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INVERSE HEAD AND SHOULDERS (HEAD-AND-SHOULDERS BOTTOM)

The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders top, as it signals that the security is set to make an upward move. Often coming at the end of a downtrend, the inverse head and shoulders is considered to be a reversal pattern, as the security typically heads higher after the completion of the pattern.

Again, there are four steps to this pattern, starting with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the previous low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which sees a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline.

The Breaking of the Neckline and the Potential Return Move

As seen from the above, the head-and-shoulders pattern is complete when the neckline is broken; the trend is then considered reversed, and the security should be heading in a new direction. The point of breakout is when most traders following the pattern would enter the security.

However, the security will not always just continue in the direction suggested by the pattern after the breakout. For this reason it's important to be aware of what is known as a "throwback" move. This situation occurs when the price breaks through the neckline, setting a new high or low (depending on the pattern), followed by a retreat back to the neckline.

This move back to the neckline is considered to be a test of the pattern and the newly reversed support or resistance. Remember that when a trend shifts (or a reversal pattern is confirmed), what was once support now become resistance, and vice versa. In the case of an inverse head-and-shoulders pattern (as shown in the chart above), the neckline represented a level of resistance for the security before it broke out. Upon the security moving above the neckline to confirm the pattern, the restrictive neckline becomes support for any move back up.

While it can be alarming to see a security move in the opposite direction of the trend suggested by the pattern, it isn't all that bad. The reason being that the successful test of this new level of support or resistance helps to strengthen the pattern and its suggested new direction. So, it's important to wait for the pattern to test out and not sell out too quickly - before the pattern makes its bigger moves.

Volume

In technical analysis and chart-pattern analysis, volume plays an important role as it is used as a secondary indicator. Volume indicates activity and money movement. When volume is high, there is a lot of activity and money changing hands - making it an important indicator to follow.

For the head-and-shoulders pattern, volume is used mainly at the point of breakout to help confirm the pattern. At this point, it's important that the breakout happens on a large-volume move. For a head-and-shoulders top, when the price breaks below the neckline (in a downward direction), it's best when this occurs during a large volume increase, which signals heavy selling. This strongly indicates that the underlying supply and demand in the market is moving in the same direction the chart pattern is predicting.

Volume can also be used as a secondary indicator during the formation of the pattern, well before the breakout, to gain an idea of the pattern's strength.

For a head-and-shoulders top, the left shoulder should show heavy volume as it hits its new peak. Low volume should take the left shoulder down to the neckline. The run towards the peak in the head should be on lighter volume compared to the peak formed in the left shoulder.

This should be a warning, as volume should move with trends - not against them. The peak formed in the right shoulder should be seen with even lighter volume than in either the head or the left shoulder. And again, the volume should be high when the neckline is broken, which is by far the most important area to watch in terms of volume. If the volume is lighter on the neckline break, the chances of the price moving back to the neckline after breaking is greater than if the neckline break was accompanied by large volume.

This interaction of volume and price movement in forming the reversal signal is not set in stone. However, it is the general tendency in the chart pattern.

Slope of the Neckline

Another key factor in the head-and-shoulders pattern is the formation of the neckline. The reason being that the neckline acts as support or resistance during the formation of the pattern, along with being the entry point at which the pattern confirms itself.

In most of the above examples, the neckline is flat, but this need not be the case for the pattern to provide a potential trade. In most cases, the neckline will in fact be slanted either up or down. In general, a technically strong head-and-shoulders top should have a flat or slightly upward-trending neckline. For a head-and-shoulders bottom, it should be flat or slightly downward

Price Objective

An important, but often overlooked, factor in technical analysis and chart patterns is the calculation of price objectives. This is a measure of where the price is considered to be headed, based on a confirmed pattern.

While the price's direction is already known, based on the signal, what needs to be calculated is the projected price movement. This is done so that targets can be set, protective stops can be instituted and the worth of a trade can be evaluated.

This is measured based on the height of the chart pattern, which is essentially the distance in price between the peak of the head and the neckline.

This price objective is not an absolute and is used as a guideline to the attractiveness of a trade. The larger the difference between the objective and the price at the neckline, the more worth the trade has, as it will yield greater returns.