In this Knowledge Series, we look at how to identify and use the Major Reversal Patterns.
The most common reversal patterns are Head & Shoulders, double tops and bottoms. Basically, Tops are seen as distribution areas and Bottoms as accumulation areas. Let's have a look at them into more details.
Head & Shoulders
On the technical analysis chart, the Head and shoulders formation occurs when a market trend is in the process of reversal either from a bullish or bearish trend; a characteristic pattern takes shape and is recognized as reversal formation – see chart example below.
In the case of a Head & Shoulders reversal pattern, volume at the 3 tops decrease. Volume increases on the breaking of the neckline. Also note that the level of volume on a downside breakout is NOT important (but light volume on the formation of the right shoulder is)
On the decline from the “head” of the pattern to the neckline, volume should be very similar to volume on the rally to the head.
On a Head & Shoulder top, the head is typically made on light volume.
Other key points to keep in mind:
- Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern.
- Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend-line, keeping the uptrend intact.
- Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.
- Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.
- Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.
- Volume: As the head and shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.
- Neckline Break: The head and shoulders pattern is not complete and uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume.
- Support turned resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break and offer a second chance to sell.
- Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements or long-term moving averages.
Inverse Head & Shoulders
For this pattern, the volume on the 3 bottoms decrease. Volume at the head is lower than the volume of the 1st shoulder. There is heavy volume on the rise from the head to the second shoulder and on the break-out of the neckline.
Triple Tops & Bottoms
Volume tends to decrease at each successive Top. There is heavy volume at the breaking of the bottom line.
In general, valid double tops/bottoms have approximately a month between their peaks and troughs.
Saucer (Rounding bottom)
In this pattern, there is a very slow and gradual turn (see below). Note that this NOT a common pattern).
In an ideal pattern, volume levels will track the shape of the rounding bottom: high at the beginning of the decline, low at the end of the decline and rising during the advance. Volume levels are not too important on the decline, but there should be an increase in volume on the advance and preferably on the breakout.
Spikes (V reversal)
This is a very quick turnaround with very little transition (common pattern but difficult to recognize).
Same volume characteristics than saucers. Again, this is NOT a common pattern.
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