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Reversal patterns indicate a high probability that the existing trend has come to an end and that there is good chance of the trend reversing direction. They give entry signals early in the formation of a new trend, making their entries quite lucrative, with fairly small protective stops. However, the trend might not reverse immediately and may enter a trading range instead.
As with continuation patterns, there must be an existing trend that is to be reversed. Without a pre-existing trend reversal patterns are not valid. The common reversal patterns include double tops and double bottoms, triple tops and triple bottoms, head and shoulders, rising and falling wedges, and the less common rounded tops and rounded bottoms.
1- Double Top and Double Bottom Patterns
The double tops and double bottoms patterns are two related chart patterns that are some of the easiest trend reversal patterns to identify that appear on line, bar, candlestick charts, and Point-and-Figure charts.
A- Double Top
VIew a more detailed Double Top Chart Pattern Video. The Double Top technical analysis charting pattern is a common and highly effective price reversal pattern.
The chart below of Altria (MO) stock illustrates the Double Top reversal pattern:
double top chart reversal
Double Top Formation Components
First High: Bulls push prices upwards making new highs; however, these new highs are short lived and prices retreat.
Second High: Prices don't retreat for long because bulls make another run, making a similar high. Nevertheless, this is bearish, because bulls were unable to push prices higher; bears held their ground at the previous high level. The bears push prices back to support (Confirmation line); this is a pivotal moment - either bulls will make another push higher or bears will take control and push prices even lower, more than likely taking over for good.
Sell when price closes below the confirmation line.
Note that traders expect a significant increase in volume to accompany the confirmation line break; if there is very little volume when price pierces the confirmation line, then the move downward is suspect. Small volume usually means weak support of price movement (see: Volume).
Another similar chart pattern is the Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Top is the bullish Double Bottom (see: Double Bottom).
Watch a video with a detailed description of the Double Bottom Chart Pattern. The Double Bottom technical analysis charting pattern is a common and highly effective price reversal pattern.
The chart below of Altria (MO) stock illustrates the Double Bottom reversal pattern:
double bottom chart reversal
To create a double bottom pattern, price begins in a downtrend, stops, and then reverses trend. However, the reversal to the upside is short-term. Price breaks again to the downside only to stop again and reverse direction upwards. With the second bottom of the double bottom pattern, it is usually more bullish if the second low is higher than the first low.
Double Bottom Buy Signal
The signal to buy is given when the confirmation line is penetrated to the upside. The confirmation line is drawn across the top of the double bottom pattern (see chart above).
Often, after price penetrates the confirmation line, price will retrace for a short time, sometimes back to the confirmation line. This retracement offers a second chance to get into the market long.
Volume also plays an important part of interpreting the Double Bottom pattern; this is illustrated in the chart below of Pfizer (PFE):
double bottom volume confirmation breakout
Generally, volume should explode when the confirmation line is penetrated as it did in the chart of Pfizer (PFE).
The Double Bottom reversal pattern is a heavily used and effective charting reversal pattern. Another similar and popular bottom reversal pattern is the Reverse Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Bottom is the bearish Double Top pattern (see: Double Top).
The triple tops and triple bottoms patterns are similar to the double tops and double bottoms patterns that appear on line, bar, candlestick charts, and Point-and-Figure charts. They are short-term trend reversal patterns with the triple top being a bearish trend reversal pattern and the triple bottom being a bullish trend reversal.
A -Triple Tops
The triple top pattern is a bearish trend reversal pattern that often marks the end of an uptrend and the start of a down trend. It consists of three consecutive peaks that reach a resistance level at more or less the same high value, with valleys creating clear separations between three distinct peaks. The low of the valleys is important for price projection purposes as is the volume. Preferably, the volume at each successive peak should be lower than the volume on the preceding peak.
The triple tops pattern has only entry signals to sell short. This signal is triggered when the price breaks below the support level created on the lowest low of the two valleys. This break should preferably be accompanied by an increase in volume as a drop in volume may indicate a false break.
