Price Patterns and Major Reversal Patterns
A fundamental principle of technical analysis is that prices move in trends. A trend is defined by a series of rising or falling peaks and throughs.
As long as the peaks and throughs are ascending the price is considered to be in an uptrend. Conversely, if the peaks and throughs are descending, the price is in a downtrend.
However, prices do not always move in clear trends. They often move sideways for a period, forming a consolidation phase. These sideways movements can signal either a pause in the current trend or the potential beginning of a new trend.
Analyzing these transition periods helps traders identify specific price patterns on the chart, offering valuable insights into future price movements.
Five Most Commonly Major Reversal Patterns
Head and Shoulders Reversal Pattern
Double Top or Bottom Reversal Pattern
Triple Top or Bottom Reversal Pattern
Spike or ‘V’ Top or Bottom Reversal Pattern
Rounding or Saucer Reversal Pattern
Preliminary Points Common to all Reversal Patterns
1. Existing Trend: A reversal pattern cannot occur without a prior trend. The first step in identifying a potential reversal is recognizing the trend that is already in place.
2. Breaking the Trendline: A key signal for a potential trend reversal is often the breach of a significant trendline. This break is the first indication that the momentum is changed.
3. Pattern Duration: The longer it takes for the reversal pattern to develop, the stronger the following price movement tends to be. A well-established pattern leads to more decisive price changes.
4. Tops vs. Bottoms: Topping patterns tend to form faster and are more volatile compared to bottoming patterns, which generally take longer to develop and show smaller price fluctuations.
5. Volume Considerations: In uptrends, volume plays a more significant role in confirming reversals. A spike in volume at a top often signals the exhaustion of buying pressure, while increased volume at a bottom indicates stronger buying interest.
Head and Shoulders Reversal Pattern is the most common from all major patterns
The pattern itself consists of three consecutive price chart tops. The middle top rises above the two adjacent ones, like a head above the shoulders.
The middle top is called the Head, while the adjacent ones are called the Shoulders.
The line connecting the bottoms between the pattern tops is called the neckline.
The volume is rising in the prior uptrend period and is falling during the formation of the pattern and is rising again after the breakout of the neckline.
How to Trade the Head and Shoulders Pattern
The Head and Shoulders pattern is formed at the end of the bullish trend and provides sell signals.
The basic idea is that an uptrend becomes a downtrend when the price drops from the right shoulder and crosses below the neckline.
At that point, when the price falls below the neckline a long exit or short entry is indicated.
For a sell entry the downside target is equal with the distance between the neckline and the head.
Drawing the Head and Shoulders Chart Pattern
The price is moving in uptrend creating higher tops and higher bottoms.
The first important sign of an emerging Head and Shoulders reversal pattern comes from the bottom created after the head is formed.
This bottom is possible to be formed on or below the trend line.
Head and Shoulder Formation
The price is testing the broken trendline from the downside.
The Right Shoulder is formed when the new high failures to move above the previous high.
The Neckline is formed connecting the bottom of the
left shoulder and the head.
If the price falls below the neckline a sell signal occurs.
Measuring the Head and Shoulder and Reversal Pattern
The distance between the Head and the neckline is the target after the break of the neckline.
One early sell signal occurs when the price falls below the neck line with stop loss above the Right Shoulder.
A second sell entry occurs when the price pullback and test as resistance the neckline.
Variations of the Head and Shoulder Pattern
The Inverse Head and Shoulder Pattern
The inverse head and shoulder bottom pattern is a mirror of the top head and shoulder.
The price moves in a downtrend and creates lower bottoms and lower highs.
The pattern itself consists of three consecutive price bottoms. The middle bottom is lower than the two adjacent ones.
Formation of the Inverse Head and Shoulder
The Inverse Head and Shoulders pattern is formed at the end of the downtrend and provides buy signals.
Break of the downtrend trendline during the formation of the middle bottom (head) is a weakness sign of the existence trend.
Break above the Neckline is a bullish entry signal.
Trading Strategy for the Bottom Head and Shoulders
The first Buy signal occurs when the right shoulder is being formed after the pullback of the neckline.
The Buy Entry level occurs when the price break above the trendline.
