Every now and again, the market turns a stock over on its head, or more specifically on its head and shoulders.
A traditional head-and-shoulders pattern is a sign that bullish trading is about to end, but when it is flipped — literally standing on its head — into an inverse-head-and-shoulders, it’s a sign that a current downtrend could be due for a reversal.
Let’s see how and why:
Inverse Head and Shoulders
The inverse head-and-shoulders pattern is the exact opposite of the traditional pattern, and you see it sometimes when a stock is in a downtrend.
After a fall, you will see a rise to a resistance — the neckline area — followed by a pullback to a brief trough, only to see the stock rise back to the neckline. From there, however, the stock forms a trough deeper and lower than the first. After this move, the stock rises back to the neckline and forms another trough. Typically, when traders see the stock break above the neckline, or resistance area, they look to get long on the breakout.
That’s a confusing word picture, so let’s look at an example in the daily chart on the iShares Russell 2000 Index ETF ( IWM), which showed an inverse-head-and-shoulders pattern earlier this year..
In the chart above, the ETF formed a neckline around the $119 area, and proceeded through a complete inverse head and shoulders. Thereafter, it broke above the resistance area, and began making new highs.
One way to make this indicator more effective is to use it in conjunction with other technical tools, such as moving averages. For example, IWM pulled back below the resistance area, which might have convinced you to exit the trade, but if you used moving averages and noticed that the 200-day simple moving average held as the support level, you would have stuck around to catch the rally.
The inverse head and shoulders pattern could serve as an indication of when a stock is likely to reverse from bearish to bullish trading. Watch it closely to see if the stock breaks above the neckline to indicate that a bullish reversal is in the cards.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.