Inverted Head & Shoulders. Should We Be Jumping For Joy?

10/06/10 09:06:25 AM

by Koos van der Merwe

Wherever I look, I see this pattern on shares. Is it a pattern that can be ignored?

Security: ING
Position: Buy

Can we ignore this pattern when we see it? I don't believe so. History has shown that the target suggested by the inverse head & shoulders pattern, like its counterpart, the head & shoulders pattern, is one that should not be ignored. The targets suggested are very real and are hit more often than not. Let us look at a typical H&S pattern, which most traders accept without argument.

FIGURE 1: HEAD & SHOULDERS FORMATION RELATED TO ELLIOTT WAVE COUNT

Graphic provided by: AdvancedGET.

Figure 1 shows how the head of a head & shoulders pattern is the top of Wave V, with Waves III and Wave B being both shoulders. This is accepted as the norm and always suggests a target. Elliott wave theory says that Wave C should be within the fourth Wave of lesser degree, whether it be the Grand Supercycle or a Sub-Minuette Cycle. The difficulty is reading the wave formation. See Figure 2.

Now, the inverted head & shoulder pattern is simply the inverse of the H&S pattern. Of course, the wave count is different, but the result should be the same: a target that can be pretty accurate.

FIGURE 2: INVERTED HEAD & SHOULDERS PATTERN RELATED TO ELLIOTT WAVE COUNT

Graphic provided by: AdvancedGET.

R.N. Elliott did refer to a structure called an "A-B" base, in which after a decline had ended on a satisfactory count, the market advanced in three waves and then declined in three waves prior to the start of a new five-wave bull market as shown in Figure 3.

FIGURE 3: "W" BOTTOM AND AB BASE

Graphic provided by: AdvancedGET.

Figure 3 shows a H&S failure at a market bottom. This suggests that an inverted H&S failure -- that is, an A-B count -- should not occur at a market bottom, but only at a market top. Any inverted H&S pattern that looks correct, especially when the neckline is broken by all accounts, should therefore be true. Arguments by bears to the contrary are suspect.

With the above in mind, I offer a chart of a share with an inverted H&S pattern to be considered.

FIGURE 4: ING, INVERTED HEAD & SHOULDERS PATTERN

Graphic provided by: OmniTrader.

Figure 4, an inverted H&S pattern on the share ING, shows how the neckline has been penetrated and acts as a support level for a rise to the target, which you will have to calculate.

But what about a "W" bottom? A "W" bottom only occurs when the shoulder shown as wave 2 on the chart falls to the same price level as Wave C. This formation negates any inverse H&S pattern.

So look at all possible inverted H&S patterns with optimism, but wait for a break of the neckline before jumping for joy.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.