One of the most commonly used reversal patterns is the head and shoulders pattern that is a top reversal pattern.
Inverse head and shoulders pattern or head and shoulders bottom is a bottom reversal pattern and indicates that an uptrend is likely to commence.
The top reversal patterns are shorter in duration and more volatile when compared with bottom reversal patterns. Bottom reversal patterns generally take more time to form.
Inverse head and shoulders pattern forms after a prolonged down trend. On completion of the pattern, we can witness a change in trend.
This formation has three consecutive troughs. The middle trough is the lowest (head) and the two exterior troughs (shoulders) are slightly higher than the middle trough and are approximately equal. These shoulders can be of different widths as well as different heights.
The peaks following the troughs are connected to form a neckline. The pattern is confirmed and completed only when the neckline is penetrated with increase in the volume.
Let us now understand inverse head and shoulders with a chart example.
The two-year down trend from 1999 in Ingersoll-Rand India (refer above chart) reversed after the formation of an inverse head and shoulders pattern. The stock almost took 18 months (August 2000 to February 2002) to complete the pattern. Longer the duration of the price pattern, the greater its significance.
The volume was heavy in the left shoulder and the head formation. This indicates greater selling pressure in the first two troughs.
The up move from the head shows an increase in volume, indicating fresh buying interest or change in investor sentiment.
In February 2002, the stock conclusively broke through the neckline accompanied by heavy volume.
Typically after a break-out, a return move back to the neckline is quite probable and in our example the stock made a return move (a pull back) to the neckline.
Subsequently, the stock resumed its uptrend and continued to trend upward.
We also notice an inverse head and shoulders pattern in the Wipro chart shown above, spanning between January and April 2008.