Two Types of Patterns: Reversal and
posted under
Philosophy of Technical Analysis
by ceecabolos
There are two major categories of price patterns—reversal and continuation. As these names imply, reversal patterns indicate that an important reversal in trend is taking place. The continuation patterns, on the other hand, suggest that the market is only pausing for awhile, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of patterns as early as possible during the formation of the pattern.
In this chapter, we'll be examining the five most commonly used major reversal patterns: the head and shoulders, triple tops and bottoms, double tops and bottoms, spike (or V) tops and bottoms, and the rounding (or saucer) pattern. We will examine the price formation itself, how it is formed on the chart, and how it can be identified. We will then look at the other important considerations—the accompanying volume pattern and measuring implications.
Volume plays an important confirming role in all of these price patterns. In times of doubt (and there are lots of those), a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted.
Most price patterns also have certain measuring techniques that help the analyst to determine minimum price objectives. While these objectives are only an approximation of the size of the subsequent move, they are helpful in assisting the trader to determine his or her reward to risk ratio.In Chapter 5, we'll look at a second category of patterns—the continuation variety. There we will examine triangles, flags, pennants, wedges, and rectangles. These patterns usually reflect pauses in the existing trend rather than trend reversals, and are usually classified as intermediate and minor as opposed to major.
Preliminary Points Common to All Reversal Patterns
Before beginning our discussion of the individual major reversal patterns, there are a few preliminary points to be considered that are common to all of these reversal patterns.
1. A prerequisite for any reversal pattern is the existence of a prior trend.
2. The first signal of an impending trend reversal is often the breaking of an important trendline.
3. The larger the pattern, the greater the subsequent move.
4. Topping patterns are usually shorter in duration and more volatile than bottoms.
5. Bottoms usually have smaller price ranges and take longer to build.
6. Volume is usually more important on the upside.
The Need for a Prior Trend. The existence of a prior major trend is an important prerequisite for any reversal pattern. A market must obviously have something to reverse. A formation occasionally appears on the charts, resembling one of the reversal patterns. If that pattern, however, has not been preceded by a trend, there is nothing to reverse and the pattern is suspect. Knowing where certain patterns are most apt to occur in the trend structure is one of the key elements in pattern recognition.
A corollary to this point of having a prior trend to reverse is the matter of measuring implications. It was stated earlier that most of the measuring techniques give only minimum price objectives. The maximum objective would be the total extent of the prior move. If a major bull market has occurred and a major topping pattern is being formed, the maximum implication for the potential move to the downside would be a 100% retracement of the bull market, or the point at which it all began.
The Breaking of Important Trendlines. The first sign of an impending trend reversal is often the breaking of an important trendline. Remember, however, that the violation of a major trendline does not necessarily signal a trend reversal. What is being signaled is a change in trend. The breaking of a major up trendline might signal the beginning of a sideways price pattern, which later would be identified as either the reversal or consolidation type. Sometimes the breaking of the major trendline coincides with the completion of the price pattern.
The Larger the Pattern, the Greater the Potential. When we use the term "larger," we are referring to the height and the width of the price pattern. The height measures the volatility of the pattern. The width is the amount of time required to build and complete the pattern. The greater the size of the pattern—that is, the wider the price swings within the pattern (the volatility) and the longer it takes to build—the more important the pattern becomes and the greater the potential for the ensuing price move.
Virtually all of the measuring techniques in these two chapters are based on the height of the pattern. This is the method applied primarily to bar charts, which use a vertical measuring criteria. The practice of measuring the horizontal width of a price pattern usually is reserved for point and figure charting. That method of charting uses a device known as the count, which assumes a close relationship between the width of a top or bottom and the subsequent price target.
Differences Between Tops and Bottoms. Topping patterns are usually shorter in duration and are more volatile than bottoms. Price swings within the tops are wider and more violent. Tops usually take less time to form. Bottoms usually have smaller price ranges,
but take longer to build. For this reason it is usually easier and less costly to identify and trade bottoms than to catch market tops. One consoling factor, which makes the more treacherous topping patterns worthwhile, is that prices tend to decline faster than they go up. Therefore, the trader can usually make more money a lot faster by catching the short side of a bear market than by trading the long side of a bull market. Everything in life is a tradeoff between reward and risk. The greater risks are compensated for by greater rewards and vice versa. Topping patterns are harder to catch, but are worth the effort.
Volume is More Important on the Upside. Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume. However, in the early stages of a trend reversal, volume is not as important at market tops. Markets have a way of "falling of their own weight" once a bear move gets underway. Chartists like to see an increase in trading activity as prices drop, but it is not critical. At bottoms, however, the volume pickup is absolutely essential. If the volume pattern does not show a significant increase during the upside price breakout, the entire price pattern should be questioned. We will be taking a more in-depth look at volume in Chapter 7.
