Head and Shoulders & Inverse Head and Shoulders Patterns

In technical analysis, few patterns are as well-known or reliable as the Head and Shoulders and Inverse Head and Shoulders patterns. These classic reversal patterns offer traders a strong indication of when an existing trend is likely to end, and a new one is about to begin. Recognising these patterns on a chart can provide valuable entry and exit points, helping traders capitalise on potential market reversals.

In this chapter, we’ll break down how both the Head and Shoulders and Inverse Head and Shoulders patterns work, why they’re important, and how traders can use them to spot trading opportunities. Let’s begin with the Head and Shoulders pattern, a well-known bearish reversal signal.

1. Head and Shoulders Pattern: A Bearish Reversal

The Head and Shoulders pattern is a classic bearish reversal pattern that signals the end of an uptrend. It consists of three peaks: a higher peak (the head) between two smaller peaks (the shoulders), with a neckline that connects the lows of the two shoulders. When the price breaks below the neckline, it signals the start of a new downtrend.

How to Spot a Head and Shoulders Pattern?

• Left Shoulder: The price rises to a peak, then declines to form a low.
• Head: The price rises again, creating a higher peak, and then declines.
• Right Shoulder: The price rises once more but forms a lower peak, followed by another decline.
• Neckline: This is the support line that connects the lows of the two shoulders. A break below the neckline confirms the pattern.

Reference of Head and Shoulders Candlestick

The Head and Shoulders pattern is significant because it reflects a weakening uptrend, where buyers gradually lose control, and sellers gain momentum. Now, let’s explore this pattern in action with a real-world example.

Example: Head and Shoulders in Reliance Industries

Image Courtesy: Tradingview

Imagine Reliance Industries has been in an uptrend, with steady gains over several weeks. The stock forms a Head and Shoulders pattern as it reaches three peaks: the left shoulder, the head (which is the highest point), and the right shoulder. When the stock fails to rise as high as it did during the head formation and breaks below the neckline, it confirms a bearish reversal.

For a trader, this pattern would signal a potential sell opportunity or a warning to close any long positions, as the price is likely to move lower from here. However, just as the Head and Shoulders pattern indicates a bearish reversal, the Inverse Head and Shoulders suggest a bullish reversal.

2. Inverse Head and Shoulders Pattern: A Bullish Reversal

The Inverse Head and Shoulders pattern is the mirror image of the regular Head and Shoulders and signals a bullish reversal after a downtrend. This pattern forms when the market creates three troughs: the head (the lowest point) between two higher troughs (the shoulders). When the price breaks above the neckline, it indicates a reversal to the upside.

How to Spot an Inverse Head and Shoulders Pattern?

• Left Shoulder: The price falls to a low, then rises slightly.
• Head: The price falls to a lower low, then rises again.
• Right Shoulder: The price falls again but doesn’t reach the low of the head, followed by another rise.
• Neckline: This is the resistance line that connects the highs of the two shoulders. A break above the neckline confirms the pattern.

Reference of Inverse Head and Shoulders Candlestick

This pattern signifies a weakening downtrend, where sellers are losing strength, and buyers are starting to take control. Let’s look at an example of how this pattern can be used to spot a buying opportunity.

Example: Inverse Head and Shoulders in Tata Motors

Image Courtesy: Tradingview

Suppose Tata Motors has been in a downtrend for several months. The stock forms an Inverse Head and Shoulders pattern, with three troughs: the left shoulder, the head (the lowest point), and the right shoulder. When the price breaks above the neckline, it confirms the bullish reversal. This would be a signal for traders to consider buying the stock, anticipating that prices will rise as the downtrend reverses.

This pattern is particularly strong when combined with other technical indicators, such as volume or moving averages, which we’ll discuss next.

Confirming Head and Shoulders Patterns

While the Head and Shoulders and Inverse Head and Shoulders patterns are powerful reversal signals, it’s essential to look for confirmation before acting. Here are a few ways traders can confirm these patterns:

• Volume: In both patterns, volume plays a critical role. For a Head and Shoulders pattern, volume should decrease as the right shoulder forms and then increase as the price breaks below the neckline. For an Inverse Head and Shoulders, volume should increase when the price breaks above the neckline, confirming the strength of the reversal.

• Moving Averages: Combining these patterns with moving averages can provide additional confidence in the trade. For example, if the price breaks below the 50-day moving average in a Head and Shoulders pattern, it strengthens the bearish signal.

• RSI (Relative Strength Index): Using the RSI to check whether the stock is overbought or oversold can offer additional confirmation. An overbought signal during the formation of a Head and Shoulders pattern or an oversold signal during an Inverse Head and Shoulders can strengthen the reversal signal.

These confirmations reduce the risk of acting on false signals and improve the overall accuracy of trading decisions.

How Traders Use These Patterns?

Traders use the Head and Shoulders and Inverse Head and Shoulders patterns as part of their overall trading strategy, particularly when identifying entry and exit points. Here’s how traders typically use these patterns:

• For Head and Shoulders: Traders often look to short the stock or sell once the price breaks below the neckline, anticipating a further decline. The distance between the head and the neckline can be projected downwards to estimate the potential price drop.

• For Inverse Head and Shoulders: Traders generally buy once the price breaks above the neckline, expecting the market to rise. As with the regular Head and Shoulders, the distance between the head and neckline can be projected upwards to estimate the target price.

By incorporating these patterns into their broader analysis, traders can increase their chances of success while managing risk effectively.

Conclusion

The Head and Shoulders and Inverse Head and Shoulders patterns are two of the most reliable reversal signals in technical analysis. The Head and Shoulders pattern signals the end of an uptrend and the start of a bearish reversal, while the Inverse Head and Shoulders indicates the end of a downtrend and the beginning of a bullish reversal.

By combining these patterns with volume analysis, moving averages, and technical indicators like the RSI, traders can confirm the strength of the reversal and make more informed decisions. Whether you’re looking for a selling opportunity at the top of an uptrend or a buying opportunity at the bottom of a downtrend, these patterns offer clear and actionable signals to guide your trading decisions.

In the next chapter, we will explore Double Top and Double Bottom Patterns: Identifying Market Reversals, which help traders recognise key chart formations that indicate a potential change in the current trend direction.