Profit from Trend Reversal Patterns!

Technical analysis is an interesting study that requires analyzing chart patterns which help decode the underlying market trend and behaviour. Any trader or an investor will agree that one of the most important things while studying charts in particular and markets in general is to identify whether the ongoing trend is going to continue or reverse. Huge amount of money can be made or losses averted by identifying early if the underlying trend is getting reversed. Says Pralhad Dhamne, who has been trading in markets using technical analysis, “Chart patterns can be classified into continuation patterns and reversal patterns. Reversal patterns tell us that an important reversal in the trend is taking place. Reversal patterns take much longer to form than continuation patterns. I have personally profited by focusing on reversal patterns.” 



TOP REVERSAL PATTERNS:

1. Head and Shoulders:

The 'head and shoulders' pattern formation occurs when a market is in a bullish trend. This pattern is considered to be a bearish reversal pattern. Head and shoulders pattern appears in the form of two shoulders and a head in-between. The pattern starts with the creation of a top on the chart. The price action then creates a second top which is higher that the first and, thereafter, the price rallies for a third time, but it fails to reach the high price achieved during the previous rally.

Identification Guidelines:

Shape:

• The price is in a clear uptrend and then it reaches a peak of the current rally and thereafter starts to decline. This forms the left shoulder in the pattern.
• The price completes a decline and rallies again to an even higher peak. However, the sellers then take control and push the prices lower towards the previous swing low. This forms the head in the pattern.
• The buyers make a final attempt to push the price higher, but it fails to break the previous high and then the sellers take control and push the price toward the neckline. This forms the right shoulder in the pattern.
• The neckline is formed by connecting the low prices registered between the left shoulder, head and right shoulders. The neckline may not be perfectly horizontal and may be upward or downward sloping.

Volume: The volume characteristics are very important in assessing the validity of this pattern. The volume activity is higher on the left shoulder than on the head and right shoulder.

Time frame: The head and shoulder can develop over virtually any time frame. However, the patterns that take a longer time to form are more significant and more likely to identify a meaningful price reversal.

Breakout: The price must break below the neckline along with strong volumes in order to complete the pattern and reversing the original trend.

Pattern Psychology: The head and shoulders pattern signals a possible trend reversal means the formation represents the loss of faith in the prevailing trend. The right shoulder on the chart signals a possible trend reversal as the buyers cannot push the price higher. The breakout of neckline is the next clue that the sentiment has shifted because the price is now also making lower lows.

Price Target: Measure the distance from the right shoulder to the neckline and then apply this length downward starting from the initial breakout point through the neckline. This will be the first target. To calculate the final target, we have to measure the distance from head to neckline and then apply this length downward, starting from the initial breakout point through the neckline. 



2. Rounding Top

The 'rounding top' pattern may form at the end of an extended uptrend and often indicates a reversal in the long term price movement. This pattern appears as an inverted ‘U’ shape.

Identification Guidelines:

Shape:

• The price must be in a clear long term uptrend.
• As the price moves up, it bends over and rounds off at the top, then continues its rounding turn until it is head down and retraces the prior rise.
• The pattern's neckline is formed by the low point preceding the inverted U’s formation.

Volume: The volumes are often lowest at the centre of the formation and higher at the either end. This observation is just a guideline and not an inviolable rule. What is important is the price rounding over and forming a bowl-shaped pattern and the volume trend just adds evidence to the veracity of the chart pattern.

Time frame: This pattern can develop over several weeks, months or even years and it is considered a rare occurrence.

Breakout: The neckline being broken by the price along with strong volumes will indicate the original uptrend is reversed.

Pattern Psychology: A rounded top forms as investors' sentiment shifts slowly from bullishness to bearishness. The lowest volume in the centre of the formation indicates indecisiveness in the market. The neckline breakout, along with strong volumes, indicate the major shift in investors' sentiment.

Price Target: Rounding tops generally do not lend well to price targets because the pattern is meandering. In most cases, one can expect a decline back to the longer term support level. 



3. Rising Wedge

The 'rising wedge' is a bearish reversal pattern that begins wide at the bottom and contracts as the price moves higher. A series of higher swing highs and higher swing lows that form the pattern narrow down into a apex point as the bulls become less interested in buying.

Identification Guidelines:

Shape:


• The price must be in a clear uptrend.
• Draw two trendlines. Both trendlines are upward sloping and eventually intersect. The upper trendline connects minimum two highs and ideally three highs, and each high should be higher than the previous one. The lower trendline which connects minimum two lows and each low should be higher than the previous one.

Volume: The volume is a key element in correctly identifying a rising wedge. Most of the time, the volume trend is downward throughout the formation. The volume becomes especially low just before the breakout.

Time frame: A rising wedge takes time to form. The price makes new higher highs and higher lows as it bounces from the trendline to trendline. It takes over three weeks for the formation to take on the wedge appearance. Rising wedges rarely last more than three months.

Breakout: The bearish confirmation of the pattern does not come until the lower trendline is broken in a convincing fashion along with expansion of volume.

Pattern Psychology: The upper and lower trendlines converge as the pattern matures. The advances from the reaction lows become shorter and shorter, which makes rallies unconvincing. The loss of momentum on each successive high gives the pattern its bearish bias. The breakout of lower trendline indicates that the forces of supply have finally won out and lower prices are likely. 

