Technical Analysis – Trend Reversal Patterns

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Technical Analysis – Trend Reversal Patterns

Trend Reversal Patterns

Chart formations are generally sorted on the basis of their significance to the current trend of the underlying currency. Formations signaling the end of the trend are known as reversal patterns. Conversely, chart formations that confirm that the underlying currency trend is intact are called continuation patterns.

The most significant trend reversal patterns are:

  1. Head-and-shoulders and inverse head-and-shoulders.
  2. Double tops and double bottoms.
  3. Triple tops and triple bottoms.

Head-And-Shoulders

The head-and-shoulders pattern is one of the most reliable and wellknown chart formations. It consists of three consecutive rallies. The first and third rallies—the shoulders—have about the same height, and the middle one—the head—is the highest. All three rallies are based on the same support line (or on the resistance line in the case of the reversed head-and-shoulders formation), known as the neckline.

Prior to point A, the neckline was a resistance line (see Figure 5.15.).

Once the resistance line was broken, it turned into a significant support line. The price bounced off it twice, at points B and C. The neckline was eventually broken in point D, under heavy volume, and the trend reversal was confirmed. As the significant support line was broken, a retracement could be expected to retest the neckline (E), now a resistance line again. If the resistance line held, the price was expected to eventually decline to around level F, which was the price target of the head-and-shoulders formation. The target was approximately equal in amplitude to the distance between the top of the head and the neckline. The price target was measured from point D, where the neckline was broken. (See the dotted lines).

Signals Generated by the Head-and-shoulders Pattern

The head-and-shoulders formation provides excellent information:

  1. The support line. This is based on points B and C.
  2. The resistance line. After giving in at point D, the market may retest the neckline at point E.
  3. The price direction. If the neckline holds the buying pressure at point E, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish).
  4. The price target. This is provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume).
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Figure 5.15. Diagram of a typical head-and-shoulders pattern

One of the main requirements of the successful development of this formation is that the breakout through the neckline occurs under heavy market volume. A breakout on light volume is a strong warning that it is a false breakout and will trigger a sharp backlash in the currency price. The time frame for this chart formation’s evolution is anywhere from several weeks to several months. The intraday chart formations are not reliable. The longer the formation time is, the more significance should be attached to this pattern. The target is unlikely to be reached in a very short time frame. Whereas there is no immediate suggestion regarding the length of target reaching time, common sense would link it to the duration of development of the chart pattern.

It is reasonable to emphasize the importance of measuring the target from the point where the neckline was broken. There is a tendency among new technicians to measure the target price not only from under the neckline but also from the middle of the formation. This may happen as they measure the height of the head. Most head-and-shoulders formations, of course, look different from that in Figure 5.16. Prices fluctuate enough to forego any possibility of a clean-looking chart line. Also, the neckline is seldom a perfectly horizontal line.

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Figure 5.16. Diagram of a typical inverse head-and-shoulders pattern

Inverse Head-And-Shoulders

The inverse head-and-shoulders formation is a mirror image of the previous pattern. Therefore, you can apply the same characteristics, potential problems, signals, and trader’s point of view from the preceding presentation. The underlying currency broke out of the downtrend ranged by the xx’-yy’ channel. The currency retested the previous resistance line (the rally number 3), now turned into a support line. Among the three consecutive rallies, the shoulders (1 and 3) have approximately the same height, and the head is the lowest. Prior to point A, the neckline was a support line. Once this line was broken, it turned into a significant resistance line. The price bounced off the neckline twice, at points В and C. The neckline was eventually broken at point D, under heavy volume. As the significant resistance line was broken, a retracement could be expected to retest the neckline (E), now a support line again. If it held, the price was expected to eventually rise to around level F, which is the price target of the head-and-shoulders formation.

The price objective is approximately equal in amplitude to the distance between the top of the head and the neckline, and is measured from the breakout point D.

Double Top

Another very reliable and common trend reversal chart formation is the double top. As the name clearly and succinctly describes, this pattern consists of two tops (peaks) of approximately equal heights. (See Figure 5.17.). A parallel line is drawn against a resistance line that connects the two tops. We should think of this line as identical to the head-and-shoulders’ neckline. As a resistance line, it is broken at point A. It turns into a strong support for price level at C, but eventually fails at point E. The support line turns into a strong resistance line, which holds the market backlash at point F. The price objective is at level G, which is the average height of the double top formation, measured from point E.

