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Crypto and stock traders view the inverse head-and-shoulders pattern as an early signal that a bullish trend reversal is in the making.
Every trader aims to buy low and sell high, but only a few are able to muster the courage to go against the herd and purchase when the downtrend reverses direction.
When prices are falling, the sentiment is negative and fear is at extreme levels, but it's at times like these that the inverse head and shoulders (IHS) pattern can appear.
The (IHS) pattern is similar in construction to the regular H&S top pattern, but the formation is inverted. On completion, the (IHS) pattern signals an end of the downtrend and the start of a new uptrend.
Inverse head and shoulders basics
The (IHS) pattern is a reversal setup that forms after a downtrend. It has a head, a left shoulder and a right shoulder that are upside down and placed below a neckline. A breakout and close above the neckline completes the setup, indicating that the downtrend has reversed.
As shown above, the asset is in a downtrend but after a significant decline, value buyers believe the price has reached attractive levels and will start bottom fishing. When demand exceeds supply, the asset forms the first trough from the left shoulder and the price starts a relief rally.
In a downtrend, traders sell on rallies. The bears sell aggressively after the pullback and the price dips below the first trough, making a lower low. However, bears are unable to capitalize on this weakness and resume the downtrend. The bulls buy this dip and start a relief rally, forming the head of the pattern. As the price nears the previous peak where the rally had stalled, the bears again step in.
That starts the decline, culminating in the formation of the third trough, which is arrested almost in line with the first trough as buyers anticipate a turnaround and purchase aggressively. This forms the right shoulder of the setup. The price turns up and this time, the bulls manage to push the price above the neckline, completing the pattern.
The neckline thereafter becomes the new floor as traders buy the dip to this support. This signals the start of a new uptrend.
Identifying a new uptrend with the (IHS) pattern
Bitcoin (BTC) had been in a downtrend since forming a local top at $13,970 on June 26, 2019. The buyers stepped in and arrested the decline in the $7,000 to $6,500 support zone, forming the left shoulder of the (IHS) pattern. This started a relief rally that pushed the price to $10,450. At this level, short-term bulls booked profits and bears initiated short positions, aiming to resume the downtrend.
Aggressive selling broke the support at $6,500 and the Bitcoin/Tether (USDT) pair plunged to $3,782.13 on March 13, 2020. The bulls viewed this fall as a buying opportunity and that started a strong relief rally, which reached close to $10,450. This second trough formed the head of the setup.
The right shoulder was shallow because the selling pressure was reduced and bulls did not wait for a deeper correction to buy. Finally, the bulls pushed the price above the neckline on July 27, completing the (IHS) pattern.
The bears tried to trap the bulls and they pulled the price back to the neckline. Although the price dipped just below the neckline, traders did not allow the pair to sustain below $10,000. This suggested a change in sentiment. The bullish momentum picked up as buyers pushed the price above $12,500.
How to calculate the pattern target of a IHS setup
To calculate the minimum target objective of the (IHS) pattern, calculate the depth from the neckline to the lowest point, forming the head. In the above example, the neckline is around $10,450, and subtracting the lowest point at $3,782.13 gives a depth of $6,667.87.
This value is then added to the breakout level, which in the above example, is near $10,550. This gives a target objective at $17,217.87. When a trend changes from down to up, it may fall short or exceed the target objective. Therefore, traders should use the target as a guide and not dump their positions just because the level has been reached.
Patience pays o because sometimes the pattern fails
No pattern succeeds at every breakout and traders should wait for the setup to complete before initiating the trades. Sometimes, the pattern structure forms but the breakout does not happen. Traders who preempt the completion of the pattern and initiate trades get trapped.
For example, Chainlink’s LINK topped out at $4.58 on June 29, 2019, and started a correction. The buyers attempted to stall the decline in the $2.20 to $2.00 zone. This formed an (IHS) pattern with a head and two shoulders as can be seen in the chart above.
Although the price reached the neckline on Aug. 19, 2019, the buyers could not push the price above it. Due to this, the pattern did not complete and the buy signal did not trigger.
The LINK/USDT pair turned down from the neckline and broke below the head of the setup at $1.96, invalidating the pattern. This trapped traders who may have purchased in anticipation of a trend reversal.
Key takeaways
The (IHS) pattern could be a useful tool for traders to jump on a new uptrend as it is getting started. There are a few important points to remember while using this setup.
Traders should wait for the pattern to complete, which happens after the price breaks and closes above the neckline, before initiating any long positions. A breakout of the neckline, which is on above-average volume, is more likely to result in a new uptrend compared to a breakout that happens on low volumes.
When a trend reverses, it generally continues for a long time. Therefore, traders should not be in a hurry to dump positions only because the pattern target has been met. At other times, the pattern completes but quickly reverses direction and the price plummets. Traders should closely watch the other indicators and price action before squaring up a position.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.
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