Inverse Head and Shoulders
Now that we have studied the head and shoulders reversal pattern we need to know the differences between this reversal pattern on an uptrend and downtrend. We also discuss what happens when the head and shoulders pattern fails and some trading strategies that might be useful. The first point to note is that the inverse head and shoulders pattern occurs in a falling market.
Lets study the inverse head and shoulders pattern first. This is a mirror image of the head and shoulders pattern and occurs in a falling market. However we know that in a falling market it takes a huge amount of support to lift something thats falling. Taking a long position when there are no buyers and all the news is so pessimistic about the future of that currencyâ€™s economy etc requires a lot of courage whether its the stock market or FX markets or any other market.
Therefore unlike the head and shoulders reversal in the uptrend where the volumes were lower on peaks, in the inverse head and shoulder volumes are high at the troughs. This is because it takes a significant amount of buying to reverse the fall or at least slow down the momentum.
At the initial formation, the formation of the left shoulder, volumes tend to be low since the market is already short and selling is saturating. The head is also marked withÂ low volumes. However the rally from the head to the neckline should be backed by a significant increase in volume. As we have mentioned it requires aggressive buying to push the currency upwards.
The move to the right shoulder should be on low volume and the breakout from the neckline should be backed by much higher volume since it requires aggressive buying for a breakout. A lot of shorts would also start looking to square their positions and maybe initiate longs at this stage. After the breakout its common to see the price retrace back to the neckline on light volumes for a rally to the minimum target price equal to the distance between the neckline and head.
For both head and shoulder formations a close below the neckline after a breakout during the price retracement signifies a failure of the head and shoulder pattern. Remember that the neckline played a strong role as a resistance in the inverse head and shoulder and must provide support to the return move post the breakout. The inverse head and shoulder pattern would typically be larger in size and duration than a head and shoulder reversal in an uptrend as it would take much more effort to initiate longs in a falling market than to sell or square in a failing rally.
It isn’t necessary for traders to wait till the full head and shoulders pattern forms. Traders start to trade during the pattern formation since no one can confidently call it a head and shoulders pattern until after the pattern has completed. However the failure of the head to sustain and retrace 100% back to the neckline is a sufficient indicator to square shorts and start initiating longs.
The right shoulder point where it should find support at the left shoulder point could be a possible entry position upto the head. If prices trace all the way to the head it could also be the formation of a double bottom, in which case prices should rebound and head towards the neckline. When prices conclusively break the neckline traders wait for retracements to add to their long positions.
Next we study the Continuation Head and Shoulders Pattern