Reversal Patterns

10 Pages·1990·0.182 MB·English

by  Bowman N.F., Hartle T.

Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle
Reversal Patterns
by Melanie F. Bowman and Thom Hartle
M
arket prices, as one well-worn adage points out, are trapped in a two-dimensional world with little
directional leeway. They are either climbing up, dropping down or moving sideways. And, the fact is,
there is no refuting this simplistic truth.
Prices distill the complex interplay of supply and demand, the collective fear and bravado of sellers and
buyers, and lay it out as up, down or sideways. The art of chart analysis lies in deducing whether a
particular motion signifies that buyers' demand or sellers' supply is predominating.
Prices move up when buyers' demand is greater than sellers' supply. The early stage of a bull market
begins from a price base, or support level. This is known as a period of accumulation or support, where
buyers are purchasing shares, and their interest at a low price keeps it from declining.
At some point, the supply of stock for sale becomes greater than buyers' appetites. The uptrend then
reverses and prices drop. This is a period of distribution or resistance. Sellers are distributing more shares
than can be sold to buyers who in turn are resisting paying any more for the stock.
On a price chart, the shift from demand to supply, from accumulation to distribution, forms a topping
pattern. The shift from supply to demand, from distribution to accumulation, creates bottoming patterns.
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The art of chart analysis lies in deducing whether a particular
motion signifies that buyers' demand or sellers' supply is
predominating.
When supply and demand are approximately equal, prices move sideways on a bar chart within a price
range known as a consolidation or trading range.
Normally, the shift from distribution to accumulation occurs gradually, taking several months to a year or
more to complete or top out. The ensuing downtrends generally move faster because sellers feel forced to
unload their declining holdings.
In either direction, price action is normally jagged. Assume prices have been dropping. At some point,
low prices tempt enough buyers back into the market to reverse the trend: accumulation has set in. Prices
rise until buyers, looking back on recent low-price history, get a bit skittish. Is this higher price range
justified? Can it hold? Buyers back off a bit and the first uptrend "corrects," or drops momentarily. A
slightly lower price entices optimistic buyers back for the possibility of a quick profit, at which point
prices swing up again. The corrective sequence continues until buyer optimism finally fades, the trend
tops out and prices reverse direction.
Technical traders use a battery of established chart patterns to pick impending tops and bottoms. As with
any interpretive tool, it is the experience and skill of the observer that determines a pattern's reliability.
HEAD AND SHOULDERS
As its name implies, the head-and-shoulders pattern (Figure 1) most resembles a trader shrugging. A first
peak is followed by a second, higher peak, followed by a third, lower peak. The formation usually occurs
at the end of a long uptrend and is one of the most common and reliable reversal formations. Its reverse,
an inverted head and shoulders at the end of a downtrend, is often less pronounced, and flatter. Either
way, it is a useful pattern for catching and estimating just how far a new price move should go.
The head-and-shoulders top formation follows a prescribed script. The left shoulder is the first to emerge,
accompanied to its peak by heavy volume that tapers off when price declines. The price swings back up
even higher to form the head, with volume again increasing on the rally and dropping off on the decline.
At this point, to rightly be called a head-and-shoulders pattern, the price must fall below the left
shoulder's peak before rallying again to form the right shoulder. On the right shoulder's rally, however,
volume is less than during the previous two peaks. During the development of the formation's left
shoulder and head, the demand for the stock appears to be quite strong. The advance will be accompanied
by heavy volume and usually positive news. Each rally, however, is actually being checked by the
appearance of sellers. These sellers are taking profits with the release of the positive news. The sellers
may be of such sophistication as to be one step ahead of the crowd.
The real value of the head-and-shoulders formation is the technical information revealed during the
formation of the right shoulder. Because the right shoulder continues the trend but lacks volume,
questions are raised as to the demand behind the advance. This lack of demand signifies an underlying
imbalance is developing between the bulls and the bears. The higher prices revealed in the minor advance
lends comfort to the holders of securities, while the market's inability to find more demand at higher
prices indicates that the buyers are satiated. With evidence that demand is lacking on a decline, a price
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markdown is implied. If the decline begins to attract sellers who are disappointed longs, the probability of
a move through the previous major demand levels increases. Most likely, further weakness will penetrate
the demand line drawn along the major support of the formation.
The line connecting the valleys on either side of the head is known as the neckline. The neckline can be
horizontal or slant up or down. When the neckline slants, the valley between the head and right shoulder
should be significantly lower than the left shoulder peak.
