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Tuesday, May 28, 2013

Inverted head and shoulders

Hi, I am happy to continue writing on my series of chart analysis. Last time we analyzed bullish and bearish pennants that are continuation patterns and today I want to expand on one specific reversal pattern. I covered head and shoulders pattern a few years ago and today I want to discuss its’ twin: inverted head and shoulders. It is often formed after a security has been in a prolonged downtrend. The pattern indicates that the downtrend is most probably over and we are going to see higher prices soon. It is a very powerful formation as prices often start trending for a prolonged period of time when the structure is eventually broken upwards. 

The pattern consists of three lows: left shoulder, head and right shoulder. The structure is joined by a neckline that constitutes resistance. 

Watch a video showing you how to trade the formation:

How is inverted head and shoulders pattern formed?

Firstly, there has to be a downtrend in order for the pattern to be formed. After a prolonged collapse prices start to go (sort of) parabolic and at some point suddenly shoot up. At this point (usually) the left shoulder and the point for a neckline are formed. Then the previous downtrend resumes and prices go below previous low (the left shoulder). Then the security rises again, but fails to go beyond previous resistance. It falls back again, but this time lower low is not achieved. At this point the right shoulder is usually formed. All the other attempts to go lower fail and the security starts going upwards bit by bit till it reaches the highs of previous rally after the left shoulder was formed. It my bounce off the level or break it (the neckline). When a break upwards occurs new uptrend usually starts. If the break does not occur and prices go below the right shoulder the pattern is distorted and you may justly call it a failure. 

False breakouts

False breakouts are a repetitive thing in financial markets and prices often come back to the range. However, you should have specific entry rules and you either you risk and jump on the trade or you stand aside and continue waiting when the breakout occurs. In the latter situation you will be sure that it was the true head and shoulders pattern after the move up have gone so far that it is no longer useful for you to join it. So, you go long after the neckline (resistance) is broken.

Various time frames

If you read classical technical analysis you will be told that these type of patterns last from six months to a few years. However, you can find both ‘head and shoulders’ and ‘inverted head and shoulders’ patterns on various time frames. These patterns might be formed on hourly charts and the patterns can stretch a few days’ or a few weeks. And you can successfully trade both long and short term patterns. At least my experience confirms the fact. 

How to trade the formation

The best way to trade the pattern is to buy the break of the necklace. The chart above shows you how you could enter the market with long orders. The necklace (or resistance) was at 80.67 point. That’s the place to enter your first package of orders (if you are a serious trend trader). The ideal place for a stop loss order was below the low of the breakout day. In our case it was 80.12 level. So, you could place your stop at 80.07 (five pips below the lowest point of the day). How could you have exited the market? There are plenty of ways to do that. Much depends on the size of your position, number of orders and the state of the market. I like moving my stop as the market makes new highs by placing the stops below clusters of daily candles. These spots are marked with blue rectangles on the chart above. Finally, market stops going upwards and starts going sideways. This is one of the signs that the tendency is about to end. Eventually, your stop loss is hit and you are out of the market with nice profits. What a nice way to trade the pattern!

Ok, I will finish now. Be sure to read related articles to learn more on technical analysis. I promise to expand on this in my future posts. 

I hope you benefited from the post. If you liked the post I would also be happy if you gave a plus on Google+, tweeted, liked it on Facebook and other social platforms. Have a nice day. 


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