Part two of the miniseries on price patterns. In the first part continuation patterns were the center of attention; this part will be all about key reversal patterns. While a continuation pattern suggests that a trend will continue in the same direction, a failed continuation pattern may well turn into a reversal pattern. Like their name implies, a reversal pattern suggests that one trend is ending and a change of direction is at hand. These reversal patterns occur before a major change in direction, and are therefore important indications for professional traders to close existing positions, and potentially enter new trades in opposite direction.
Like with every tool in technical analysis, these patterns provide clues about possible direction changes, but they do not predict what prices will do. Below we discuss the main reversal patterns you might see on your price chart, which include Head & Shoulder, Double Top- and Bottom, M-Top and W-Bottom, and broadening formation patterns.
Head & Shoulder patterns
One of the most powerful reversal patterns is the head and shoulder pattern. This pattern is formed by three price peaks, with the highest peak in the middle. This is where the name refers too, a head as the middle high peak, and the two shoulders as the lower peaks left and right from the head. Underlying it makes sense that this pattern has a high probability of reversal. When making the right shoulder the market is unable to make a higher high, indicating weakness in trend.
So the left shoulder is formed from an uptrend, followed by a pullback. For now everything seems in line with the uptrend.
Again the trend upwards continues and makes a new higher high. A first signal can come to us via a pullback that is usually a little deeper as we would like to see, sometimes breaking an important uptrend support line.
After the pullback a new top is formed. Only this time it is lower as the former top (head), indicating that the market has not enough strength to continue the up-trend immediately. This new top should be around a similar level as the top which forms the left-shoulder. Now that we have lower highs a first requirement for a downtrend is there. In order for this pattern to be complete, it is necessary that the price breaks downwards through the so-called ‘neckline’. The neckline is the support line that we could draw underneath the two bottoms that are between the three tops that form this pattern.
After the completion of a head&shoulder pattern the market will likely start the reverse move in trend. Often there will be a pullback towards the earlier broken ‘neckline’. Sometimes this recovery pullback move to the neckline is so strong that it breaks the neckline again and causes the pattern to be a ‘failed head-and-shoulder’. So always place your stop-loss just above the neckline when taking positions after it completes the initial pattern.
An inverse head and shoulders is a similar pattern only occurring after a downtrend. Instead of paying attention to three different tops in price, we now see three bottoms.
Direction of the neck-line
Important indication to note when trading head and shoulder patterns is the direction of the neckline. For normal head-and-shoulder formations the neckline is often slightly upwards sloping or horizontal. When the neckline is sloping downwards, it is already a signal of weakness in trend. If that is the case we call it a ‘mixed blessing’. Mixed because on the one hand we want this extra signal that is in favor for the direction we are looking to trade. But the disadvantage is that because it is downward sloping it takes longer before the market reaches the neckline in order for it to break through it. This will result in loss of potential profit.
For inverse head-and-shoulder patterns the neckline is often slightly down-sloping. When the neckline is up-sloping, we again speak of a ‘mixed blessing’.
Exits when trading head-and-shoulder patterns are commonly calculated as follows. After completion of the pattern we determine the pip difference between the highest (lowest, for inverse h&s) price and the neckline. The difference will be deducted (added, for inverse h&s) from the price where the neckline is broken.
Double Top & Bottoms
Probably the most common reversal pattern in technical analysis is the double top or bottom. This pattern is formed when price makes two peaks at roughly the same level, or for the double bottom two bottoms at roughly the same level. The idea behind this reversal pattern is that if price reacts twice to the same level, it is a good indication that this level is probably a strong level of support and resistance.
To give this pattern reliability it is important that the double top and bottoms do not lay too close to each other. It is best if there is a clear v-shape between the double top, and inverse v-shape between the double bottom.
M-Top and W-Bottom
Very similar to the double top and bottom pattern are the M-Top and W-bottom. The minor difference is that the thrust to a previous high or previous low does not reach the same level as the first high or low. So for the M-top pattern we see that the second peak in price is unable to reach as high as the initial peak. Vice versa for the W-bottom, where the second bottom is slightly higher as the previous lowest low. A break of interim low (M-top), or interim high (W-bottom), results in a good setup for entry orders.
A broadening formation is characteristically for its divergence in support and resistance. Tops only get higher, while bottoms get lower. This indicates that there is a constant switch of power between buyers and sellers. A difficult pattern to trade since it will often give long and short opportunities when a new top or low is formed. With broadening formations we often see a cycle of two or three higher highs and lower lows before breakout, and completing the pattern. Like with a head-and-shoulder pattern it is not uncommon that price will make a pullback after it broke support. These pullbacks can be a nice buying/selling opportunity for the people who missed the initial break.
Being familiar with price patterns will give you a much better understanding of what is happening in the overall market. Having knowledge about continuation- and reversal patterns will help you in building strong cases for a trade, and finding trading strategies that provide a great edge.