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Reverse Head and Shoulders Formation

The reverse head and shoulders formation (also known as inverse H&S formation) is one of the most popular and reliable formations used in technical analysis. As the name suggests, it has a shape similar to the head and shoulder. This head and shoulders bottom pattern usually signals a change in price trend. When it occurs the security is likely to move against the previous downtrend.

Gold and the Reverse Head and Shoulders Pattern

The reverse head and shoulders formation is characterized by 2 similar lows (called shoulders) and one higher low called head. Neckline is determined by the tops between shoulders and head. Price can go over neckline, but when the price will come back to the neckline it will reflect of it. Bellow you can find a picture presenting this pattern.

Charts courtesy of http://stockcharts.com/

This pattern has formed at the bottom of a downtrend and is considered a trend reversal pattern, because price continues to rise after the formation’s completion. This pattern works especially when the neckline is crossed after the second shoulder.

There are 4 steps in this formation. When they are seen, the pattern signals a reversal in trend.

  • The first step is forming the left shoulder. This occurs when the price of the asset reaches a new bottom and retraces to a new top (mid December).
  • The second step is forming the head. This happens when a new low is established (lower than the previous one in the left shoulder) and price comes back to near the level in the left shoulder top (early February).
  • The third step is forming the right shoulder. Another new low is formed, but it is higher than the previous one (in the head) and somewhere near the level of the bottom formed in the left shoulder (mid March).
  • The fourth step completes the whole pattern. Price rises above the neckline, which then becomes a support line established by the two tops between the head and shoulders.

After completing this formation there is a high probability that price will continue rising even if it falls momentarily (as in the last days of March). After a short period of decline, it will bounce off the neckline and start to rise again. This decrease in price after neckline breakout is referred to as “verification”. This move is a test for our formation and our new support level (the neckline). It can be alarming, but as long as price doesn’t break our support line our formation is confirmed and can be considered as strong signal of change in trend (from downtrend to uptrend).

However, it is essential to wait until this test is completed and to not take a position too quickly because the main move will occur after this test.

Volume plays significant role in the confirmation of the trend. Unlike the H&S top, there are no strict rules concerning volume in the reverse head and shoulders formation. But significant changes (lows, peaks or breaking through the neckline) should be accompanied by high volume. (Notice the volume action when price broke the neckline).

To see this more clearly, look at the chart below. Notice that the head and right shoulder were established with higher volume.

Another very useful feature of this formation is that it allows us to calculate objective price (target price).

This is a measure of where the price is considered to be headed, based on a confirmed (or verified) pattern. Since we already know price direction (from the confirmed pattern), now we can forecast a minimum value for how large that move will be.

Here's the simplified method. Suppose that our head bottomed at the level of $128 and the neckline is at $141 (at its end). The target price is calculated by summing the neckline level at its end, and the difference between the neckline and head bottom (marked as a red line in the chart above). In our case that will be $141 (the end of the neckline level) + $12 (difference between neckline and head) = $153 (price objective – at the upper end of the upper red line). This is shown on the chart using red lines. Note that the upper red line ends a bit higher than $153, and that is because of the logarithmic scale we used on the chart (as opposed to a linear scale). A log scale is better for large moves which is the case in the chart. That is why we need to use the detailed method.

The detailed method calculates the range in relative terms. The first step is to calculate how high the neckline is above the head (in relative terms), and then apply this to the end of the neckline. Here, we have $140 / $128 = 1.09375 and $141 * 1.09375 = $154.22

As we can see in the chart the price rise ended very close to $154, so this forecast was quite accurate. However, even though the targets are often accurate, we prefer to use them as approximations (we would say, for instance, in the above example GLD was likely to move above $150). We consider target price not as a rigid value, but as a sign of how strong the rally is likely to be. The rule is simple: the lower the head, the higher the price is headed.

To sum up, the reverse head and shoulders has been seen several times in the current gold bull market and is in fact quite common in technical analysis. It usually gives strong and firm signals. However, you must be careful and wait for confirmation. You should also use the target price as a measure of the strength of the price move.

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