The inverse head and shoulders is a candlestick formation that occurs at the end of a downward trend and indicates that the previous trend is about to reverse.
Often associated with bullish price reversals, this unique pattern is one of the most accurate and effective chart patterns in technical analysis.
But how do you identify and use it? And how can you maximize your profitability when using the inverse head and shoulders chart pattern in forex trading? All the answers are in this article.
- What is the inverse head and shoulders candlestick pattern?
- How to identify and use the inverse head and shoulders candlestick pattern in forex trading?
- How to trade forex using the inverse head and shoulders candlestick pattern – Strategies and examples
- The inverse head and shoulders candlestick pattern – Pros and cons
- Key takeaways
What is the Inverse Head and Shoulders Candlestick Pattern?
The inverse head and shoulders pattern is a bullish candlestick formation that occurs at the end of a downward trend and potentially signals the end of a trend and the beginning of a new upward trend.
In terms of its structure, the inverse head and shoulders pattern has three bottoms with the middle bottom being lower than the first and third bottoms (the two shoulders). As a result, it has a formation of inverse head and shoulders.
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How to Identify and Use the Inverse Head and Shoulders Candlestick Pattern in Forex Trading?
To identify the inverse head and shoulders pattern on a trading chart, you need to find three bottoms with the following components – left shoulder, head, and right shoulder. Furthermore, the pattern appears at the end of a downward trend and should have a clear neckline used as a resistance level.
In the AUD/JPY chart below, you can see how the inverse head and shoulders pattern was formed after a bearish trend and include the left and right shoulders and the head bottom level. As soon as the price breaks above the neckline level, a new bullish trend starts.
With the above in mind, the next steps can help you in identifying and using the inverse head and shoulders pattern in forex trading:
- Identify three bottom levels after a downward trend that include left shoulder, head, and right shoulder
- Find the neckline resistance level
- Wait for the breakout to occur and place a buying order once a candle closes above the neckline
- Set a stop-loss order below the neckline (preferably at the lowest level of the right shoulder) and use a risk-reward ratio
How to Trade Forex Using the Inverse Head and Shoulders Candlestick Pattern – Strategies and Examples
Since the inverse head and shoulders is a bullish candlestick pattern, you’ll obviously need to find the ideal entry-level for a long position. But much like any other candlestick chart pattern, there are several ways and techniques to trade the inverse head and shoulders pattern.
Below, we mention two trading strategies to use this unique pattern:
1. Trading the Breakout
The most common way to trade the inverse head and shoulders pattern is to immediately enter a position when the price breaks above the resistance neckline.
In this case, once you’ve identified the right shoulder and have a clear neckline level, you are ready to enter a position when the breakout occurs.
Let’s see an example of the inverse head and shoulders breakout.
As you can see in the AUD/JPY 1H chart above, when the breakout occurs, there’s no retest around the neckline and the price rises. The risk in using this technique is that in many cases a price pullback might occur (or a false breakout) and your stop loss will be triggered.
To protect yourself from this situation – when you enter a position at the breakout, it is advisable to place the stop loss market order at the lowest level of the right shoulder bottom.
2. Confirm the Inverse Head and Shoulders Pattern with Fibonacci Levels
Even though many traders like to work on a clean chart without any drawings and technical analysis tools, in my view it is vital to confirm a charting pattern with other technical indicators. One such tool is Fibonacci support and resistance levels.
Taking the same example from above, we have added Fibonacci retracements from the highest level of the previous trend to the lowest level of the head section.
As seen in the AUD/JPY chart, the 38.2 % Fibonacci level is slightly above the neckline of the pattern and serves as another confirmation of a trend reversal.
In that scenario, a trader will enter a long position once the price rises above the 38.2% level and place a stop-loss order at the 23.6% level, which is the lowest level of the right shoulder.
The Inverse Head and Shoulders Pattern – Pros and Cons
These are the most common pros and cons of trading the head and shoulders chart pattern:
- An accurate and reliable charting pattern
- Stop loss and take profit levels are well defined
- Works well with Fibonacci levels
- Could be complicated for beginner traders to identify the pattern
In conclusion, here are the key takeaways:
- An inverse head and shoulder is a bullish reversal pattern that appears after a downward movement and may signal a possible trend reversal
- To identify the inverse head and shoulders candle pattern, you need to find three bottoms after a bearish trend with the following components – left shoulder, head, and right shoulder
- A trade should be made when the price breaks above the neckline with a stop loss at the lowest level of the right shoulder
- As a trading strategy, the inverse head and shoulders pattern works best in combination with Fibonacci levels
How accurate is the inverse head and shoulders pattern?
In essence, the inverse head and shoulders pattern is a bottoming chart pattern – meaning, sellers fail in pushing prices lower below a certain support level. As a result, in the vast majority of cases, the asset’s price is expected to rise after the inverse head and shoulders pattern has occurred and the pattern is, indeed, among the most accurate patterns in technical analysis.
What does an inverse head and shoulders pattern indicate?
Like many other candlestick patterns, inverse head and shoulder patterns indicate that the market reaches a certain level and the price cannot break below or above this level. In other words, the selling pressure stops, setting a new market sentiment for a rebound or a new trend. Consequently, when the head and shoulders pattern occurs and the price breaks above the neckline, a bullish trend reversal is very likely to occur.
What’s the target price when the price breaks below the neckline?
In trading, exiting a position can be quite challenging for traders and finding the right profit targets levels requires experience and trading skills. For that matter, when you identify the inverse head and shoulders pattern and you are looking for a target price to exit the position, the best solution is to draw Fibonacci retracement levels and set your take profit target at one of the next Fibonacci levels.
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