When analyzing price movements in the market traders face difficulties to adequately determine trend direction, trace confirmation signals and moments of trend reversal. To facilitate execution of these tasks we use patterns of trend reversal, which we are going to review below. Construction of a pattern is an individual process, which has no clear algorithm but still submits to the rules. Looking at the chart different people can see completely different pictures as the patterns do not have strictly outlined shapes and they can be interpreted in different ways. It is worth noting that market analysis is a creative process. When we see a pattern on the chart, we assume that quite often this pattern has often been the same in the past. The key word here is often (Not always). Building of patterns is based on historical data, as is any technical analysis; therefore we should treat the patterns with a little skepticism.
In this article we are going to review the following patterns of the trend reversal:
- “head and shoulders” and inverse “head and shoulders”;
- “double top” and “double bottom”;
- “triple top” and “triple bottom”.
The pattern, which gives a signal of the downtrend, goes first in line, followed by a pattern indicating the development of the uptrend. In addition, with the help of these patterns we can evaluate changes in price within the trend. It is better to review the reversal patterns on the daily charts; as on the hourly charts, and below these patterns, is generally not analyzed by traders.
The first pattern we are going to consider is “head and shoulders”. As we can see on the picture, the pattern consists of three peaks that go one after the other, as the highs; the middle of the three peaks is higher than the two others. The two side peaks are called “shoulders” and the middle one is called the “head”. An important role in this pattern is played by the “neck”, which is usually built after two lows of the pattern. When the right shoulder crosses the line of the neck, the price falls by one level, equal to the distance from the “head” to the “neck”. When the decline in price reaches this point, it is advisable either to close positions or to place trailing stop. The picture shows that the price had not stopped but went further down.
The pattern inverse “head and shoulders” is almost similar to the pattern “head and shoulders” with the only difference that it is an inverse analogue of the “head and shoulders” indicating the uptrend instead of the downtrend.
The pattern “head and shoulder” is a classic example of the trend reversal pattern. It often happens that some patterns do not have a “head”. Such patterns are called “double top”. This pattern has a line of the neck but it is built with the help of only one low point, which is more complicated than the case with the “head and shoulder”. Therefore, it is usually built parallel to the line drawn through the two peaks. The upper line crosses both of the peaks.
The middle line, which is parallel to it and goes through the local lows, defines the “neck”. The bottom line is at the same distance from the line of the “neck” as the top line. It determines the expected decline in price after breaking out of the "neck" level, which takes place after the completion of the second swing.
The pattern “double bottom” is similar to the “double top” with the except that it is inverted analogue of the “double top”, indicating the development of the uptrend.
In some cases, the pattern is similar to the “head and shoulders”; however, the middle peak is not higher than the side peaks. All three tops are of the same height. This pattern is called “triple” top, and it also give a signal of the nearing trend reversal. The principle of building the “neck” for this pattern is the same as for the pattern “head and shoulders”, the only difference that the top line will go through all three peaks but not only through the “head”. An expected decline in price can be determined by the distance from the line of the "neck", to the right "shoulder".
Note particularly, that all patterns of the trend reversal shall be reviewed together with the histogram of volumes. Changes in trend and breakout of one of the lines will be always accompanied by an increase in volumes. It is also recommended to utilize additional technical indicators in order to confirm signals.