The inverse head and shoulders
Three lows, the middle one lowest, with a neckline above. When the price rises above it, the previous downtrend counts as over. Whether it's really a turn only shows afterwards.
The inverse head and shoulders is the mirror image of the well known head and shoulders. It appears after a decline and counts as a sign that sellers are getting tired.
What it's about
The price falls to a low, recovers, falls to an even lower low, recovers again and afterwards only falls to a higher low. Sellers no longer manage a new bottom.
How to recognise it
- There was a clear decline beforehand.
- Three lows, the middle one clearly the lowest.
- The two highs in between form the neckline.
- Only a close above the neckline completes the pattern.
How the price target is estimated
Measure the distance from the head to the neckline and add it to the breakout point. Head at €40, neckline at €50: the target is around €60.
Where it misleads you
Many buy at the right shoulder already, anticipating the pattern. If the price then falls below the head, it was just a pause in the downtrend. Even after the breakout above the neckline, the price quite often falls back.
An example trade with made up numbers
Aylin has €10,000 in her account and risks at most €150 per trade. A stock rises above the neckline at €50, with the right shoulder at €48.50. Aylin buys at €50.50 and sets her stop loss at €48.50. With that distance, she buys 75 shares for €3,787.50. Costs: €1 each to buy and sell, plus about 2 cents of spread per share on each order.
If it works: The price reaches the target at €56 and Aylin sells. Aylin is €412.50 ahead. After €2 in fees and €3 in spread, €407.50 is left.
If it goes wrong: The breakout fails and the stop fills at €48.40. That's a €157.50 loss, €162.50 with costs.
Aylin placed her stop below the right shoulder. If the price gets there, the pattern is disproved, and that's exactly when she wants out.
As with the regular head and shoulders, many watch volume. A breakout above the neckline on clearly rising volume counts as more credible. After the breakout, the price often tests the neckline once more from above.
The measuring rule for the target comes from classic chart analysis of the 1930s and 1940s. It's a rule of thumb without firm grounding and is often not reached in practice.
Summary
- The inverse head and shoulders appears after a decline.
- Only the close above the neckline completes it.
- The stop belongs where the pattern is disproved.
Did you get it?
Head at €40, neckline at €50. Where is the estimated target?
Around €60.
Why is buying at the right shoulder risky?
Because the pattern isn't complete there and the price can keep falling.
Where do many set their stop?
Below the right shoulder.
Sources and further reading
- StockCharts ChartSchool, Head and Shoulders Bottom. View source ↗
- Thomas N. Bulkowski: Encyclopedia of Chart Patterns, 3rd edition 2021.
Related
- Head and shouldersChart pattern
- Double bottomChart pattern
- Setting a stop lossLesson