Reversal Patterns

Reversal patterns, or tops and bottoms, indicate a radical change in a long-term trend.

Tops are usually less stable and shorter than bottoms. Bottoms usually have smaller price variations and are slower to set up.

A breakout through a trend line is used together with a reversal pattern for monitoring price level- and timing-related signals.

The longer the time required for the formation of a pattern and the greater the price fluctuations within it are, the more substantial the forthcoming price movement is likely to be. The time frame is, normally, from several days to several months. Intraday patterns are much less reliable.

Reversal patterns offer some of the most important opportunities for entering a market with a good profit potential. They usually represent fundamental changes in the underlying character of a particular market, and often go on to yield big moves.

However, a market top or bottom is often difficult to identify. It is even more difficult to choose the appropriate entry and exit points. One of the related problems is distinguishing between the actual change in a trend and a mere congestive phase in the middle of a move. In most cases, it is advisable to wait for prices to actually confirm a trend reversal by developing one of these well-tested and reliable reversal patterns. The actual buy or sell signals are based on a breakout in the direction of the new trend.

The most popular Reversal Patterns include: head and shoulders, double tops and bottoms, and V-Top.

Head and Shoulders
The head and shoulders pattern is formed by three peaks. The center peak, or head, is somewhat higher than its two lower, and not necessarily symmetrical, shoulders. The line connecting the bottoms of the two shoulders is called the neckline. Due to unsteadiness, the neckline is seldom symmetric or precisely horizontal.

The pattern is not complete until the neckline is broken. It is advisable to wait for confirmation.

Volume should be assessed to confirm the validity of reversal patterns. Volume is, normally, the heaviest during the formation of the left shoulder. It also tends to be quite heavy when a price is approaching the peak. The real confirmation of a developing Head and Shoulders pattern comes with the formation of the right shoulder, which is invariably accompanied by a distinctly lower volume.

Double Top
This pattern consists of two tops of almost equal height. A line is drawn below and parallel to the resistance line that connects the two tops. The neckline is a strong support for price level but eventually fails.

As with a Head and Shoulders, after the two rallies and their respective reversals are completed, the double tops is confirmed only when the neckline is broken. The support line then becomes a resistance line, which often holds a market rebound.

A Double Bottom pattern is a mirror image of a double top pattern: The average height of the bottoms gives a good indication of the price objective.

V-Top
The V-Top pattern is an unusual pattern in that a sharp trend switches from one direction to the other without warning and with high volume at or just after the turnaround.


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