A price projection for the triple tops formation is similar to that of the double top. It is calculated by taking the distance from the support level formed at the low of the intervening valleys to the top of the peaks and subtracting it from the point at which the support level was subsequently broken. However, the price will usually attempt to retest the previous support level, which would now become a resistance level and may even violate this level before the down trend takes effect. Should the resistance level be broken on strong volume you should be cautious and perhaps exit the trade, looking to re-enter when the price breaks down below the resistance level.
b - Triple Bottoms
The triple bottom pattern is the bullish trend reversal counterpart to the triple top pattern. It often marks the end of a down trend and the start of an uptrend. This pattern consists of three consecutive and distinct dips that reach a support level at more or less the same low value, with peaks creating clear separations between three dips. The high reached by the peaks is important for price projection purposes. The volume is also important. Preferably, the volume should increase as each successive dip is formed.
As with the triple bottom pattern, the triple top pattern has only entry signals to buy long. This signal is triggered when the price breaks through the support level created on the highest high of the two intervening peaks and closes above it. This break should preferably be accompanied by an increase in volume as a drop in volume may indicate a false break.
A price projection for the triple bottom formation is similar to that of the double bottom. It is calculated by taking the distance from the resistance level formed at the high of the intervening peaks to the bottom of the dips and adding it to the point at which the resistance level was subsequently broken. However, the price will usually attempt to retest the previous resistance level, which would now become a support level and may even violate this level before the uptrend forms. Should the support level be broken on strong volume you should be cautious and perhaps exit the trade, looking to re-enter when the price breaks up above the support level.
The Head and Shoulders chart pattern is a heavily used and quite profitable charting pattern, giving easily understood buy and sell signals.
The chart of Home Depot (HD) below shows a Head and Shoulders pattern:
head and shoulders chart reversal
Head and Shoulders Components
Left Shoulder: Bulls push prices upwards making new highs; however these new highs are short lived and prices retreat.
Head: Prices don't retreat for long because bulls make another run, this time succeeding and surpassing the previous high; a bullish sign. Prices retreat again, only to find support yet again.
Right Shoulder: The bulls push higher again, but this time fail to make a higher high. This is very bearish, because bears did not allow the bulls to make a new higher or even an equal high. The bears push prices back to support (Confirmation line); this is a pivotal moment - Will bulls make another push higher or have the bears succeeded in stopping the move higher.
If prices break the confirmation support line, it is clear that the bears are in charge; thus, when price closes below the confirmation line, a strong sell signal is given.
Note that a downward sloping confirmation line is generally seen as a more powerful Head & Shoulders pattern, mainly because a downward sloping confirmation line means that prices are making lower lows.
Reverse Head and Shoulders
The opposite of the Head & Shoulders pattern is the Reverse Head & Shoulders pattern which is another strong pattern, this time a bottoming pattern.
head and shoulders reversal pattern
Reverse Head and Shoulders Components
The reasoning behind a Head & Shoulders pattern is as follows:
Left Shoulder: Bears push prices downwards making new lows; however, bulls begin to return and push prices slightly higher.
Head: Price gains don't last long before bears return and push prices even lower than before; a bearish sign. Prices then find buyers at the new lower prices.
Right Shoulder: The bears push downward again, but this time fail to make a lower low. This is generally seen as bullish sign, bears were unable to push prices further down. Decision time occurs when the price is pushed higher back to support (Confirmation line); either bears will push prices back down or bulls will push prices higher, regaining control of the stock, future, or currency pair.
When price closes above the confirmation line, a strong buy signal is given.
Usually an upward sloping confirmation line is seen as a more powerful Reverse Head & Shoulders pattern, mainly because an upward sloping confirmation line means that prices are making higher highs.
Volume analysis is important when using the Head & Shoulders chart pattern. How to incorporate volume into the study of the Head & Shoulders pattern is discussed next.
Volume and Head and Shoulders
When the confirmation line of a Head & Shoulders pattern breaks to the downside, a large amount of volume should occur as well.
The chart below of General Electric (GE) shows a sharp increase in volume when the confirmation line of the Head & Shoulders pattern was broken:
head and shoulders with volume confirmation
In addition to the sharp increase in volume, the gap down on the chart of GE also gave strong indication to sell when the confirmation line was pierced.
The same concept applies to a Reverse Head & Shoulders pattern, the break of the
confirmation line should be accompanied by an increase in volume.
The chart below of Gold futures illustrates a rise in volume when the confirmation line was pierced:
head and shoulders reversal pattern
The Head & Shoulders pattern is a highly effective classic charting pattern. Other similar chart patterns are the Double Top formation (see: Double Top) and the Double Bottom formation (see: Double Bottom).
