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.
Vytas.
Related posts:
Disclaimer
Trading
financial markets carries a high level of risk, and may not be suitable for all
investors. All information on the blog http://trend0.blogspot.com/ is of educational
nature and cannot be considered as advice, recommendation or signals to trade
in any financial markets.