Chapter 18 – Reversal Pattern and Trading Tactics

What are Chart Patterns?

  • Chart patterns are derived from price behaviour.
  • These patterns are extensions to trend lines and support and resistance.
  • Reflect the underlying psychology of bulls and bears in the market.
  • These patterns are researched and found to have a higher probability to certain outcomes.
    • However, they have failures too!
    • Patterns can change as they are being formed.
  • Two main types of patterns
    • Reversal
    • Continuation
Types of chart patterns

Types of chart patterns

 

Reversal – Double Top and Triple Top

Double top reversal pattern resembles a letter 'M'

Double top reversal pattern resembles a letter ‘M’

CharacteristicDiscussion
Price trendUpward move.
ShapeTwo distinct tops that look similar. Can be slightly higher or lower.
SeparationThe twin peaks are several weeks apart with most falling in 2 to 6 week range.
ConfirmationThe double top confirms as a true double top once price closes below the valley between the two peaks (lower horizontal).
VolumeUsually lower on right peak relative to left peak.
ActionSell when price closes below valley between two peaks.
FailureWhen price closes above the peaks.

Triple top -forms the third top; characteristics similar to double top.

 

Reversal – Double Bottom and Triple Bottom

Double top reversal pattern resembles a letter 'W'

Double top reversal pattern resembles a letter ‘W’

CharacteristicDiscussion
Price trendDownward move.
ShapeTwo distinct bottoms that look similar. Can be slightly higher or lower.
SeparationThe twin valleys are several weeks apart with most falling in 2 to 6 week range.
ConfirmationThe double bottom confirms as a true double bottom once price closes above the peak between the two valleys (higher horizontal).
VolumeUsually lower on right valley relative to left valley.
ActionBuy when price closes above top between two valleys.
FailureWhen price closes below the two valleys.

Triple bottom – forms the third bottom; characteristics similar to double bottom.

 

Reversal – Head and Shoulders Top

Head and shoulders reversal top

Head and shoulders reversal top

CharacteristicDiscussion
Price trendUpward move.
ShapeDistinctly three tops; head must be higher than right/left shoulder.
VolumeHighest at left shoulder, followed by the head, followed by the right; volume trends down.
NecklineJoin the two armpits i.e. two valleys between the shoulders and the head.
ConfirmationWhen price closes below the neckline.
ActionSell when price closes below neckline; pullback may happen.
Failure'Dead cat bounce' above necklines ; failure in such case will give rise to powerful upwards move.

Special discussion

Signs that give away a better head and shoulders pattern

 

 

Reversal – Head and Shoulders Bottom (Inverted)

Inverted head and shoulders (bottom reversal)

Inverted head and shoulders (bottom reversal)

CharacteristicDiscussion
Price trendDownward move
ShapeDistinctly three bottoms; head must be lower than right/left shoulder
VolumeHighest at left shoulder, followed by the head, followed by the right; volume trends down
NecklineJoin the two armpits i.e. two peaks between the shoulders and the head
ConfirmationWhen price closes above the neckline
ActionBuy when price closes above neckline; throwback may happen
FailureClose below neckline

 

Reversal – Falling Wedge

Falling wedge

Falling wedge

CharacteristicDiscussion
Price trendCan be any direction leading to the pattern.
ShapeA narrowing and descending triangle shape.
Trend linesPrice bounces between two downsloping and converging trend lines.
TouchesPrice should touch trend lines at least five times to outline a good pattern. That's 3 touches of one trend line and 3 of the opposite.
Duration3 weeks is the minimum duration, otherwise it's a pennant.
VolumeTrends downwards until the breakout.
BreakoutCan be in any direction but tendency up.
ConfirmationWhen price closes outside one of the trend lines.
ActionBuy on breakout of upper trend line on heavy volume; sell on breakout of lower trend line.
FailurePrice falls back into the wedge.

 

Reversal – Rising Wedge

Rising wedge

Rising wedge

CharacteristicDiscussion
Price trendCan be any direction leading to the pattern.
ShapeA narrowing and rising triangle shape.
Trend linesPrice bounces between two up-sloping and converging trend lines.
TouchesPrice should touch trend lines at least five times to outline a good pattern. That's 3 touches of one trend line and 3 of the opposite.
Duration3 weeks is the minimum duration, otherwise it's a pennant.
VolumeTrends downwards until the breakout.
BreakoutCan be in any direction but tendency down.
ConfirmationWhen price closes outside one of the trend lines.
ActionBuy on breakout of upper trend line on heavy volume; sell on breakout of lower trend line.
FailurePrice rises back into the wedge.

 

Reversal – Rounding Bottom

Rounding bottom/ cup and handle pattern

Rounding bottom/ cup and handle pattern

CharacteristicDiscussion
Weekly or dailyAppears on either the daily or the weekly chart. Rounded nature is more apparent in weekly chart.
ShapeA rounded bowl shape, usually over many months.
BlipPrice may shoot up midway through the turn, near the bottom, but price usually retraces most (not all) of the way back to where it started.
VolumeU-shaped volume pattern.
ConfirmationThe pattern confirms when price closes above the highest peak of the pattern.
ActionBuy when price closes above highest peak on heavy volume.
FailurePrice falls back below the highest peak.

 

Practical Technical Analysis (2006) Chapters 15-17Practical Technical Analysis (2006) Chapters 19-20

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