Reversal Pattern

Reversal patterns

Head-and-shoulders

The head-and-shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. And as one might imagine from the name, the pattern looks like a head with two shoulders. Let's see how the pattern forms.

It is important to establish the existence of a prior uptrend for this to be a reversal pattern. While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trend line. From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. The decline from the peak of the right shoulder should break the neckline. (Fig.7)

Fig.7

The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders top, as it signals that the price is set to make an upward move. Often coming at the end of a downtrend, the inverse head and shoulders is considered to be a reversal pattern, as the price typically heads higher after the completion of the pattern. Let's see how this pattern forms.

It is important to establish the existence of a prior downtrend for this to be a reversal pattern. Without a prior downtrend to reverse, there cannot be a Head and Shoulders Bottom formation. After forming this trough, an advance ensues to complete the formation of the left shoulder. The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact. From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline. The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend. The decline from the high of the head begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete. (Fig.8)

Fig.8

Double-top and double-bottom

The double top and double bottom are another pair of well-known chart patterns whose names don't leave much to the imagination. These two reversal patterns illustrate the price's attempt to continue an existing trend. Upon several attempts to move higher, the trend is reversed and a new trend begins. These chart patterns formed will often resemble what looks like a "W" (for a double bottom) or an "M" (double top). The double-top pattern is found at the peaks of an upward trend and is a clear signal that the preceding upward trend is weakening and that buyers are losing interest. Upon completion of this pattern, the trend is considered to be reversed and the price is expected to move lower. (Fig.9) Double bottom is the opposite pattern of the double top as it signals a reversal of the downtrend into an uptrend. This pattern will closely resemble the shape of a "W". (Fig.10)

Fig.9

Fig.10

Triple top

The triple top is a reversal pattern made up of three equal highs followed by a break below support. This bearish reversal pattern is formed when the price that is trending upward tests a similar level of resistance three times without breaking through. Each time the price tests the resistance level, it falls to a similar area of support. After the third fall to the support level, the pattern is complete when the price falls through the support; the price is then expected to move in a downward trend.

Fig.11

Triple bottom

The triple bottom is a reversal pattern made up of three equal lows followed by a breakout above resistance. It resembles the inverse Head & Shoulders pattern but all three minimums are in the equal level. The triple-bottom pattern illustrates a price that is trading in a downtrend and attempts to fall through a level of support three times, each time moving back to a level of resistance. After the third attempt to push the price lower, the pattern is complete when the price moves above the resistance level and begins trading in an upward trend. (Fig.12)

Fig.12

V-top

A V-top pattern resembles a deep cavity. Fig.13 shows that there is a long-term downtrend till the middle of February, 1985. However V-bottom means a reversal of tendency (the victory of the bulls over the bears).

Fig.13

V-bottom

A V-bottom pattern resembles a deep cavity. Fig.14 shows that there is a long-term downtrend till the middle of February, 1985. However V-bottom means a reversal of tendency (the victory of the bulls over the bears).

Fig.14

Round tops and round bottoms

A rounding-bottom pattern looks similar to a cup and handle (see below), but without the handle. The basic formation of a rounding bottom comes from a downward price movement to a low, followed by a rise from the low back to the start of the downward price movement - forming what looks like a rounded bottom.

The pattern should be preceded by a downtrend but will sometimes be preceded by a sideways price movement that formed after a downward trend. The start of the rounding bottom (its left side) is usually caused by a peak in the downward trend followed by a long price descent to a new long-term low. A rounding-top is the exact opposite pattern. (Fig.15, 16)

Fig.15

Fig.16

Rhomb

This pattern resembles a rhomb or diamond (Fig.17). In a geometrical sense, it is not perfect on charts. A rhomb is usually a reversal pattern. However, if after breaking the price comes back to the middle of this pattern, it means that something is wrong and it is better to close a position.

Fig.17

Cup-and-handle

A cup-and-handle pattern is very rare and resembles the shape of a tea cup on a chart. It also resembles round bottom pattern but the difference between a cup-and-handle and round bottom is that the former appears in the middle of a trend. It is considered to be a bullish continuation pattern where the upward trend has paused, and traded down, but will continue in an upward direction upon the completion of the pattern.

The cup-and-handle pattern is preceded by an upward move, which stalls and sells off. The sell-off is what forms the initial part of this pattern. After the sell-off, the price will basically trade flat for an extended period of time, with no clear trend. The next part of the pattern is the upward move back towards the peak of the preceding upward move. The last part of the pattern, known as the handle, is a relatively smaller downward move before the price moves higher and continues the previous trend. (Fig.18)

Fig.18