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The behaviour underlying the “Inverse Head & Shoulders” classical chart pattern in technical analysis
The psychology behind the inverse head and shoulders chart pattern revolves around the shift in sentiment from bearish to bullish. The pattern forms after a prolonged downtrend, indicating that sellers have been dominant and the price has been consistently pushed lower.
1. Left Shoulder and Head (Pessimism and Selling Exhaustion)
The left shoulder represents a low point where the market sentiment is predominantly bearish. As the price declines, more traders start to anticipate a reversal, but the downtrend continues as sellers are still in control. The subsequent decline to form the head creates a sense of pessimism and fear as the price drops to a new low. Traders who have been holding short positions may become more cautious as the price approaches this low, fearing a potential bounce.
2. Right Shoulder (Doubt and Reversal Anticipation)
During the formation of the right shoulder, the price attempts to rally but fails to reach the heights of the head. This failure creates doubt among remaining bears who expected the downtrend to continue. At this point, some traders who were aggressively short might start to cover their positions, fearing a possible reversal. Bulls, on the other hand, become more active as they see potential for an uptrend.
3. Neckline Break (Confirmation and Bullish Momentum)
The neckline is a horizontal line connecting the highs between the left shoulder, head, and right shoulder. The psychology here is crucial. When the price breaks above the neckline, it signifies that buyers have gained enough strength to overcome the resistance and push the price higher. This breakthrough confirms the reversal and attracts more traders who were waiting for confirmation. The fear of missing out (FOMO) can further accelerate buying, reinforcing the bullish sentiment.
4. Uptrend (Optimism and Momentum)
As the price continues to rise after breaking the neckline, the psychology shifts to optimism. Traders who bought during the confirmation of the pattern now see their positions in profit, boosting their confidence. Other market participants who were on the sidelines may also start buying to capitalize on the upward momentum, further propelling the price higher.
In essence, the inverse head and shoulders pattern captures the transition from pessimism and selling exhaustion to optimism and buying interest. It highlights how changing perceptions and emotions of market participants collectively influence price movements.
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How to trade the “Inverse Head & Shoulders” classical chart pattern
Trading the inverse head and shoulders pattern involves identifying the pattern, confirming its validity, and then executing trades based on the expected price movement. Here’s a step-by-step guide on how to trade this pattern:
1. Identify the Pattern
- Look for a prolonged downtrend in the price chart.
- Identify the formation of three distinct troughs: a lower low (head) between two higher lows (left shoulder and right shoulder).
- Visualize a neckline by connecting the highs between the left shoulder, head, and right shoulder.
2. Confirm the Pattern
- Ensure that the pattern is well-defined and symmetrical. The shoulders and head should be relatively evenly spaced and visually recognizable.
- Confirm the breakout by waiting for the price to close above the neckline, signaling the end of the downtrend and the potential start of an uptrend.
3. Entry
- Once the price closes convincingly above the neckline, consider entering a long (buy) position.
- Some traders prefer to wait for a slight pullback or a retest of the neckline before entering to ensure the breakout’s strength. This can provide a better entry price.
4. Stop Loss
- Set a stop-loss order below the neckline to protect your investment in case the pattern fails. The stop-loss level should be determined based on your risk tolerance and the pattern’s characteristics.
Also see: Stop Loss . . . and its importance in trading – Some ways of setting up stop loss levels
5. Price Target
- Estimate the potential price target by measuring the vertical distance from the head to the neckline, and then adding that distance to the neckline’s breakout point. This gives you a rough idea of how much the price could potentially rise.
6. Exit
- Once the price reaches your estimated target or starts showing signs of reversal (e.g., bearish candlestick patterns, loss of momentum), consider exiting the trade to secure your profits.
Also see: Some ways of setting up take profit levels
7. Risk Management
- Calculate your position size based on your risk tolerance and the distance between your entry point and stop-loss level.
- Consider using proper risk-reward ratios to ensure that potential profits outweigh potential losses.
Also see: How to determine one’s tolerance to risk?
8. Confirmation from Other Indicators
- While the pattern itself is a strong signal, you can enhance your analysis by using other technical indicators, such as moving averages, volume, or momentum oscillators, to support your trading decision.
9. Patience and Discipline
- Keep in mind that not all patterns result in successful trades. It’s essential to exercise patience, follow your trading plan, and avoid emotional decisions.
Remember that no trading strategy is foolproof, and risk is always involved in trading. Always practice proper risk management and be prepared for unexpected market movements. Additionally, consider paper trading or using a demo account to practice trading the pattern before committing real capital.