The rounding bottom pattern, which is also called a saucer bottom, is a rare long-term reversal pattern that is sometimes seen on long time-frame charts. This pattern usually takes several months to a few years to form. The length of time the rounding bottom takes to form makes it rather difficult to identify. Its appearance is similar the cup section in the cup and handle pattern. Unlike the cup and handle pattern, though, the rounding bottom usually appears at the end of a downtrend or during a protracted ranging market.
In the rounding bottom pattern, the rate at which prices decline slows and eventually turns up slowly before accelerating gently. These price movements are usually advances and decline with increasingly shallower lows initially followed by increasingly higher highs after the upturn. The time it takes to form the left half of the pattern, i.e., the slowing decline, should be similar to the time it takes to form the slowly accelerating right half of the pattern.
The volume accompanying this pattern is of important in confirming this pattern. The volume should be high at the start of the pattern and should weaken as the price decline slows toward the low. Once the price turns and starts to advance away from the low, volume should also increase.
The rounding bottom gives a long entry signal when the price breaks above the resistance level formed by the peak that marks the start of the pattern. At this point the downtrend is considered to have reversed and an uptrend should form.
Continuation patterns are formed when the price enters a consolidation or correction phase during a trend and indicate that the continuation of the preceding trend is highly probable. The existence of an existing trend is a prerequisite for a continuation pattern as there must be some trend that will continue after the pattern is completed. If there is no preceding trend, then the pattern is not a valid continuation pattern. Valid continuation patterns include the cup and handle pattern, flags and pennants, symmetrical triangles, ascending triangles and descending triangles, and the rectangle pattern.
1 - Triangles
For a more detailed description of the triangle chart pattern in format, see Symmetrical, Ascending, & Descending Triangle Chart Pattern . The Triangle is a continuation pattern using the concepts of support and resistance and price breakouts.
A - ascending Triangles
The ascending triangle pattern is similar to the symmetrical triangle except that its upper trend line is a horizontal resistance line. Ascending triangles are generally bullish in nature and are most reliable when they appear as a continuation pattern in an uptrend. In these patterns, buyers slightly outnumber sellers. The market becomes overbought and prices start to drop. However, buyers then re-enters the market and prices are driven back up to the recent high, where selling occurs once more. Buyers re-enter the market, but at a higher level than before. The result is a steady high at more or less the same level but series of higher lows. Prices eventually break through the resistance level where the high peaks were formed and are propelled even higher as new buying comes in and volume increases.
An entry signal is given when the price breaks out of the ascending triangle to the upside. This should occur about 66% into the triangle. If the price breakout occurs near the apex of the triangle, it is not valid entry signal as these breakouts tend to lack momentum and have a higher tendency to fail.
A price projection of the ascending triangle can be calculated by taking the widest part of the triangle and adding it to the breakout point. Alternatively, a trend line can be drawn parallel to the resistance trend line which slopes in the direction of the breakout, with the extension being the target price for the move.
The descending triangle pattern is similar to the symmetrical triangle except that its lower trend line forms a horizontal support line. Descending triangles are bearish in nature and are most reliable when they appear as a continuation pattern in a downtrend. In these patterns, sellers slightly outnumber buyers. The market becomes oversold and prices start to climb. However, sellers then re-enters the market and prices are driven back down to the recent low, where buying occurs once more. Sellers re-enter the market, but at a lower level than before. The result is lower highs with a steady low. Prices eventually break through the support line where the lows were formed and are propelled even lower as selling increases along with an expansion in volume.
An entry signal is given when the price breaks out of the descending triangle to the downside. This should occur about 66% into the triangle. If the price breakout occurs near the apex of the triangle, it is not valid entry signal as these breakouts tend to lack momentum and have a higher tendency to fail.
A price projection of the descending triangle can be calculated by taking the widest part of the triangle and subtracting it from the breakout point. Alternatively, a trend line can be drawn parallel to the support trend line which slopes downward, in the direction of the breakout, with the extension being the target price for the move.
