One of the greatest advantages of reversal patterns is their ability to quickly alert the trader to the fact that he or she is on the wrong side of the market. Once traders managed to recognize their errors, they take defensive actions in order not to come off a loser.
The trickiest part of the technical analysis is to recognize the shapes of these patterns on price charts and to define your price objectives accordingly. That’s why we decided to arm you with knowledge of these patterns.
Before a study of the forecasting implications of the reversal patterns, let us define what these reversal patterns are. Reversal patterns are formations which appear on price charts and help you realize that an important reversal in trend is taking place. Next, I suggest to take a look at some preliminary points to a study of the reversal patterns.
1. A major prerequisite for any reversal pattern is the existence of a prior trend. You must admit that market before reversing has actually to have something to reverse.
2. There should be a breach of a continuous trend line.
3. Topping patterns are usually shorter in terms of duration and more volatile than bottoms ones. The trader can usually make more money a lot faster by catching the short side of a bear market than by trading the long side of a bull market. Well, yes, unfortunately, everything in life is a matter of tradeoff between reward and risk. The greater risks are usually compensated by greater rewards and vice versa. Therefore, topping patterns are less risky, but at the same time they are less rewarding.
4. The greater the size of the pattern, the greater the potential for the ensuing price move.
5. Bottoms usually have wider price ranges and take longer to build.
Now we are ready to take a next step on our thorny way of cracking reversal patterns. Let’s look at first at on of the best known reversal patterns – head and shoulders. It is usually formed at the end of the uptrend.
The pattern consists of a head (the second and the highest peak) and 2 shoulders (lower peaks) and a neckline (a horizontal/vertical line which connects the lowest points of the two troughs and represents a support level). The pattern is confirmed when the prices broke below the neckline once they formed a second shoulder. To identify your price objectives, you should take the vertical distance from the head point to the neckline and then project that distance from the point where the neckline is broken.
Assume that the top of the head is at 50 and the neckline is at 20, so the vertical distance will be 30. That 30 points should be measured downward from the level at which the neckline is broken. There you’re, your price objective is built.
The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders. It occurs at the end of a downtrend and indicated bullish reversal.
The triple tops and bottoms are slight variation of the major head-and shoulders pattern. The main difference is that the three peaks at this patterns are at the same level.
A more common reversal pattern is the double top or bottom. The main characteristics of this pattern are similar to that of the head and shoulders and triple tops/bottom ones expect that only two peaks appear instead of three.