8 Indicators to Confirm an Inverse Head and Shoulders Breakout

During a confirmed inverse head and shoulders breakout, key indicators like volume, RSI, and MACD show distinctive shifts.

Historically, volume might spike at least 30% above the average as the price crosses the neckline.

Concurrently, RSI often rises above 60, signaling increasing bullish momentum.

The MACD might display a bullish crossover, with the MACD line crossing above the signal line right at the breakout point, reinforcing the trend reversal.

For example, in Apple’s 2019 breakout, volume surged by 35%, RSI hit 65, and the MACD confirmed with a clear crossover.

Price Movement Beyond the Neckline

When trading an inverse head and shoulders pattern, the most critical aspect to consider is the price action breakout above the neckline. This shift in price indicates a potentially significant bull run, and it is crucial to consider several technical indicators with caution when interpreting such a move. For instance, in a recent case involving Tesla , a stock in late 2020 formed an inverse head and shoulders pattern with the neckline at roughly $450.

Price analysis indicated that when the prices went above this level, it was not just the breakout that presaged a bullish signal; in addition to t he price action, several other technical indicators confirmed the strength and sustainability of this bullish move:

Volume Analysis: There was roughly a 20% increase in trading volume compared to the previous ten days’ average, indicating a strong participation of buyers.
MACD : The Moving Average Convergence Divergence showed a bullish crossover when the bulls broke the neckline. The MACD line went above the signal line, confirming the strength of this shift in momentum.
RSI : The Relative Strength Index went above 60, suggesting that the bulls were in charge, but the stock was not overbought. Legroom to the upside allows the price to ramp up further.

For a more conservative approach, setting the Fibonacci Retracement from the low price of the head at the breakout point at the neckline might allow one to consider key support and resistance levels both when the price pulls back and rallies, respectively.

Another essential tool is the ATR to set the stop loss. For a more conservative approach while managing volatility, one could set the stop loss just below the 1x ATR from the breakout point while giving legroom for the trade.

Finally, studying behavior at the 20-day and 50-day moving averages shows that a strong breakout, with the price staying above these moving averages, suggests that the bullish trend is still in play.

Increasing Trading Volume

For the inverse head and shoulders pattern, trading volume increases at critical points, which provides necessary confirmation for the pattern and the trend reversal to hold.

To use trading volume as an indicator effectively, some detailed strategies regarding its use can be considered.

Volume Comparison

The most common strategy, the increase in volume, can be quantified by comparing it to the average volume for the previous period, which can be set at around 20 or 50 days. At the breakout, volumes need to be at least 50% higher to be convincing in the breakout. If Netflix is trading 5 million shares daily, a breakout day at Netflix needs to be 7.5 million shares and more to qualify for an uptrend.

Volume Indicators

There are several volume indicators to use:

On-Balance Volume is a cumulative indicator that adds volume on up days and subtracts on down days. It can provide a line that moves with price and can lead movements. If the OBV line is moving up with the price, the uptrend is confirmed.
Volume Price Trend helps find the balance between supply and demand by looking at volume to determine the extent of price movements. If prices are moving down, and VPT is moving up, strong buying pressure is denoted.
Volume Moving Average uses an average volume to determine the direction that the volume is moving. The 20-day volume moving average can help. The breakout needs to have higher volume than this moving average.

Volume Spikes

They are evident in bar charts. For a breakout from the inverse head and shoulders, the volume bar going through the neckline needs to be significantly higher than previous days and the days that follow.

Practical application for traders should be setting up some alerts when the trading volume goes through a certain level. This can provide real-time execution.

MACD Crossover

The MACD “moving average convergence divergence” ) crossover is the standard yardstick for a trader analyzing the inverse head and shoulders pattern. A quantifiable and historical rationale for anticipating a trend reversal is presented by this indicator which uses two moving averages .

