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

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Trend Continuation Pattern

Continuation patterns

Triangles

It is one of the most frequent patterns in technical analysis. The basic construct of this chart pattern is the convergence of two trendlines - flat, ascending or descending - with the price moving between the two trendlines.

There are three types of triangles:

• The symmetrical triangle
• The ascending triangle
• The descending triangle

Symmetrical triangle

The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. It is formed by the convergence of a descending resistance line and an ascending support line. The two trendlines in the formation of this triangle should have a similar slope converging at a point known as the apex. The price will bounce between these trendlines, towards the apex, and typically breakout in the direction of the prior trend. If preceded by a downward trend, the focus should be on a break below the ascending support line. If preceded by an upward trend, look for a break above the descending resistance line. However, this pattern doesn't always lead to a continuation of the previous trend. A break in the opposite direction of the prior trend should signal the formation of a new trend.

Fig.1

Above is an example of a symmetrical triangle that is preceded by an upward trend. The first part of this pattern is the creation of a high in the upward trend, which is followed by a sell-off to a low. The price then moves to another high that is lower than the first high and again sells off to a low, which is higher than the previous low. At this point the trendlines can be drawn, which creates the apex. The price will continue to move between these lines until breakout.

The pattern is complete when the price breaks out of the triangle - look for an increase in volume in the direction of the breakout. This pattern is also susceptible to a return to the previous support or resistance line that it just broke through, so make sure to watch for this level to hold if it does indeed break out.

Ascending triangle

The ascending triangle is a bullish pattern, which gives an indication that the price is headed higher upon completion. The pattern is formed by two trendlines: a flat trendline being a point of resistance and an ascending trendline acting as a price support.

The price moves between these trendlines until it eventually breaks out to the upside. This pattern will typically be preceded by an upward trend, which makes it a continuation pattern; however, it can be found during a downtrend.

Fig.2

Descending triangle

The descending triangle is the opposite of the ascending triangle in that it gives a bearish signal to chartists, suggesting that the price will trend downward upon completion of the pattern. The descending triangle is constructed with a flat support line and a downward-sloping resistance line.

Similar to the ascending triangle, this pattern is generally considered to be a continuation pattern, as it is preceded by a downward trendline. But again, it can be found in an uptrend.

Fig.3

The first part of this pattern is the fall to a low that then finds a level of support, which sends the price to a high. The next move is a second test of the previous support level, which again sends the stock higher - but this time to a lower level than the previous move higher. This is repeated until the price is unable to hold the support level and falls below, resuming the downtrend.

This pattern indicates that buyers are trying to take the price higher, but continue to face resistance. After several attempts to push the stock higher, the buyers fade and the sellers overpower them, which sends the price lower.

Flag

Flag is the most reliable pattern of trend continuation and formed when there is a sharp price movement followed by generally sideways price movement, which is the flag or pennant. The pattern is complete when there is a price breakout in the same direction of the initial sharp price movement. The following move will see a similarly sharp move in the same direction as the prior sharp move. The complete move of the chart pattern - from the first sharp move to the last sharp move - is referred to as the flag pole.

The flag is considered to be flying at half-mast, as the distance of the initial price movement is thought to be roughly equal to the proceeding price move. The reason these patterns form is that after a large price movement, the market consolidates, or pauses, before resuming the initial trend.

Fig.4

Wedge

A wedge pattern appears during a power trend after sharp, steep movement. It represents a tendency of short duration which is directed to the opposite side of the initial sharp price movement but there are no signs of consolidation. A wedge is similar to the triangles, in that the price movement bounces between the two trendlines, which are bounding the price movement. (Fig.5)

The price movement in the wedge should at minimum test both the support trendline and the resistance trendline twice during the life of the wedge. The more times it tests each level, especially on the resistance end, the higher quality the wedge pattern is thought to be.

Fig.5

Rectangle

A rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation zones or congestion areas.

A rectangle pattern shows that supply and demand are in approximate balance for an extended period of time. The trading instrument moves in a narrow range, hitting resistance at the rectangle’s top and finding support at its bottom. The rectangle can occur over a protracted period of time or form quickly amid a relatively wide-ranging series of bounded fluctuations. It is a pattern which shows trader indecision, one in which the bulls and bears are approximately equally powerful.(Fig.6)

Fig.6

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