If prices break through the neckline after the right shoulder is formed, that signals that the prices will
continue in that direction. Some technicians require a breakout to travel a distance equal to 5% of the
distance from the neckline to the peak of the head before they take it seriously and consider low volume
on the breakout to be a warning that the signal is false and the lows may be retested.
Turn this pattern upside down and you have the inverted head and shoulders (Figure 2), except the
breakout must be accompanied by a large increase in volume.
In either case, the distance from the neckline to the top of the head is how far the breakout should
continue to move past the neckline. It is not uncommon, however, for the price to momentarily head back
to the neckline before continuing its breakout direction toward the price objective. This price objective
assumes that, prior to the head-and-shoulders formation, the price moved at least the distance between
the neckline and the top of the head.
DOUBLE AND TRIPLE TOP/BOTTOM
Double and triple tops or bottoms are successive peaks or troughs of approximately the same height that
signal intermediate- to long-term changes in trend. A double top looks like an M (Figure 3); the double
bottom resembles a W. Triple tops and bottoms lack the central peak that is characteristic of head and
shoulders. The three peaks or troughs can be slightly, but not noticeably, higher or lower than the first
peak or trough.
Volume helps to distinguish double and triple top/bottoms from a head-and-shoulders formation. As a
double or triple top emerges, volume tapers off with each succeeding peak. The opposite is true for the
double/triple bottom, in that volume increase! with each rally from the trough. For head and shoulders,
volume changes dramatically on the third peak.
Because it is easy to misjudge a reaction after any uptrend as a double top, it is best to wait for price to go
below the valley low after the second peak. During a strong uptrend the demand that appeared at the price
level that established the valley should occur again if the formation is only a resting phase in an ongoing
bull market. Likewise, watch for the price to rise above the peak before declaring a double bottom.
Two tops that are close together could be part of a consolidation pattern — a sideways motion. One rule
of thumb requires that double peaks/troughs be one month apart and the intervening trough/peak be at
least 15% lower/higher than the highest/lowest price. Peaks and troughs of a triple top/bottom need not
be equidistant, and they can be deep or shallow.
The significant feature for both the triple and double top is the lowest price level between two peaks.
Similarly, the significant feature of a triple or double bottom is the highest price level between two
troughs. When the price breaks through these levels it signals that the trend is reversing. Again, some
analysts insist that the breakout is viable only after it has traveled a distance equal to at least 5% of the
distance from the lowest to highest price in the formation. Prices should then continue in the direction of
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the breakout until they have covered the low-to-high distance.
DESCENDING/ASCENDING TRIANGLE
Considered to be the heralds of profit opportunities, triangles can take anywhere from several weeks to
several months to complete. They appear regularly on daily charts and frequently are the corrections in a
large-scale trend. An ascending triangle gives a bullish outlook to the market, while a descending triangle
is considered bearish.
A triangular formation consists of a horizontal baseline and a sloped line. In a descending triangle, for
instance, a downward slanting line is drawn through two or more successively lower peaks. These peaks
bottom out at approximately the same approximate price so that the horizontal line can be drawn through
the bottom of two or more valleys (Figure 4). The line drawn along the price peaks represents a supply
line. As the market advances the sellers enter the market at consecutively lower price levels. This supply
entering the market can indicate the aggressiveness of the sellers relative to the buyers. While the market
will hold up along the demand line established as the horizontal base of the triangle at some point, if the
bears are correct then this area of demand will be overcome by the sellers. A descending triangle is
simply an inverted ascending triangle.
The curious thing about triangles is that the price should never
reach the apex of the formation, or the point, where the slope
intersects the horizontal baseline.
The curious thing about triangles is that the price should never reach the apex of the formation, or the
point, where the slope intersects the horizontal baseline. If the price simply continues along the horizontal
base and out the apex, it is not a triangle. This continued sideways price movement is an indication that
the market is consolidating the recent trend and is not reversing. In a triangle, the price should break
through the horizontal base before reaching the apex, usually with a sharp increase in volume.
To determine how far prices can be expected to travel in the breakout direction, the analyst draws a line
parallel to the triangular slope equidistant to the horizontal base but on the opposite side. The price
should reach this parallel slope.
RISING/FALLING WEDGE
Like triangles, wedges define converging prices, although unlike a triangle, both boundaries of a wedge
are slanted. For a rising wedge, the lower line is steeper than the upper line (Figure 5). The opposite is
true for a falling wedge.
Like triangles, the price does not continue through the apex of the wedge. Breakouts normally occur
about two-thirds of the way to the apex. Volume diminishes as price heads toward the apex and, like a
triangle, jumps up on the breakout.
