The head and shoulders, including its closely-related cousin the inverse head and shoulders, is a popular trend reversal pattern. However, not much is written about its shortcomings. This article addresses these by showing you the common hallmarks of a failed (inverse) head and shoulders pattern and how to mitigate losses when this happens.
What is a Head and Shoulders Pattern?
A head and shoulders pattern is a chart formation that technical analysts use to predict a bearish trend in prices.
While this can be a continuation of a previous bearish trend, it is more common to see it reverse an upward trend. In this case, it acts as a bearish reversal pattern; giving rise to its other name, head and shoulders top.
True to its name, it consists of 3 peaks that resemble the shape of a person’s head and shoulders.
Optically, this appears as a large “hump” (the head) sandwiched between 2 smaller “humps” (the shoulders).
The line connecting all 3 peaks at their base represents a support line, that if broken, signals the beginning of a new downtrend. Traders refer to this line as the neckline.
However, as is often the case in technical analysis, this is not a hard-and-fast rule. The head and shoulders pattern produces “false signals” just like all other indicators and chart patterns do.
This is otherwise known as a failed head and shoulders pattern, which we will come to later.
What is an Inverse Head & Shoulders?
If you understand the basics of the standard head and shoulders formation, then you should have no problems with the inverse head and shoulders pattern.
In fact, it is just the mirror image.
As such, it appears as an upside-down head and shoulders. That is, instead of having 3 peaks, it has 3 troughs. And instead of being a bearish pattern, it is a bullish pattern.
Again, while it’s possible that an inverse head and shoulders pattern appears after an uptrend, it is more common to see it form following a downtrend. In these instances, it acts as a bullish reversal pattern. Hence why it is sometimes referred to as a head and shoulders bottom.
Visually, the middle trough is shallower than the 2 surrounding troughs, and the line connecting all 3 at their highs represents a resistance level, that if broken, signals the beginning of a new uptrend. This makes it very similar to another chart pattern called the cup and handle. In fact, if you remove the left shoulder they look identical.
As you might have guessed, an inverse head & shoulders pattern doesn’t guarantee a new uptrend. Later, I will show you what a failed inverse head and shoulders looks like and how we might go about mitigating it.
How to Trade the (Inverse) Head and Shoulders Pattern
Before we can spot what a failed head and shoulders pattern looks like, we first need to know what happens when everything goes to plan.
We need a benchmark to reference, after all!
These 4 steps show you what an ideal trade setup looks like for both a standard and inverse head and shoulders pattern:
- Identify the head & shoulders
- Draw neckline
- Wait for breakout
- Set profit target
Identify the Head & Shoulders
The first step is to identify 3 peaks or troughs that resemble the shape outlined earlier.
For a standard head and shoulders, this will look like 2 smaller “humps” surrounding 1 larger “hump”.
Conversely, an inverse head and shoulders pattern occurs when you have 2 smaller troughs surrounding 1 larger trough.
In general, both shoulders should roughly be of equal height.
The following chart from TradingView shows what both of these look like. Of course, the first pattern is a standard head & shoulders, while the second is an inverted head & shoulders.
For those interested, TrendSpider and Finviz are two other popular TradingView alternatives capable of pattern recognition.
Draw Neckline
Once you are confident that you have the correct pattern, you now need to draw the neckline.
For a standard head and shoulders, this will be a straight line that connects all 3 peaks at their respective lows.
For an inverse head and shoulders, this will be a straight line that connects all 3 troughs at their respective highs.
It is important to know that this neckline doesn’t have to be perfectly horizontal. Nor does it have to connect prices at their exact highs or lows. It can have a slight tilt and only roughly connect the relevant prices. Discretion is down to the individual.
Wait For Breakout
Before entering a trade, it is important is to wait for breakout confirmation. By this, I mean waiting for the right shoulder to fully form and seeing if prices break through the neckline.
For a standard head and shoulders, this is the point at which the price drops through the neckline. The red circle shows where this occurs in the chart below. When this happens, you should think about exiting an existing long position or entering a new short position.
For an inverse head & shoulders pattern, the breakout occurs when the price rises through the neckline. This is where the green circle is drawn. At this point, you should think about exiting an existing short position or entering a new long position.
You should also check volume before entering a trade. Ideally, you want to see rising volume leading up to the breakout, as this increases the chance a sustainable move. This is probably more important for an inverse head & shoulders than a standard head & shoulders, as rallies tend to need more momentum than sell-offs. Indeed, sell-offs can occur simply through lack of interest.
Nonetheless, you can see that volume increased in the days leading up to the breakout in both patterns below and the breakout was successful in each case.
Set Profit Target
The final step when trading a head and shoulders pattern is to set a price target. This is where you will exit the position.
Thankfully, there is a useful rule-of-thumb to help us do this.
It consists of 2 steps:
- Measure the vertical distance between the top of the pattern (head) and the neckline.
- Subtract the same distance from the neckline’s breakout point for a standard head & shoulders. Add this distance to the neckline’s breakout point for an inverse head & shoulders.
Voila! Your profit target is the price at which this second line ends.
The chart below illustrates this for both patterns. As you can see, it provided pretty timely exit points for the initial price swing.
One slight caveat, however. As mentioned, this is only a rule-of-thumb. It won’t work 100% of the time. Sometimes prices will fall short of this target and other times it will exceed it. That’s just how it goes sometimes. At most, it gives you a disciplined framework to take profits.
Failed (Inverse) Head and Shoulders
Ok, now we know what a successful head & shoulders breakout looks like, it should be easy to spot a failed (inverse) head and shoulders pattern.
Essentially, a failed head and shoulders occurs when the initial breakout fails and prices quickly reverse back through the neckline in the opposite direction.
As you can see in the chart below, this happened almost immediately after the initial breakout. The day after, in fact. It means bears couldn’t overcome the bulls and push prices below the psychological neckline level. The rejection of such intense selling pressure is usually a bullish signal.
Unfortunately, it is almost impossible to tell when this might happen in advance. If it was, we’d all be rich.
As mentioned earlier, you can look for clues in volume – ideally looking to see it increasing leading up to the breakout. However, even this isn’t full-proof. For example, in the chart above, volume was actually increasing in the 3 sessions before the breakout candle. Obviously, this wouldn’t have helped us in this case.
The only real way to mitigate losses in the event of a failed head & shoulders pattern, is to set a stop loss just above the neckline. Of course, for an inverted head & shoulders the stop-loss would be set just below the neckline.
FAQs
Is the Head and Shoulders Pattern Bullish?
No, the head & shoulders is generally considered a bearish pattern.
Is the Inverse Head and Shoulders Pattern Bullish?
Yes, the inverse head & shoulders is considered a bullish pattern.
How Reliable is an (Inverse) Head and Shoulders?
Unfortunately, there is not much empirical data on the efficacy of these patterns, as they are incredibly difficult to program into backtests. However, anecdotal evidence suggests that the standard and inverse head & shoulders patterns are generally considered two of the more reliable chart patterns in technical analysis. I happen to agree with this based on my own experience.
How Do You Know When an (Inverse) Head and Shoulders Pattern has Failed?
A head & shoulders has failed when the initial breakout reverses and prices break back through the neckline.