This is part 13 of a series on technical analysis surrounding reversal chart patterns. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns. Click here for part six on Bollinger Bands. Click here for part seven on trend lines. Click here for part eight on Fibonacci retracements. Click here for part nine on moving averages. Click here for part 10 on support levels. Click here for part 11 on resistance levels.Click here for part 12 on momentum and relative strength.
Much of technical analysis is focused on patterns, and one of the easiest ways to see patterns as they develop is on the price chart. We already discussed candlestick chart patterns earlier in this series, but there are many patterns which are found on standard price charts but not necessarily on candlestick charts. In some cases, these other patterns can be identified on both standard price versus time charts and candlestick charts.
Patterns generally fall into one of two categories: reversal patterns and continuation patterns. As you might expect, reversal chart patterns signal that the trend which has been in place could be about to reverse, while continuation patterns suggest the current trend could continue. Let’s discuss some of the most common reversal chart patterns and how to interpret them.
Head and shoulders
One of the most common reversal chart patterns you will notice is the head and shoulders. This pattern is very easy to identify because it looks like three peaks with the middle peak being higher than the two outer peaks. The head is the taller peak in the middle, while the two outside peaks are the shoulders. This pattern also appears in an inverse variant called the inverse head and shoulders.
One important step when identifying chart patterns is the need to draw trend lines on the chart. These trend lines are used in the identification of chart patterns and to help spot the formations. In the case of a perfect head and shoulders pattern, the bottoms of each of the peaks touch roughly the same price level, which is where the trend line is drawn.
The head and shoulders pattern usually appears after a long upward move with high volumes. After the long upward move, there is a bit of a reaction to it and prices slide a bit in low volumes. Then there’s a new price rally after the prices slid, and volumes increase again as the head is formed. After the peak that forms the head, prices slide again, falling back to about where they fell to between the left shoulder and the head. Finally, there’s a third price rally that rises to the same level as the left shoulder but not as high as the head before prices start to fall and keep falling below the level marked by the drops in between each of the shoulders and the head.
The head and shoulders pattern is a reversal pattern because it signals a sort of pause in the price rally ahead of a new downtrend. When the head and shoulders pattern appears, it is a bearish signal which suggests the downtrend that follows the right shoulder could be significant. The reversal chart pattern is confirmed when prices fall below the support level on which the shoulders and head rest.
The inverse head and shoulders pattern is a bullish signal because it’s the opposite of the regular head and shoulders pattern. The peaks point downward instead of upward, and the pattern is confirmed when the price exits the right shoulder and continues to climb past the resistance level marked by the pause in the decline between each of the shoulders and the head. The key difference between the regular head and shoulders pattern and the inverse variant is that the inverse version appears in a downtrend that reverses to an uptrend after the pattern completes.
The head and shoulders are not usually shaped perfectly. The pattern is often tilted upward or downward, but when it does appear, it is very distinct. Sometimes one of the shoulders looks a little broader than the other, and the support or resistance line may not be perfectly horizontal.
Double and triple top and bottom
The double top pattern appears quite often at the end of a bull market, while the double bottom often appears at the end of a down market. The double top looks like two peaks which are about the same separated by a valley. The price may go up and down slightly in the valley, but the change will be very minimal compared to the two peaks. The pattern is completed when the price falls below the support level formed by the bottoms after the two peaks. In some cases, the price might rally very slightly after bottoming following the second peak, but if the price falls below the support line, then the pattern is confirmed.
The double top pattern is a sign that there is more demand for the asset in question than there is supply. This causes the first top in the pattern. Then the price falls as demand falls as the number of sellers outpaces the number of buyers. The double top is a bearish warning if the support line is breached and the price falls below it. Volumes are higher as each peak approaches and then fall as the valley between the two tops is formed.
The double bottom is the opposite of the double top, and it signals a bullish reversal instead of a bearish one. The pattern forms below a resistance line, and when the price rises above the resistance line at the end of the pattern, it signals that more upside is ahead.
The triple top and bottom appear less often than the doubles, but the principle is the same, except with three peaks or valleys instead of two. Like the double top, the triple top generally appears in an uptrend, so when the pattern is complete, the trend reverses course and becomes a downtrend.
One important difference between the double top and bottom and the triple top and bottom is that the peaks and valleys must not necessarily be evenly spaced in the triple versions. If two tops are close together and not followed by a third one, then it probably wouldn’t be considered a double top at all. Instead, the two tops would probably be considered part of the same consolidation and a signal that the current trend could continue.
Wedge patterns are considered to be minor patterns because they’re part of a much larger trend. A falling wedge appears as a temporary pullback after a long upward move and ahead of a significant uptrend. A rising wedge occurs after a long downward move just before a significant drop-off. In both cases, the pattern appears as a tightening range of prices. The case of a rising wedge, the tightening range is gradually drifting higher, while in a falling wedge, the tightening range is trending gradually lower. Rising wedges usually appear as a lengthy pause of increasing prices in the middle of a downtrend, while falling wedges are a lengthy pause of declining prices in the middle of an uptrend.
Wedges typically occur over a period of about three to four weeks. Because they are part of an intermediate trend rather than a major overall trend, wedges can be limited in their usefulness in terms of identifying prices where it would be good to buy or sell. However, identifying a wedge can help you see where the uptrend or downtrend is taking a rest before the next big move. Buying the security toward the end of a falling wedge can be a smart move because it means you’re buying toward the bottom before a new uptrend begins.
The next article in this series will focus on continuation patterns.