The breakdown from a rising wedge is a sign that the market is technically weak and prices will fall in
earnest, especially if the broad market is already in a bear market. The diminishing volume during the
final stages of the rising wedge indicates that the demand is usually just short-covering, with sellers
backing away from the market. The lack of demand (indicated by the light volume) on the decline will
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usually cause a swift move to the downside. A breakout from a falling wedge is a signal that the market is
technically stronger, although prices will tend to move sideways before rising. The breakout does not
have a price objective based on this chart formation.
KEY REVERSAL TOP/BOTTOM
The key reversal is a very quick, very simple pattern that occurs frequently, either by itself or within other
patterns. Generally, it arrives and completes during a single trading day and its significance is for the
short term. Key reversal tops appear most regularly in thinly traded stocks that have made an active
advance (Figure 6). The key reversal bottom is also known as a selling climax (Figure 7).
The key reversal top/bottom reaches a high/low that exceeds the previous day's high/low, but winds up
closing near the low/high of the day. Extremely high volume usually accompanies it. The top/bottom
pattern takes on more significance if it occurs after a long unbroken trend, or if the volume is abnormally
large, or if its peak/trough is much higher/lower than the previous day's or if the closing price is
below/above the previous day's closing. Typically, these types of reversal are accompanied by extremes
in investor psychology in that investors are either euphoric or panicked. For the key reversal top, the
bullishness is very high. The key reversal bottom is at the final stages of liquidation and extreme
bearishness.
ROUNDING TOP/BOTTOM
Unlike the quick, plentiful key reversal, a rounding top or bottom appears rarely and forms slowly. The
formation is seen occasionally in interest-sensitive securities where wide price swings are not the norm.
Rounding tops/bottoms occur gradually over several months, signifying a long, slow struggle between
supply and demand. The longer the pattern takes to complete, the more significant it is in calling the
direction of the new trend.
A rounding top is roughly shaped like an umbrella, with frequent small peaks (Figure 8). The rounding
bottom has the gentle curve of a teacup saucer (Figure 9) . Volume tends to rise through the first portion
of the curve and stabilize during the advance. The rounding bottom does not have a clear-cut buy signal,
so a trader can either wait for a sharp increase in volume on the upside of the curve or wait conservatively
until a definite uptrend line can be drawn through the bottoms of the upside curve. These longer-term
formations can offer good gains for the investor, as the formations are due to long-term changes in stock
fundamentals. As the fundamental data become clearer to the investing public, the long-term trends will
be very much in force. Looking for these long-term rounding formations can provide opportunities well
ahead of the crowd.
Melanie Bowman is a writer and former Managing Editor of Stocks & Commodities. Thom Hartle is
Technical Editor of Stocks & Commodities.
References
Pistolese, Clifford [1989]. Using Technical Analysis, Probus Publishing.
Meyers, Thomas A. [1989]. The Technical Analysis Course, Probus Publishing.
Hutson, Jack. Technical Analysis of Stocks & Commodities, Wyckoff series.
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FIGURE 1 The head-and-shoulders pattern most resembles a trader shrugging. This pattern usually
occurs at the end of a long uptrend and is one of the most common and reliable reversal formations.
FIGURE 2 The shift from supply to demand, from distribution to accumulation, creates bottoming
patterns.
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FIGURE 3 Double and triple tops or bottoms are successive peaks or troughs of approximately the
same height that signal intermediate- to long-term changes in trend. A double top looks like the letter M;
a double bottom resembles a W.
FIGURE 4 Considered the heralds of excellent profit opportunities, triangles can take anywhere from
several weeks to several months to complete. A descending triangle as shown here is considered
bearish.
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FIGURE 5 Like a triangle, wedges also define converging prices, although a wedge's boundaries are
slanted. The breakdown from a rising wedge is a sign the market is technically weak and prices will fall,
especially if the broad market is already in a bear market.
FIGURE 6 A quick, simple pattern that occurs frequently, a key reversal arrives and completes during a
single trading day, and its significance is for the short term. Key reversal tops appear most regularly in
thinly traded stocks that have made an active advance.
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FIGURE 7 Key reversal bottoms are also known as selling climaxes. Extremely high volume usually
accompanies key reversals. The key reversal bottom is at the final stages of liquidation and extreme
bearishness.
FIGURE 8 Rounding tops and bottoms are rare patterns that form slowly. The formation is seen
occasionally in interest-sensitive securities where wide price swings are not the norm. Rounding tops
are roughly umbrella-shaped, with frequent small peaks.
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FIGURE 9 The rounding bottom has the curve of a teacup saucer. The bottom formation does not have
a clear-cut buy signal, so the trader can either wait for a sharp increase in volume on the upside curve
or wait until a definite uptrend line can be drawn through the bottom of the upside curve.
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