Have you ever identified an Inverse Head and Shoulders Pattern on a chart and traded it accordingly? Let’s see what it is all about.
The significance of this pattern for a trader lies in giving a confirmation of trend reversal for a security and the potential return it is able to generate if traded properly.
Inverse Head and Shoulder pattern when formed shows that the previous trend of the security is coming to an end and a bullish trend is about to start.
On breakout of the pattern, traders need to be positioned on the long side to catch the big up move that the security may give.
Formation of the Inverse Head and Shoulder Pattern
Inverse Head and Shoulders pattern is formed of two Shoulders which may or may not be of equal size and a Head which is bigger in size than the shoulders . A straight line joining the peaks of the shoulder and head curves makes the neckline for this pattern. This neckline can be horizontal or slanting upwards or downwards.
A pattern with upward slanting neckline is considered more strong. In routine you may not see the pattern as symmetrical as shown in figures because securities move randomly and not symmetrically. So you need to be very vigilant to spot the pattern on the chart.After the formation of second Shoulder, when the security breaks above the neckline with higher than normal volumes, it confirms the pattern.
The time taken by the pattern to complete can be days,weeks or months. The longer it takes to complete, the longer it would take take to accomplish the target.
How to trade Inverse Head and Shoulders Pattern ?
Break out above the Neckline is the signal for taking long positions in that security. Point to be taken care of is that volumes of the trade should be higher than average when it breaks out.
Stop loss for the trade is the lowest level touched by the stock when it was in the making of Head of the pattern. Projected target for this trade is the difference in the price of the security at the peak of shoulder 1 and the trough of the head.
Let’s take an example. The chart in the Figure taken from moneycontrol.com is for Heromotocorp stock which has formed an Inverse Head and Shoulders pattern and accomplished the target after breakout. The orange line joining points 3 and 5 makes the neckline and the stock breaks out at point 7 (arrow) which coincides with stock price of ₹ 1715.
The target for this breakout is difference between point 3 and point 5.so it comes out to be 1767 – 1435 = ₹ 332 above the breakout levels. So, our target comes out to be 1715 + 332 = ₹ 2047 which was achieved by the stock and even went higher than that. You earned 20 % in four months. Stop loss we need to place at level of 1430 (see blue line at the head – point 4).
To keep our stop loss short, we can place it at point 6 (₹ 1615) also but the risk of it being triggered or violated is high. Sometimes, after breakout stock may see lower levels just to test the trough of second shoulder as in this case it went even lower than that.
The thing here a trader can do is to anticipate the breakout and buy the stock at the trough itself when it has formed and the stock starts to rise. The risk here is that the pattern may or may not confirm and there is no breakout.
Another thing you can do if stop loss is placed at point 6 is that you give some space to the stock to fluctuate as per your risk profile.This is called Trade Managing.