An h-pattern is a chart pattern that emerges when a security that has fallen precipitously later retests the low point of its recent decline, making fresh lows. The pattern begins with a steep decline, followed by a “dead-cat bounce” — meaning the price of a security exhibits an initial rebound from its low that lures in bullish traders with the false hope of a continued recovery. Eventually the rebounding price reverses, falling below the initial low.

The h-pattern appears when market participants rush in to buy a declining security, only to discover that demand for the security is unsustainable. As the momentum behind the rebound wanes, often on low or decreasing trading volume, the same participants then exit their position, fearing that their decision to enter the trade was premature. The price of the security then dives to a new low.

As a result, the price chart of a security experiencing this three-step price-action will form a pattern that resembles a lower-case "h".

How I trade an h-pattern set up

Swing traders who look for mean-reversion opportunities will often seek out securities whose charts exhibit break-downs similar to the moves that define the first leg down of an h-pattern.

When I discover a chart containing what looks like an emerging h-pattern, I prefer to approach the opportunity with caution, holding off on a trade until the second leg down of the h-pattern breaks the key support level established by the low point of the first leg down. I take this approach because according to traditional technical analysis, an h-pattern is complete only after the breach of the recent low. Traders refer to this completion event as “confirmation”. And a seasoned trader will patiently wait until a pattern is confirmed before initiating a trade.

Pattern traders who are keen to trade from the short side may seek out the h-pattern to profit from falling prices. When using this pattern as a short signal, I prefer to enter the trade only after prices have rebounded to the top of the h-curve. The reason is that for a support-and-resistance trader like myself, this area constitutes a natural level of price resistance. For safety measures, I like to apply a trailing stop-loss, placing it considerably above the highest candle of the previous week on a daily chart whenever I put a position on.

In the event the trade works in my favor, and the security continues to decline, I carefully consider whether or not to take on additional risk by scaling my position size up.

When a security that exhibits this pattern genuinely breaks support, I choose a downside target based on the amount of risk thatI took on when I placed my initial stop loss. I prefer that my profit targets are larger than the losses set by my stops. In the event the price falls precipitously, I usually trail my stop loss behind the falling price of the security, letting my profits run until price reverses and I am naturally stopped out with a profit.

The ‘h-pattern’ : Small piece of a bigger technical picture

The h-pattern is a feature of one of the better known chart patterns in classic technical analysis, the “Head & Shoulders” (H&S) pattern. It consists of a left and right shoulder, and a head that sits between them, serving as the peak of this reversal pattern. The line beneath the shoulders is referred to as the neckline. When prices fall below the neckline, many traders expect further decline.

Trader lore suggests that the H&S pattern portends a challenging trading environment ahead for the bulls, as the pattern depicts a period when a security’s price action transitions from bullish to bearish. But the effectiveness of the H&S pattern isn’t just a figment of the trading community’s imagination. In a research paper titled Head and Shoulders: Not Just a Flaky Pattern, Carol Osler and Kevin Chang detailed their experience using an objective, computer-implemented algorithm to rigorously evaluate the predictive power of the head-and-shoulders pattern as applied to daily exchange rates. 

Osler and Chang then compared simulated profits from trading signals derived from the HS pattern with the distribution of profits for 10,000 simulated trades generated from a random walk. They researchers found that trades inspired by the HS pattern significantly outperformed random trades.

Because the H&S pattern is capable of appearing on any chart timeframe and across all varieties of asset classes, it can be used by a wide range of technically-minded traders and investors. Many pattern traders believe this chart pattern reveals crucial levels that they can use as profitable entry points, to establish risk-managed stop losses, and set to profit targets. 

When I initiate a short trade after recognizing a H&S pattern, I place my sell orders just below the neckline (support line) because if price passes through this area, I take it as a sign that it has broken resistance. This area is also where I expect price to receive support once it begins to move lower. You can identify the neckline by drawing a line across the bottom of both shoulders.

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