Setting the MACD Parameters: Normally, the MACD indicator is set with a fast EMA or 12 days, a slow EMA or 26 days, and a signal line or The trader’s strategy and the asset’s volatility will need the EMA to be adjusted. The inverse head and shoulders pattern should be confirmed by the MACD crossover. The bullish signal is confirmed when the MACD line or 12 day EMA minus 26 day EMA crosses above the signal line or 9 day EMA. This should happen at the point that the price is occurring, breaking above the neckline or $220.

Quantifying the Crossover: The quantity to be measured at the crossover point is the separation between the MACD line and the signal line. The greater the separation of the lines, the greater is the momentum of the breakout. In the period of August 2020, Google’s stock GOOGL $3 above the signal line which is 3 points above the signal line, supported the breakout above the neckline at $1500.

Confirming with Histograms: The MACD histogram is an additional visual indication to confirm the strength of the movement. A building histogram represents an increasing bullish exposure, which is critical to confirm the neckline breakout.

Historical Precedence: The trader can now look at the past back-testing of similar setups. For example, in May 2019, for MSFT, the MACD crossover at the price action resulted in a 15% increase in price.

RSI Reversal Signals

RSI Relative Strength Index is a strong momentum oscillator used widely to identify potential reversals.

The strategies include:

Setting RSI parameters: Generally, the RSI takes a period of 14days, but it can be adjusted due to one’s trading style and the market being traded. Lower periods are used to make the oscillation more sensitive. On the contrary, higher periods give smoother oscillations.

Key levels: These are levels where the RSI shows that the security is oversold 30 and over-bought 70. In the inverse head and shoulders, a strong signal of RSI will occur when the RSI will start producing oscillation out of the oversold region as the price forms the right shoulder or breaks above neckline.

RSI divergency: This is when the price will hit a low that is lower, than the previous low the head, but the RSI will form a higher low. This is a bullish signal of divergence and often gives strong signals before the security or price substantially rises. For instance, if Apple’s stock reached at $130 for low, but RSI would show a higher low than the previous trough, then, it means that downward moment is becoming weaker.

Quantifying from the strength of the reversal. The strength can often be measured over the momentum. When an RSI will pull back and rally in the same horizon, then the momentum is measured. Generally, if the RSI picks to the 50s, then there is a strong interest of buying in the stock.

Stochastic Oscillator Trends

The Stochastic Oscillator is a momentum indicator that evaluates a particular closing price of a security to a range of its prices over a time frame. It is often used to analyze inverse head and shoulders patterns and identify potential reversal points by pointing to changes in momentum.

Defining the Parameters: A stochastic oscillator consists of two lines — the %K line showing the current price as a percentage of the range period over a specific number of days or weeks and the %D line, which is the moving average of the %K line .

The settings can be adjusted to assign more relevance to the changes by making the oscillator more sensitive or to smooth the lines by averaging the %D line over additional days or weeks, depending on the market and trading preferences.

Identifying the Overbought and Oversold Areas: The oscillator readings vary between 0 and 100, with value below 20 indicating that a stock moved closer to the bottom range and above 80 suggesting that it approached the higher range. For inverse head and shoulder patterns one should watch for the oscillator to rise above 20, implying an opportunity to buy during the completion of the right shoulder.

Searching for the Cross: A buy signal is given when the %K line crosses the %D from the bottom to the top, while both are in the oversold area, namely below 20 and begin to head up .

Quantifying the Difference: A trader should also watch for the difference in these readings, in order to forecast a consistent uptrend. A substantial shift from oversold conditions to around 50 is a strong bullish signal.

For example, when the breakout above the ascending trendline occurred at the end of June 2020 Nvidia formed an inverse head and shoulder pattern, with the stochastic oscillator rising from 15 to 50 as the price made a similar move from $350 to $500 and above in early July.

Candlestick Confirmation

Candlestick patterns play a crucial role in confirming potential trend reversals noted by the inverse head and shoulders pattern.

