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Reversal patterns
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Reversal patterns

Reversal Patterns Price patterns are pictures or formations that appear on price charts. Each pattern will fall into one of two categories; continuation or reversal patterns. In this section we will be focusing on Reversal Patterns. The patterns we will be discussing in this section are early indications that indicate potential changes in trend. Reversal Patterns are a valuable trading signal that offer predictive value and are starting points for major price swings. One of the tricks to trading reversal patterns is to identify them as early as possible in the process. One of the most important pre requisites to understanding price patterns is to have a great understanding of the basic concepts of a trend. Prerequisites A prior trend must exist Watch for the first sign of weakness The larger the pattern, the bigger the potential move Bottoms take longer to form than tops Volume is a confirming indicator Consistency When searching for price patterns, remember that consistency will contribute to the probability of success.

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Reversal patterns

Figure 1: Inconsistent action points Remember that prices need to react off a price level or trendline more than once to be considered support/resistance. Inconsistent patterns typically lead to inconsistent results. Head & Shoulders The Head & Shoulders pattern is the best known, widely accepted, and most reliable reversal pattern in its category. Looking at the diagram, you can see how this pattern simply goes from higher highs & lows, to lower highs and lows. As the name implicates, this pattern should be found at the top of an uptrend. The break of the neckline with elevated levels of volume acts as a great entry signal to enter this trend reversal pattern.

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Reversal patterns

Figure 2: A Head & Shoulders Pattern Inverse Head & Shoulders The Head & Shoulders Bottom has the exact same implications as the Head & Shoulders Top. However, the difference is that this pattern is inverted, and is found at the bottom of a downtrend. As you can see, the stock goes from lower highs & lows, to higher highs and lows. A break above the neckline with elevated volume acts as a great entry point to enter a bullish trade as the trend reverses.

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Figure 3: An Inverse Head & Shoulders Pattern Double Tops The Double Top is a bearish continuation pattern that forms at the top of an upward trending stock. Visually you can see how the trend fails to establish new highs when prices are rising. Once the stock breaks through support and confirms a lower low with elevated volume, this acts as a great entry signal to take a bearish position as the trend starts to reverse.

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Figure 4: A Double Top Pattern Triple Tops The Triple Top is a bearish reversal pattern that forms at the top of an upward trending stock. Visually you can see how the trend fails to establish new highs when prices are rising. Once the stock breaks through support and confirms a lower low with elevated volume, this acts as a great entry signal to take a bearish position as the trend starts to reverse.

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Reversal patterns

Figure 5: A Triple Top Pattern Double Bottoms The Double Bottom is a bullish continuation pattern that forms at the bottom of a downward trending stock. Visually you can see how the trend fails to establish new lows when prices are falling. Once the stock breaks through resistance and confirms a higher high with elevated volume, this acts as a great entry signal to take a bullish position as the trend starts to reverse.

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Reversal patterns

Figure 6: A Double Bottom Pattern Triple Bottoms The Triple Bottom is a bullish continuation pattern that forms at the bottom of a downward trending stock. Visually you can see how the trend fails to establish new lows when prices are falling. Once the stock breaks through resistance and confirms a higher high with elevated volume, this acts as a great entry signal to take a bullish position as the trend starts to reverse.

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Figure 7: A Triple Bottom Pattern

Broadening Formation This pattern is commonly referred to as the "Expanding Triangle" and commonly marks major market tops. It is unique compared to other triangles since volatility expands as the pattern forms, while with other triangles it contracts. Watch for a break of support to enter a bearish position as the trend reverses.

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Reversal patterns

Figure 8: A Broadening Top Pattern Symmetrical Triangle Triangles are commonly known as continuation patterns. The Symmetrical Triangle is the only exception. The price action within the pattern is relatively neutral, and while the majority of the time the stock moves with the direction of the prior trend, many times it doesn't. With this pattern, watch which direction it decides to break and plan your trade accordingly.

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Figure 9: The Symmetrical Triangle Pattern Volume During the development of a price pattern, it is common to see volume levels contract. As a pattern confirms and price break through a support or resistance level, volume levels typically expand on the breakout. In many cases, however, volume levels will not change. This will usually be the case in downside moves as opposed to upside moves. High volume levels are usually indicative of more explosive price movements. Low volume breakouts do not necessarily need to be avoided. Price Targets Long term price targets

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One of the reasons price patterns are a popular trading method is that they offer predictive value. Each individual pattern you trade will have its own characteristics. To determine the potential price movement of your pattern, measure the widest point of the pattern to determine a price objective.

Figure 10: Calculating Price Targets Short term price targets Another popular method for price pattern traders is to measure the long term price target and reduce it by 50%. Prices will achieve these values in a fraction of the time and will allow the trader to move through positions quickly. Remember, all price objectives are forward projected from the breakout point. Time Targets

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After a breakout, prices might not accelerate as fast as wed like. In many cases it might seem like the stock is taking too long to reach its price objective. It is important to define in the early stages of the trade, what is considered too long. One of the great things about price patterns is that they offer time targets as well as price targets. This way, you can determine up front how long you will stay in a trade in order to reach your price target. To define a time target of any pattern, simply measure the length of the pattern. For example, if a pattern has taken 6 weeks to form from start to finish, then expect prices to take 6 weeks at the most to reach their respective price targets.

Figure 11: Calculating Time Targets Entry Points Anticipatory entries

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Identifying the pattern in the early stages is the key to success when taking anticipatory entries. Anticipating a breakout is an acceptable trading method, so long as you are able to properly manage risk.

Figure 12: An Anticipatory Entry Point Breakouts In many instances, it will be hard to identify a pattern before it takes place. If this is the case, it is perfectly fine to wait for prices to breakout and enter the trade at that point. However, the further prices travel from the breakout point, the less attractive the trade becomes. Re-tests If you have missed a confirmed breakout, dont worry. In many cases, prices will retrace or retest their prior support or resistance levels. At that point, you are essentially buying a dip, or selling a rip to get a good entry point.

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Figure 13: A Re-Test of a Prior Support Level It is important to note that not all stocks will re-test prior support or resistance levels. Exit Points Aim for Short term price targets/Long term price targets Weakness If prices start to slow down before reaching either price target, once can use trendlines, moving averages, or other technical indicators to determine exit points. Pattern Failure Pre Confirmation Failure If you have taken an anticipatory entry and prices move against you and trade outside the pattern range, quickly close the trade at a loss before it gets worse. Copyright 2008, Trading Addicts, LLC. All Rights Reserved Page 15

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Post Confirmation Failure After a stock has confirmed a breakout, in some cases prices will immediately retrace back into the range of the pattern. This is called a false breakout.

Figure 14: A False Breakout It is important to keep mechanical or mental stop in place to help avoid this situation. It is acceptable to give prices a little wiggle room, but dont gamble with a potential loss. References The Official Trading Addicts Price Pattern Tutorial http://www.tradingaddicts.com/storage/tutorials/TA_PPT_2.0.pdf Breakout Trading Article http://www.investopedia.com/articles/trading/08/trading-breakouts.asp Copyright 2008, Trading Addicts, LLC. All Rights Reserved Page 16