What Is an Inverse Head and Shoulders Pattern?

The stock market moves fast, with opportunities appearing and disappearing at an incredible speed. That’s why, for traders, understanding market patterns is crucial. Otherwise, the chances of missing out on the best opportunities to make profits or cut losses rise. 

One such market pattern is the inverse head and shoulders pattern (or reverse head and shoulders pattern), which can be a critical indicator in predicting a given security’s price rise or fall. 

In this guide, we’ll explore the ins and outs of the inverse head and shoulders pattern, imparting all the knowledge you need to define, understand, and trade the pattern. 

Decoding the inverse head and shoulders pattern

Think of the inverse head and shoulders pattern––widely called head and shoulders pattern or head and shoulders chart––as a powerful tool in technical analysis, which serves as a bullish reversal signal after a downward trend. 

Over the last few decades, the pattern has become an important staple in the toolkit of quants, technical analysts, and chart pattern enthusiasts. That’s because of its simplicity and effectiveness in signaling trend shifts, allowing traders and investors worldwide to identify potential profit opportunities and make more informed decisions.  

With the advent of digital trading platforms and advanced charting tools, the pattern has arguably become even more popular, largely because traders now have the advantage of real-time analysis, enabling them to spot inverse head and shoulders formations as they unfold. The integration of artificial intelligence (AI) and algorithmic trading has further enhanced the precision and speed of this kind of pattern recognition, allowing more investors to take advantage of this classic pattern.

An inverse head and shoulders pattern manifests as three distinct parts:

• A lower low

• A lower low with a deeper decline (the "head")

• And a higher low following the head

This pattern is widely believed to signal a shift in market sentiment, suggesting sellers are losing control and buyers are gaining strength. Traders often see this pattern as a precursor to a trend reversal, anticipating a bullish upswing in the immediate future. 

Perhaps unsurprisingly, understanding its anatomy is crucial for investors seeking opportunities to capitalize on impending market shifts. Below, we’ll lay out the anatomy in greater detail. 

Crucial components of the inverse head and shoulders pattern

The inverse head and shoulders pattern is particularly important as it suggests a significant market sentiment, and understanding its key components is essential to make intelligent decisions.

Here are its three parts: 

1. Lead-in downtrend

An inverse head and shoulders pattern typically emerges after a sustained downtrend in the price of a security—most often, a stock. This preceding downtrend sets the stage for the pattern, reflecting a period dominated by bearish sentiment in the market. Traders and analysts keen on identifying trend reversals scrutinize this initial downtrend, looking for signs of exhaustion and, thus, a potential shift in market dynamics.

2. Inverse head and shoulders formation

The inverse head and shoulders pattern counts three principal components: the left shoulder, the head, and the right shoulder. 

• Left shoulder: This is formed when the security’s price falls to a new low and then rises to a certain point, creating a trough.

• Head: After the left shoulder’s formation, the price falls again, but this time to a lower level than the left shoulder, and then rises back up. This deeper trough forms the pattern’s "head."

• Right shoulder: Finally comes the right shoulder, which forms when the price falls again after the head, but not as low as the head, and then rises back up again, roughly to the same level as the left shoulder. This creates a second, shallower trough.

As these elements represent minor troughs or lows in the price movement, they appear as a pattern visually resembling an inverted head and shoulders. This distinct shape is a crucial aspect of pattern recognition.

3. Reversal breakout (neckline resistance)

Critical to the inverse head and shoulders pattern is the neckline, a horizontal line connecting the high points of the left and right shoulders. The reversal breakout occurs when the price convincingly surpasses this neckline resistance. This is a pivotal moment because it confirms the pattern and indicates a potential transition from a bearish trend to a bullish one. Traders often await this breakout to initiate positions, anticipating a new upward trend.

Why volume matters in the inverse head and shoulders pattern

Volume is a critical factor when analyzing an inverse head and shoulders pattern, providing insight into the potential trend reversal’s strength and sustainability. It measures market interest and participation, offering traders a bird’s eye view of the market sentiment.

During pattern formation, volume can reveal the level of conviction behind the downtrend. Ideally, it should diminish as the pattern progresses, signaling a weakening bearish sentiment. As the price forms the left shoulder, head, and right shoulder, a decrease in volume indicates a potential exhaustion of selling pressure, laying the groundwork for a reversal.

In fact, volume becomes particularly crucial in the breakout stage. A convincing breakout above the neckline with a surge in volume adds weight to the pattern’s validity. High volume during the breakout suggests strong market interest and commitment to the emerging bullish trend. It signifies that many market participants actively participate in the reversal, reinforcing the potential for a sustained upward move.

Traders often look for a combination of decreasing volume during the pattern formation and a substantial increase in volume during the breakout to confirm pattern strength. This volume analysis enhances the pattern’s reliability as a signal for a trend reversal, instilling more confidence in traders in their decision-making process.

How to trade with technical indicators using Composer

Trading based on technical indicators with Composer is a seamless process combining AI’s power with easy, user-friendly tools. Here's a step-by-step guide to help you get started:

1. Sign up to Composer for free 

Begin your journey by signing up for Composer's 14-day free trial, which lets you try out the platform without obligation. Create your account to access a platform designed for both novice and experienced traders.

2. Head to "Create a New Symphony" 

Navigate to the Create button located in the top left corner of the platform. Click on "+ New Symphony" to start building your trading strategy.

3. Use the AI tool to craft a symphony 

Engage with the AI tool by clicking "Create with AI." Open a chat with the tool, and instruct it to build a strategy based on the technical indicators available on Composer.

4. Tailor the strategy with the no-code editor 

Finally, refine your strategy using Composer's intuitive no-code editor. Add different assets to diversify your portfolio and employ various logic functions to fine-tune your trading approach. The no-code editor helps you gain increased control over your strategy without the need for programming expertise.

Trade with Composer using AI

With Composer, trading based on technical indicators isn’t a dull task. Instead, because of our combination of cutting-edge technology with a friendly, intuitive design, trading is seamless and effective, helping you invest your hard-earned cash in the right place. 

To learn more about Composer and our services, head to composer.trade and sign up for free.