Price Target: Calculate the distance between the last upward leg and then apply this length downward, starting from the initial breakout point. This will be the first target. To calculate the final target, we have to measure the distance of largest leg and then apply this length downward, starting from the initial breakout point. 



BOTTOM REVERSAL PATTERNS:


1. Inverted Head and Shoulders:

The inverted head and shoulders also called a ‘Head and Shoulders Bottom’. The inverted head and shoulders pattern occurs after an extended downward move. It represents a possible exhaustion point in the market where possible reversal may occur.

Identification Guidelines:

Shape:

• The price is in a clear downtrend. It reaches a trough of the current rally and starts rising. This forms the left shoulder in the pattern.
• The price completes a rise and declines again to an even lower trough. However, the buyers take control and push the price higher towards the previous swing high. This forms the head in the pattern.
• The sellers make a final attempt to push prices lower, but it fails to break below the previous low and then the buyers take control and push the price toward the neckline. This forms the right shoulder in the pattern.
• The neckline is formed by connecting the high prices registered between the left shoulder, head and the right shoulder. The neckline may not be perfectly horizontal and may be upward or downward sloping.

Volume: The volume represents another clue to the validity of inverted head and shoulders pattern. The left shoulder or head has the highest volume, with diminished volume on the right shoulder.

Time frame: The inverted head and shoulder can develop over virtually any time frame. However, the pattern that takes a longer time to form is more significant and more likely to identify a meaningful price reversal.

Breakout: The inverted head and shoulders pattern is not complete until the neckline is broken. This breakout must occur in a convincing manner with an expansion in volume.

Pattern Psychology: The inverted head and shoulder pattern can be formed because the sentiment that was formerly producing the downtrend is possibly shifting and selling pressure decreasing. The right shoulder on the chart signals a possible trend reversal as the sellers cannot push the price lower. The breakout of neckline is the next clue that the sentiment has shifted because the price is now also making higher highs.

Price Target: Measure the distance from the right shoulder to the neckline and then apply this length upward starting from the initial breakout point through the neckline. This will be the first target. To calculate the final target, we have to measure the distance from the head to the neckline and then apply this length upward, starting from the initial breakout point through the neckline



2. Rounding bottom

The rounding bottom pattern may form at the end of an extended downtrend and often indicate a reversal in the long term price movement. As a stock is trending lower, the rate of the decline will begin to slow down. This is followed by a range pattern, which ultimately shifts into a slow gradual increase. This rise ultimately leads to a bullish move.

Identification Guidelines:

Shape:


• The price must be in a clear long term downtrend 
• When the price is trading lower, the rate of the decline will begin to slow down. This is followed by a range pattern which ultimately shifts into a slow gradual increase. This series of price movements graphically forms the shape of a ‘U’.
• The pattern's neckline is formed by the high point preceding the U’s formation.

Volume: The volume is similar to the shape of the rounding bottom—high at the beginning of the decline, low at the end of the decline and rising during the gradual increase. The volume is not too important on the decline, but there should be an increase in volume on the upside.

Time frame: This pattern can develop over several weeks, months or even years and it is considered a rare occurrence.

Breakout: The neckline being broken by the price along with strong volumes will indicate that the original downtrend is reversed.

Pattern Psychology:
The rounding bottom forms a gradual bowl shape, which indicates a gradual shift in the sentiments of the investors from bearishness to bullishness. The volume tends to mirror the price pattern—decreasing as bearishness wanes and investors become indecisive. As sentiment becomes more decisively bullish, volume tends to increase. The neckline breakout along with strong volume indicates a major shift in investors' sentiments.

Price Target: Measure the distance from the neckline to the lowest point of the pattern and then apply this length upward, starting from the initial breakout point through the neckline. This will be the minimum expected target for rounding bottom pattern. 



3. Falling wedge

The falling wedge pattern appears in a downtrend and it is considered as a bullish reversal pattern. It occurs when the price is making lower highs and lower lows, which form two contracting trendlines. The falling wedge usually paves the way for a reversal on the upside.
 
Identification Guidelines:

Shape:


• The price must be in a clear downtrend.
• Draw two trendlines. Both are downward sloping and eventually intersect. The upper trendline connects minimum two highs and ideally three highs and each high should be lower than the previous one. The lower trendline connects minimum two lows and each low should be lower than the previous one.

Volume: Most of the time, the volume trend is downward throughout the formation. The volume becomes especially low just before the breakout. The volume expansion must happen after the breakout.

Time frame: It takes over three weeks for the formation to take on the wedge appearance. Falling wedges rarely last more than three months.

Breakout: The bullish confirmation of the pattern does not come until the upper trendline resistance is broken in a convincing fashion along with expansion of volume.

Pattern Psychology:
The loss of momentum on each lower lows gives the pattern its bullish bias. The breakout of upper trendline indicates that the forces of demand have finally won out and higher prices are likely to follow.

Price Target:
Calculate the distance between the last downward leg and then apply this length upward, starting from the initial breakout point. This will be the first target. To calculate the final target, we have to measure the distance of the largest leg and then apply this length upward, starting from the initial breakout point. 



Conclusion :

Reading the underlying trend in the markets correctly is the most important aspect for any trader. How to read the trend accurately is an art that very few can master. With practice and observation of the markets, such skills can be developed over time. The trend reversal patterns discussed in this story are no doubt useful, but what is important is identifying them at the opportune time and knowing exactly the breakout price. 


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