Following are the necessary steps for a trader to utilize candlestick confirmation for an inverse head and shoulders setup:

Notable Candlestick Patterns: At the peak of an inverse head and shoulders, the bullish reversal candlestick that appears include the hammer, inverted hammer, and the bullish engulfing pattern . They should appear around the end of the right shoulder or at the breakout above the neckline .

Quantitative Analysis: Measure the size and the volume of the breakout candle. If the candle has a large body with minimal wick, it signifies there was more buying than selling pressure . For instance, if the candle of breakout is orders of magnitude larger than the average size of a candle over the last 14 days and the volume at that time was above the average, it is a strong buy signal.
Historical Patterns: Look for past performance of bullish reversal candlesticks followed by a breakout from the inverse head and shoulders neckline. For instance, in mid-2018, there was a bullish engulfing candlestick that had closed 2% above the neckline; over the next two months it rose by 10% . However, past performance is not always indicative of future results.
Positioning: The most important factor to consider. The most reliable signals are when the bullish candlestick is right above the resistance line of the neckline, indicating that the buyers have gained momentum and are pushing the price above and beyond the resistance.

Complementing it with Other Indicators: To increase the reliability of reversal patterns, they should be coupled with other indicators such as analysis of volumes or buying and selling pressure oscillators like MACD or RSI. For example, if there is a bullish engulfing pattern the same day combined with a significantly higher volume and simultaneous bullish reversal of MACD-a Buy.

Moving Average Support

Generally speaking, the averages smooth out price data to form a continuously updated average price. This is particularly useful as it can identify where the market sentiment is headed and supports the breakout of the neckline. Here is how traders can use moving averages to support their trades:

Types of Moving Averages: Common moving averages include the 20-day, 50-day, and 200-day moving averages .

While the 20-day moving average is more sensitive to the price movements, the 200-day moving average is less reactive, providing a sense of a long-term trend.

As such, the 50-day moving average provides a valuable balance: It is reactive enough to get a general sense of what’s happening but not so reactive as to see a general sense of the medium-term trend.

Analyze the Slope: As the pattern forms, the slope of the moving average should either flatten out or start to slope upwards.

Were the moving average does not follow the first acts as a bellwether to a lack of support getting the investment notion to new lowest levels and second, the slope over the neck informs that the downwards momentum has slowed and that the upwards potential has started.

For example, Adobe’s stock price in 2017 rose so consistently and the price showed great propensity for the 50-day moving average during the right shoulder and after the neck had broken and it was signaling the increasing buying interest from the market.

Plot the historical data on a daily chart so as to view the past instances that these averages have acted as a support.

More often than not, dip buyers step in and buy the dip. The likelihood of a fake or a failed breakout decreases if the price remains in the 50-day after breaking the right shoulder.

Market Sentiment Analysis

When it comes to assessing the likelihood of the inverse head and shoulders pattern, the conduct of the market sentiment analysis is crucial because it allows understanding the overall sentiment as well as specific emotions or behaviors of traders which may influence particular movements in the price .

Sentiment analysis may be performed in many different ways and it essentially refers to the measurement of how “happy or sad” the market is.

Many mainstream trading platforms offer quantitative sentiment services utilizing such indicators as Bull/Bear Ratio which is the proportion of bullish investors to bearish investors, or the Volatility Index which readily assesses the measure of risk in the market and is closely related to the sentiment of how volatile markets will be.

The VIX value is expected to decline quantitatively when the market is going to reverse to the bullish phase as well as the Bull/Bear Ratio supposed to increase.

Among more advanced structurally complex trading platforms, the sentiment analysis tools are scanning reposts and social media data, news, and sentiment about certain topics or stocks .

For example, there could be a dramatic growth in positive re-posts in social media about some company when the sentiment data correlates with the right shoulder in the inverse head and shoulders pattern indicating that traders are getting confident about that stock.

There are several steps needed to be applied when performing a market sentiment analysis. These steps are as follows: