal.
Determining the Reversal Length
Unlike some patterns, the inverse head and shoulders pattern can indicate a profit target too. This is determined by measuring the distance between the bottom of the “head” of the pattern and the neckline and then projecting that same distance from the breakout. For example, if the measured distance between the head and neckline is 15 points, then traders would set a profit target of 15 points above the neckline of the pattern. Another tip for trading the inverse head and shoulders is to set a stop-loss order below the breakout candlestick.
Limitations of the Inverse Head and Shoulders Pattern
The limitations to this pattern are observed in what strategy a trader implements. It can be traded both aggressively and conservatively, but it can backfire. Trading aggressively would be to place a buy order above the neckline of the inverse head and shoulders pattern in anticipation of the reversal. However, while this would mean catching the breakout at the start for maximum value, you wind up with high slippage if the breakout turns out to be false and the reversal doesn’t occur. Trading conservatively can result in less slippage, but you could miss the trade in the event of a pullback.
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