Stop loss will be placed below the Right Shoulder and take profit above the neckline pips equal with
Bottom and Top Reversal Head and Shoulder Pattern
Double Top “M” and Double Bottom “W” Reversal Pattern
The most common reversal patterns is the double top or bottom.
This Pattern has two peaks at the same about level. Some times is possible the second peak to be a bit lower .
The pattern is complete when the price breaks the neckline and moves beyond the point B.
How to identify the Double Top
In an uptrend the price makes a new high at point A an then declines to point B.
After the bottom B the price tries to make new high but is enable to penetrate the previous peak and create a new peak C at similar level than A. Sometimes the peak C is higher or lower up to 10 pips than A.
The ideal double top has two prominent peaks at about the same level. Volume tends to be heavier during the first peak and lighter at the second.
If the price penetrates the trendline and falls below the level B than the Double Top has completed. In this phase the volume is heavier than the peaks A and C.
Measuring Technique of the Double Top Reversal Pattern
The measuring technique for the double top is the height of he pattern projected between the two tops A and C, from the breakdown point B.
An alternative measuring is the height of the first top point A to B and project that length downward from the middle trough at point B.
Trading Strategy
Step1: Confirm the double top pattern. Wait the price to create the top C and confirms the double top formation.
Step 2: Place a first sell stop order one pip below the confirmation candlestick.
Step 3: You can place a second sell stop order one pip below the bottom B.
Stop Loss 5 pips above the confirmed candlestick.
Take profit will placed 1 :1 up to 1:2 of the pips difference between A,B.
Variation of the Double Top Reversal Pattern
Sometimes the two tops are not exactly at the same level.
One occasion is the second peak to be slightly lower than the first.
A second occasion is if the second peak exceeds the first peak.
In this case a price filter criterion 3% or time filter will implement .
Lighter volume also during the upside break out is a signal of false breakout.
Double Bottom Reversal Pattern
The double bottom occurs at the end of a downtrend and it forms when the price attempts to break a support area twice.
At point A, the downtrend is proceeding as expected and takes corrective push up to point B.
Then market dips again to point C, but cannot moves lower the previous bottom point A. At this point the pressure from the buyers push the price higher .
When the price penetrates the neckline above the point B, is possible to test it again as support.
Trading Strategy for the Double Bottom
When the price penetrates the trendline is a weakness of the previous downtrend.
A Buy entry will places when the price breaks above the neckline.
Take profit will be equal distance of pips with the distance of the bottom with the neckline.
Stop loss will be initial below the bottom 2 and will be modified higher below the trendline.
Triple Top and Bottom Reversal Patterns
Triple tops may occur on all time frames, after an uptrend.
The opposite of a triple is a triple bottom, which indicates the asset’s price is no longer falling and could head higher.
The triple top pattern occurs when the price of an asset creates three peaks at nearly the same price level.
Variation of the Triple Bottom
In the real live chart the price always creates variations of an ideal pattern.
The important is to recognize the reversal areas on the chart from support to resistance.
After the breakout is possible a reversal of the price until the middle of the distance bottom to neckline.
Saucer or Rounding Reversal Pattern
These patterns are more common as bottom bullish long term reversal patterns but is possible to create and as top bearish reversal.
The saucer bottom indicates a very slow and gradual turn from downtrend to sideways to up.
Saucer bottoms are usually spotted on daily, weekly or monthly chart.
The saucer bottom will be completed when the price break above a significant resistance level.
It looks like similar with a cup with the handle.
How to trade the Saucer Bottom
Identify the support area below the bottoms.
The distance between the resistance line with the bottoms area is a reaction area.
The first buy signal occurs when the price penetrates above the resistance line.
Usually the price after the breakout creates the “handle” consolidation.
Spikes or V- Reversal Patterns
The V-Pattern is the hardest market turns because it happens very quickly with little or no transition period.
It happens usually when the market has gotten so overextended in one direction, that a adverse news causes the market to reverse direction very abruptly.
A breakout of a significant support or resistance triggers –V- reversal patterns.
How to trade V- patterns
Wait to close the candlestick after the support breakout.
Will place Buy order above this candlestick with stop loss 2 pips below it.
Target for the first trade is the resistance above the breakout.
A second buy signal occurs when the price moves above the resistance line.