Symmetrical triangles are chart patterns that can appear in an uptrend or a downtrend and are characterized by a series of higher lows and lower highs. When the support trend line joining consecutive lows and the resistance trend line joining consecutive highs are drawn, they result in a convergence of two trend lines with a degree of symmetry. These symmetrical triangles indicate a period of indecision when the forces of supply and demand in the market are nearly equal. During these conditions attempts to push the price up are met with selling and attempts to push the price down are met with buying. There is also a tendency for volumes to drop off during the formation of this pattern. Eventually the price will break out of the triangle, usually this break out is accompanied by an increase in volume, and is usually in the direction of the preceding trend. Elliott Wave practitioners also see symmetrical triangles as part of a correction that interrupts the larger trend, though the symmetrical triangle can also be part of a complex correction.
In a symmetrical triangle, a strong entry signal is given when the price breaks out of the triangle in the direction of the existing trend between 50-75% into the triangle. In other words, if the trend preceding the symmetrical triangle is an uptrend, the price should breakout to the top, and conversely for a downtrend. If the price breaks out in the opposite direction, it is not considered valid entry signal. However, a breakout that occurs between 50-75% into the symmetrical triangle pattern is often more reliable while an early or late breakout is more prone to failure. Thus, if the price breaks out before the 50% point or after the 75% point of the triangle, it is not considered a valid entry signal as these break outs have a higher tendency to fail.
A price projection of the symmetrical triangle pattern can be calculated by taking the widest part of the triangle and adding it to, or subtracting it from, the breakout point, depending on the direction of the existing trend. Alternatively, a trend line can be drawn parallel to the trend line which slopes in the direction of the breakout, with the extension being the target price for the move.
A symmetrical triangle pattern can be seen on the following daily chart of the Australian 200 (ASX 200) Index. The ASX200 was in the early stages of an uptrend when a correction took it back to the 5,000 level on August 7, 2013. It oscillated between two converging trendlines until a breakout occurred on September 2, 2013 at approximately 5,112. The projected price target is the widest part of the triangle, which is approximately 196 points, making out projected target 5,308. This target was reached on September 26, 2013.
A rectangle is formed when the price moves between a support and resistance line several times, touching both on each occasion. These support and resistance lines are usually horizontal but may slope upward or downward, forming a channel. Regardless of whether the lines are horizontal or sloping; they must be parallel lines. The rectangle is formed when the price moves up from a support line (1) to a resistance line (2), then back to the same support line (3) and finally back to the previous resistance line (4) where it bounces off to complete the fourth point in the rectangle. A rectangle can also be formed when the price moves from a resistance line to a support line, then back to the resistance line and finally back to the support line. Four is the minimum number of points required for a rectangle, with two points touching the upper resistance line and two points touching the lower support line. If the price does not bounce off the fourth point, but breaks the channel line instead, then a rectangle has not been formed.
The ultimate entry signal for the rectangle is the price breakout. When the price violates either the support line or the resistance line, trade in the direction of the breakout, with a protective stop loss just inside the rectangle. A price breakout is validated when the volume increases at the breakout. The volume should be at least 33% to 50% higher at the breakout; otherwise it might be a false breakout.
You can also trade within the rectangle. You could go long at the support line, with a protective stop loss just below the support line, and your price target at the resistance line. Or you could sell short at the resistance line, with a protective stop loss just above the resistance line, and your price target at the support line.
The height of the rectangle is the price target when trading within the rectangle and is the minimum price target when trading the breakout. When the price breaks out of the rectangle pattern, take the height of the rectangle and project it in the direction of the breakout. This is the minimum price projection. The maximum price projection is the width of the rectangle from the first point to the breakout. The width is projected from the point of the breakout in the direction of the breakout.
the Flag Chart Pattern as well as the related Pennant Chart Pattern. The Flag pattern usually occurs after a significant up or down market move. After a strong move, prices usually need to rest. This resting period usually occurs in the shape of a rectangle, thus the word "flag". The Flag is considered a continuation pattern because after resting, prices will usually continue in the direction they did before.
The chart of eBay (EBAY) shows many Flag patterns:
When price has moved higher and prices have consolidated, creating a channel of support and resistance, a buy signal is given when prices penetrate and close above the upward resistance line.
Flag Sell Signal
Assuming prices previously moved downward, then after a period of price consolidation, a sell signal is given when price penetrates and closes below the support line.
For more information on the concept of support and resistance, (see: Support & Resistance). Another similar pattern discussed is Triangles (see: Triangles).