Technical analysis is an important tool used by traders to identify trading opportunities and make informed decisions. By analyzing price trends and chart patterns, traders aim to forecast future price movements. Of the many chart formations traders look for, bullish patterns signal an upward climb in prices and present lucrative buy opportunities.
There are several notable bullish patterns that astute traders keep an eye out for. But arguably the most bullish formation is the inverse head and shoulders pattern. This powerful setup is beloved by technical analysts for its ability to mark reversing trends and major uptrends. Let’s take a closer look at what makes the inverse head and shoulders so bullish.
What is the Inverse Head and Shoulders Pattern?
The inverse head and shoulders pattern forms at the bottom of a downtrend and signals a reversal in the movement of prices. It is characterized by its distinct shape that resembles a head with two shoulders on either side, as seen in the example below:
| Left Shoulder | Head | Right Shoulder |
|---|---|---|
| Lower peak | Lowest trough | Lower peak |
It is called an inverse pattern because it is essentially the mirror image of a regular head and shoulders pattern that forms at market tops. The inverse version is a bottoming pattern that arises in downtrends and signals a bullish reversal.
Key Features
Here are the key features that characterize the inverse head and shoulders pattern:
- It appears in a downtrend – The first thing to notice is the security is in a downtrend before the pattern starts forming.
- The left shoulder forms first – It is marked by a peak (shoulder) where selling pressure pushes the security down from its high.
- The head is next – It marks the lowest point (trough) where bears take control and drive prices down even further.
- The right shoulder follows – It is another peak but at a price level above the head and forms when selling pressure eases.
- The neckline joins the two shoulders – This key level marks bullish breakouts when the price closes above it.
These ingredients complete the formation of the inverse head and shoulders reversal pattern. Now let’s examine why this setup generates such bullish sentiment.
Why is it Considered Bullish?
There are several reasons why the inverse head and shoulders pattern is beloved by bullish traders:
It Marks Bottoms and Reversals
The defining feature of the inverse head and shoulders is it appears at the bottom of a downtrend, indicating the selling pressure that created the decline is now waning. As bears lose control, the pattern emerges signaling a potential bullish reversal.
Indicates a Shift in Supply/Demand
The formation of lower peaks and higher troughs shows the shift in the supply-demand balance that powers reversals. Reduced supply and increased demand from buyers implies emerging bullish sentiment.
Neckline Breakouts Trigger Moves Higher
The neckline is the key level to watch. When the price breaks and closes above it, the pattern completes and validates the turnaround. Traders enter long positions as the breakout triggers a surge in buying momentum.
Reliable Pattern with Measured Move
The inverse head and shoulders almost always leads to a substantial move higher once confirmed. Analysts use the pattern’s height to project the size of the potential advance and target upside price objectives.
High Probability Setup
Extensive backtesting shows the inverse head and shoulders produces accurate bullish signals time and again. It has one of the highest success rates among chart patterns, giving traders confidence in the bullish outcomes.
How to Trade the Inverse Head and Shoulders
Now let’s discuss how to actually trade the inverse head and shoulders pattern:
Locate the Left Shoulder, Head, and Right Shoulder
Identify a security in a downtrend and then spot the formations of the three peaks and troughs that create the pattern’s distinctive shape.
Draw the Neckline
Connect the bottoms of the two shoulders to draw the neckline. This is the breakout level to watch.
Compute Pattern Height
Calculate the height from the head’s low up to the neckline. This projects the expected rise after breakout.
Place Buy Stop Order
Place a buy stop order slightly above the neckline. This triggers and enters long trades when the breakout occurs.
Manage Risk
Use a stop loss below the right shoulder to contain potential losses if the pattern fails.
Take Profit near Measured Move
Aim to take profits near the measured move target calculated from the pattern height.
By following these guidelines, traders can capitalize on one of the most lucrative chart patterns and gain an edge with bullish inverse head and shoulders setups.
Real World Example
Let’s look at an actual example to see the inverse head and shoulders pattern in action:
EURUSD 4 Hour Chart
This chart shows the EURUSD currency pair forming the characteristic head and shoulders shape. A break above the neckline around 1.13500 triggers buy entry orders.
| Left Shoulder | Head | Right Shoulder |
|---|---|---|
| 1.12750 | 1.11800 | 1.12250 |
The pattern’s height is around 1,700 pips projecting the potential rise. Traders target upside objectives based on this measure near the 1.15500 price level. Stops below 1.12000 limit downside risk if wrong.
Price Surges on Breakout
The EURUSD skyrockets higher following the bullish breakout above the neckline just as forecasted by the inverse head and shoulders pattern.
Conclusion
In summary, the inverse head and shoulders pattern marks bottoms and reversals with one of the most bullish chart formations. Its measured move forecasts sizable upside targets. Traders watch for this high probability setup and enter long positions when the neckline is breached. Stops contained potential losses if the pattern fails. But executed properly, the inverse head and shoulders presents extremely profitable buy opportunities in emerging uptrends.