In this chapter, we'll be examining the five most commonly used major reversal patterns: the head and shoulders, triple tops and bottoms, double tops and bottoms, spike (or V) tops and bottoms, and the rounding (or saucer) pattern. We will examine the price formation itself, how it is formed on the chart, and how it can be identified. We will then look at the other important considerations—the accompanying volume pattern and measuring implications.
Volume plays an important confirming role in all of these price patterns. In times of doubt (and there are lots of those), a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted.
Most price patterns also have certain measuring techniques that help the analyst to determine minimum price objectives. While these objectives are only an approximation of the size of the subsequent move, they are helpful in assisting the trader to determine his or her reward to risk ratio.In Chapter 5, we'll look at a second category of patterns—the continuation variety. There we will examine triangles, flags, pennants, wedges, and rectangles. These patterns usually reflect pauses in the existing trend rather than trend reversals, and are usually classified as intermediate and minor as opposed to major.
Preliminary Points Common to All Reversal Patterns
Before beginning our discussion of the individual major reversal patterns, there are a few preliminary points to be considered that are common to all of these reversal patterns.
1. A prerequisite for any reversal pattern is the existence of a prior trend.
2. The first signal of an impending trend reversal is often the breaking of an important trendline.
3. The larger the pattern, the greater the subsequent move.
4. Topping patterns are usually shorter in duration and more volatile than bottoms.
5. Bottoms usually have smaller price ranges and take longer to build.
6. Volume is usually more important on the upside.
The Need for a Prior Trend. The existence of a prior major trend is an important prerequisite for any reversal pattern. A market must obviously have something to reverse. A formation occasionally appears on the charts, resembling one of the reversal patterns. If that pattern, however, has not been preceded by a trend, there is nothing to reverse and the pattern is suspect. Knowing where certain patterns are most apt to occur in the trend structure is one of the key elements in pattern recognition.
A corollary to this point of having a prior trend to reverse is the matter of measuring implications. It was stated earlier that most of the measuring techniques give only minimum price objectives. The maximum objective would be the total extent of the prior move. If a major bull market has occurred and a major topping pattern is being formed, the maximum implication for the potential move to the downside would be a 100% retracement of the bull market, or the point at which it all began.
The Breaking of Important Trendlines. The first sign of an impending trend reversal is often the breaking of an important trendline. Remember, however, that the violation of a major trendline does not necessarily signal a trend reversal. What is being signaled is a change in trend. The breaking of a major up trendline might signal the beginning of a sideways price pattern, which later would be identified as either the reversal or consolidation type. Sometimes the breaking of the major trendline coincides with the completion of the price pattern.
The Larger the Pattern, the Greater the Potential. When we use the term "larger," we are referring to the height and the width of the price pattern. The height measures the volatility of the pattern. The width is the amount of time required to build and complete the pattern. The greater the size of the pattern—that is, the wider the price swings within the pattern (the volatility) and the longer it takes to build—the more important the pattern becomes and the greater the potential for the ensuing price move.
Virtually all of the measuring techniques in these two chapters are based on the height of the pattern. This is the method applied primarily to bar charts, which use a vertical measuring criteria. The practice of measuring the horizontal width of a price pattern usually is reserved for point and figure charting. That method of charting uses a device known as the count, which assumes a close relationship between the width of a top or bottom and the subsequent price target.
Differences Between Tops and Bottoms. Topping patterns are usually shorter in duration and are more volatile than bottoms. Price swings within the tops are wider and more violent. Tops usually take less time to form. Bottoms usually have smaller price ranges,
but take longer to build. For this reason it is usually easier and less costly to identify and trade bottoms than to catch market tops. One consoling factor, which makes the more treacherous topping patterns worthwhile, is that prices tend to decline faster than they go up. Therefore, the trader can usually make more money a lot faster by catching the short side of a bear market than by trading the long side of a bull market. Everything in life is a tradeoff between reward and risk. The greater risks are compensated for by greater rewards and vice versa. Topping patterns are harder to catch, but are worth the effort.
Volume is More Important on the Upside. Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume. However, in the early stages of a trend reversal, volume is not as important at market tops. Markets have a way of "falling of their own weight" once a bear move gets underway. Chartists like to see an increase in trading activity as prices drop, but it is not critical. At bottoms, however, the volume pickup is absolutely essential. If the volume pattern does not show a significant increase during the upside price breakout, the entire price pattern should be questioned. We will be taking a more in-depth look at volume in Chapter 7.
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