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Figure 5.17. Diagram of a typical double-top formation

Signals Provided by the Double Top Formation

The double top formation provides information on:

  1. The support line, set between points A and E.
  2. The resistance line, set between points В and D.
  3. The price direction. If the neckline holds the buying pressure at point F, then the formation provides information regarding the price direction: diametrically opposed to the direction of the peaks (bearish).
  4. The price target, provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume).

Exactly as in the case of the head-and-shoulders pattern, a vital requirement for the successful completion of the double-top formation is that the breakout through the neckline occurs under heavy market volume. Again, please remember that gauging volume in traditional ways is only possible in the currency futures market. Therefore, the trader must estimate the size of the cash market volume by extrapolating from The currency futures’ volume and the trading “noise.” A breakout on light volume is a strong case for a false breakout, which would trigger a sharp backlash in the currency price. The time frame for this chart formation’s evolution is anywhere from several weeks to several months. The intraday chart formations are less reliable. There is a strong correlation between the length of time to develop the pattern and the significance of the formation.

The target is unlikely to be reached in a very short time frame. There is no direct suggestion regarding the length of target reaching time; but foreign exchange common sense links it to the duration of development.

It is important to measure the target from the point where the neckline was broken. Avoid the trap of measuring the target price from the middle of the formation under the neckline. This may happen as you measure the average height of the formation.

Double Bottom

The double bottom formation is a mirror image of the previous pattern. (See Figure 5.18.). Therefore, one may apply the same characteristics, potential problems, signals, and trader’s point of view from the preceding presentation.

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Figure 5.18. Diagram of a typical double-bottom formation

The bottoms have about the same amplitude. A parallel line (the neckline) is drawn against the line connecting the two bottoms (B and D.) As a support line, it is broken at point A. It turns into a strong resistance for price level at C, but eventually fails at point E. The resistance line turns into a strong support line, which holds the market backlash at point F. The price objective is at level G, which is the average height of the bottoms, measured from point E. (See the dotted lines).

Triple Top And Triple Bottom

The triple top is a hybrid of the head-and-shoulders and double-top trend reversal formations. (See Figure 5.19.) Conversely, the triple bottom is a hybrid of the inverse head-and-shoulders and double-bottom formations.

(See Figure 5.20.) Consequently, they have the same characteristics, potential problems, signals, and trader’s point of view as the double top or double bottom, respectively.

As shown in Figure 5.19., in a typical triple-top formation, the tops have about the same height. A parallel line (the neckline) is drawn against the line connecting the three tops (B, D, and F.) As a resistance line, the neckline is broken at point A. It turns into a strong support for price levels at С and E, but eventually fails at point G. The support line turns into a strong resistance line, which holds the market backlash at point H. The price objective is at level I, which is the average height of the three tops formation, as measured from point D (see the dotted lines).

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Figure 5.19. Diagram of a triple-top formation

As a double top, the formation fails at point E. The price moves up steeply toward point F. The resistance line is holding once more and the price drops sharply again toward point G. At this level, the market pressure is able to penetrate the support line. After a possible retest of the neckline, the prices drop further, to eventually reach the price objective.

The opposite is true for the triple bottom

As shown in Figure 5.19., in a triple-bottom formation, the bottoms have about the same amplitude. A parallel line (the neckline) is drawn against the line connecting the three bottoms (B, D, and F.) As a support line, the neckline is broken at point A. It turns into a strong resistance for price levels at С and E, but eventually fails at point G. The resistance line turns into a strong support line, which holds the market backlash at point H. The price objective is at level I, which is the average length of the triple-bottom formation, as measured from point D (see the dotted lines).

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Figure 5.20. Diagram of a typical triple-bottom formation.

Rounded Top and Bottom Formations

The rounded top and bottom, also known as saucers consist of a very slow and gradual change in the direction of the market. These patterns reflect the indecision of the market at the end of a trend. The trading activity is slow. It is impossible to know when the formation is indeed completed, and not for a lack of trying. Like any other consolidation pattern, the longer it takes to complete, the higher the likelihood of a sharp price move in the new direction.

Diamond Formation

The diamond formation tends to occur at the top of the trend. The price activity may be outlined by a shape resembling a diamond (see Figure 5.21.). The increase and decrease in trading volume closely mimic the combination of divergent and convergent support and resistance lines. Upon breakout, volume picks up substantially. The price target is the height of the diamond, measured from the breakout point.

The head-and-shoulders, the double top and bottom and the triple top and bottom, due to their significance in trend reversals, are generally known as major reversal patterns.

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Figure 5.21. A scheme of a diamond reversal formation

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