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Reverse Head and Shoulders Pattern

Investors use the reverse head and shoulders pattern to identify trend reversals in a stock, ETF or index. As one of the most popular stock chart patterns, the reverse head and shoulders is easy to recognize and widely used by technical analysts.

The reverse head and shoulders pattern is characterized by three troughs with the center one the lowest of the three. The trough on the left forms the left shoulder and the trough on the right forms the right shoulder. The important feature is the center trough must be the lowest of the three. When you look at the pattern it looks like an upside down head and shoulders formation.

If you want to learn more on the reverse head and shoulders or many other technical chart patterns consider the book by Thomas N. Bulkowski who wrote Encyclopedia of Chart Patterns (Wiley Trading) . It is the only definitive study of chart patterns that includes statistical analysis of the success and failure of over 50 chart patterns. An excellent reference.

Reverse Head and Shoulders Pattern Explained

A reverse head and shoulders can form within a longer term down trend, as a low after down trend, and during an up trend. Many technical investors assume the reverse head and shoulders stock pattern only occurs at the end of a long down trend. This is not be true, making the pattern more useful than many realize.

The left shoulder of an reverse head and shoulders pattern forms when an interim low has been made and the price rises. After a brief rise the price turns down again and forms a lower low. This new trough creates the inverse head of the pattern. Once the lower low or head is in place the price rises again for a brief period before turning back down again. The third move down forms a higher low by turning back up before the price reaches the last low. This last move up forms the right shoulder. Often volume increases when the right shoulder appears, as astute investors realize this pattern is a positive for the market.

When you look at a reverse head and shoulders pattern, it looks like you flipped the bullish head and shoulders pattern upside down as the chart below shows.

reverse head and shoulders pattern

Another feature of the reverse head and shoulders pattern is the neckline that connects the top of the left and right shoulders. This neckline is offers a resistance level that investors use to trigger a buy. The neckline also helps to identify the potential target as defined by the measured move rule.

When a head and shoulders bottom forms with more than two shoulders, it is called a complex head shoulders stock pattern. However, the basics of a head and shoulders bottom are the same.

Volume is an important indicator for many head and shoulder bottoms. Usually the volume is higher on the right shoulder as some traders realize this might be a good buying opportunity. When volume increases after the low of the right shoulder has formed, it is a confirmation that the head and shoulders bottom stock pattern is in place and ready to perform.

Trading Reverse Head and Shoulder Patterns

Trading the reverse head and shoulders pattern is a straightforward process. When you recognize the formation of the lower right shoulder, it is time to be ready to take action. If you are confident the formation is a head and shoulders bottom, you should get your stock watch list ready with the best buying opportunities ready to go.

The reverse head and shoulders has a very low failure rate of 5% according to Bulkowski's study. As a result, you can take some risk when you recognize the head and shoulders bottom pattern has formed. 

If you decide to buy on a break of the neckline of an reverse head and shoulders pattern, a good place to place your initial stop is just below the neckline. You can also enter before reaching the neckline trigger, if you believe the formation of the right shoulder is real. When you buy early, place your initial stop just below the low of the right shoulder.

The reverse head and shoulders pattern provides an easy way to assess the target of the move up using the measured move technique. To calculate the measured move you take the middle of the neckline for the left and right shoulder and subtract the closing low of the head. Take this difference and add it to the middle of the neckline to arrive at the target for the move up.

In the chart above, the middle of the neckline was 105 with the close on the up-side-down head at 98. This gives us a difference of 7. Add 7 to 105 (the middle of the neckline) gives you 112 as your target. As you can see on the chart the price on the SPY rose to 113, before turning down, so we hit our target in this example. I like to use round numbers for these calculations as this rule is not designed to be absolutely precise to the penny in its target.

Risks using Reverse Head and Shoulder Patterns

According to Bulkowski’s book, the reverse head and shoulders pattern has a 5% failure rate during the course of his study. As one of the lowest failure rates, this indicates that the reverse head and shoulders pattern is a valuable stock investing tool. While all investing and trading incurs risk, when this stock pattern forms, you should be ready to employ the proper money management techniques to reduce your risk of loss.

Probably the biggest risk most investors face when they encounter a well-formed reverse head and shoulders pattern is they fail to recognize the pattern and delay buying the best stocks on their watch list. Since a reverse head and shoulders pattern often takes place during a period of weakness in the market, investors tend to be afraid to make a commitment. When this happens investors are exchanging a well founded trading discipline for emotion. Whenever emotion enters your investing, it usually results in a bad outcome. In this case, you are missing out on an opportunity to make money with a low risk trading pattern.

This does not mean a reverse head and shoulders pattern is guaranteed to make you a winner. However, when you find this pattern, the probabilities are with you when you make a buy.

Conclusion

Reverse head and shoulders patterns occur quite often. Since they offer investors and traders a reliable chart pattern that reflects the behavior of investors who are about to bid up the price of a stock.

As always, use proper trading discipline to protect your precious capital. They include trailing stops, closing part of all of your long positions after a nice move up and adding down side protection to reduce your risk of loss.


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