Reverse Head & Shoulder

Shape:

  • The reverse (or inverted) head and shoulders is a bullish reversal pattern that forms during a downtrend.
  • It consists of three troughs: a central trough (the head) that is the lowest, flanked by two higher troughs (the shoulders).
  • A neckline is drawn by connecting the peaks of the pattern. The pattern indicates a potential reversal from a downtrend to an uptrend as buying pressure increases.

Success Rate:

  • Historically, the reverse head and shoulders pattern has a relatively high success rate, especially when accompanied by strong volume.
  • Success rates can vary, but some studies suggest that the pattern has a success rate of around 65-70% in achieving its price target once a breakout occurs.

Buy:

  • Enter a buy position when the price breaks out above the neckline with a significant increase in volume.
  • Confirm the breakout with a close above the neckline.

Take Profit (TP):

  • Measure the distance from the head to the neckline.
  • Add this distance to the breakout point (where the price breaks the neckline) to set the initial take profit target.
  • Example: If the distance from the head to the neckline is Tk.5 and the breakout point is at Tk.20, the target would be Tk.25.

Stop Loss (SL):

  • Place the stop loss slightly below the right shoulder or the most recent swing low within the pattern.
  • This helps limit potential losses if the breakout fails and the price reverses.

Sell:

  • Selling should be considered if the price fails to break out and instead falls below the right shoulder.
  • Also, consider selling if the price reaches the take profit target or shows signs of a reversal.

Profit Trailing:

  • Use a trailing stop to lock in profits as the price continues to move in your favor.
  • Adjust the stop loss level upwards as the price rises, keeping it a set distance (e.g., a percentage or taka amount) below the current price.

Lot Size:

  • Determine the lot size based on your risk tolerance and account size.
  • Ensure that the potential loss (difference between entry price and stop loss) does not exceed a predetermined percentage of your account balance (e.g., 1-2%).
Risk-to-Reward Ratio: 
  • Aim for a favorable risk-to-reward ratio (e.g., 1:2 or higher), where the potential reward is at least twice the potential risk.
Leverage: 
  • Use leverage cautiously. While leverage can amplify gains, it also increases potential losses. Ensure you have a clear understanding of how leverage works and its impact on your trades.

Other Conditions:

  • Confirm the breakout with increased volume, indicating strong buying interest.
  • Monitor overall market conditions and sentiment to ensure alignment with the bullish outlook.

Caution:

  • False breakouts can occur, leading to potential losses. Always wait for confirmation before entering a trade.
  • Market volatility and external factors can influence the pattern's reliability.
  • Avoid trading reverse head and shoulders in a weak or bearish market, as the success rate may decrease.

Pros and Cons of the Reverse Head & Shoulders Pattern

Pros:

  1. High Success Rate:

    • Historically, reverse head and shoulders have a high probability of successful breakouts, especially when confirmed by increased volume.

  2. Clear Entry and Exit Points:

    • The pattern provides clear levels for entry (breakout above neckline) and exit (stop loss below right shoulder), making it easier to plan trades.

  3. Bullish Reversal Signal:

    • The pattern signals a reversal from a downtrend to an uptrend, providing opportunities for traders to enter at the start of a new trend.

  4. Easy to Identify:

    • The pattern's structure is relatively straightforward, making it easy for both novice and experienced traders to identify.

  5. Quantifiable Targets:

    • The distance from the head to the neckline can be used to set price targets, providing a systematic approach to profit-taking.

Cons:

  1. False Breakouts:

    • Reverse head and shoulders can sometimes lead to false breakouts, where the price moves above the neckline but then quickly reverses. This can result in losses if not managed properly.

  2. Volume Requirement:

    • Successful breakouts often require a significant increase in volume. If the breakout occurs on low volume, it might be less reliable, leading to potential failure.

  3. Market Conditions Dependency:

    • The pattern's effectiveness can diminish in volatile or bearish market conditions. It is most reliable in a stable or bullish market environment.

  4. Subjectivity:

    • Drawing necklines can be somewhat subjective. Different traders might identify slightly different levels of resistance and support, leading to variations in pattern recognition.

  5. Time Frame Variability:

    • The pattern can form over various time frames, from minutes to months. The reliability and interpretation might differ based on the time frame, requiring traders to adapt their strategies accordingly.

Trading Psychology of Reverse Head & Shoulders

Formation:

  • Initial Downtrend: The pattern typically forms during an existing downtrend. Traders are pessimistic, and selling pressure is strong.
  • Left Shoulder: The price makes a new low and then rebounds, forming the left shoulder. This indicates initial buying interest.
  • Head: The price declines again, making a lower low (head), but then rebounds more strongly. This suggests increasing buying pressure and potential bottoming out.
  • Right Shoulder: The price declines once more, but the low is higher than the head, forming the right shoulder. This reinforces the idea of a potential reversal.

Market Sentiment:

  • Buyers' Confidence: As the pattern forms, buyers become more confident that a reversal is imminent. The higher low of the right shoulder indicates increasing bullish sentiment.
  • Sellers' Weakness: Sellers attempt to push the price lower, but their efforts weaken as buyers step in at higher levels. This indicates diminishing selling pressure.

Breakout Psychology:

  • Anticipation: Traders who recognize the reverse head and shoulders anticipate a breakout above the neckline. They prepare to enter buy positions upon confirmation of the breakout.
  • Volume Increase: A significant increase in trading volume during the breakout confirms that more traders are entering the market, reinforcing the bullish sentiment.
  • FOMO (Fear of Missing Out): As the breakout occurs, more traders rush to buy, fearing they might miss out on the price surge. This further drives the price up.

Post-Breakout:

  • Validation: Successful breakout validation (price closing above neckline with increased volume) reassures traders that the pattern is legitimate. This leads to sustained buying interest.
  • Profit-Taking: Some traders might take profits near the target price derived from the head-to-neckline distance. However, the overall sentiment remains bullish unless significant resistance is encountered.
  • Trailing Stops: Experienced traders use trailing stops to lock in profits while allowing for further upside potential. This approach balances profit-taking with the possibility of continued price increase.

Failure and Risk Management:

  • False Breakouts: Not all breakouts succeed. False breakouts can occur, leading to trader frustration and potential losses. Proper risk management, such as stop-loss orders, is essential.
  • Reevaluation: If the breakout fails, traders reassess their strategy. They might look for other patterns or signals to guide their next moves.

General Tips for Managing Trading Psychology:

  1. Patience: Wait for the breakout confirmation before entering a trade to avoid false signals.
  2. Discipline: Stick to your trading plan, including predefined entry, exit, and stop-loss levels.
  3. Emotional Control: Manage emotions like FOMO and fear by focusing on your strategy and risk management principles.
  4. Continuous Learning: Stay informed about market conditions and continuously improve your technical analysis skills.

Understanding the psychology behind the reverse head and shoulders can help you make more informed trading decisions and better anticipate market movements.