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Chapter 25 — Reversal Patterns
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Reversal Patterns

The end of a trend can be difficult to predict. Technical analysts have come up with some “reversal patterns” that will show you when a trend is about to reverse. The most common reversal patterns are: Head and shoulders top and bottom, double top and bottom, rounding top and bottom, broadening formation, and rising and falling wedge.

Like simple technical patterns, reversal trends can be confirmed when there is a high level of volume.

 

Head and Shoulders, Top and Bottom

The head and shoulders top formation is one of the most common reversal patterns. It looks like a left shoulder with a head in the center, and a right shoulder.


 

The left shoulder forms by an increase in price, which then drops on low volume. Then the head begins with a sharp increase in price on very heavy volume. Over time the head will form with heavy volume on the increase and low volume on the decline. The right edge of the head may be above or below the left shoulder, but not above the top of the left shoulder.

With a head and shoulders formation, you can draw a “neckline.” You can use this neckline as a signal to sell the stock when the right shoulder breaks through. The neckline does not need to be perfectly level and the formation does not need to be perfectly symmetrical as long as the lowest point on the right shoulder is lower than the highest point on the left shoulder.


A head and shoulders bottom is the exact opposite of the head and shoulders top. The difference is that the formation will be upside down, and the points of increasing volume will occur on the right side of the head instead of the left side. When the right shoulder breaks through the neckline, it is a signal to buy.

Double Top and Bottom

A double top is quite common. It appears in the form of an “M” shape. After reaching a peak, the price declines to a valley and recovers to another peak. Then the price drops toward a new downtrend. A double top formation can be tricky to predict because it is often the formation is an uptrend in disguise.

Volume is the key to seeing the difference between a true double top and a fake double top. If the volume in the first peak is higher than that at the second peak, then it is more likely to be a double top. If the volume of the second peak is higher, the formation is more likely to be a fake double top.

 

 

Volume is the key to seeing the difference between a true double top and a fake double top. If the volume in the first peak is higher than that at the second peak, then it is more likely to be a double top. If the volume of the second peak is higher, the formation is more likely to be a fake double top.

The time period for the double tom formation can also offer a clue for the double top. If the two tops are close together, it is more likely to be a fake double top. If the two tops are separated over a longer time period, it is more likely to be a real double top.

 

The double bottom is the exact opposite of the double top. Its graph looks like a “W” on a price chart, and the volume patterns are reversed.


Rounding Top and Bottom

A rounding top is a price movement that forms the shape of an upside down “U”. It generally forms at the end of a long upward trend and may indicate a reversal. This pattern should be accompanied by a deterioration of volume.




A rounding bottom is the opposite of a rounding top. It forms in the shape of a “U”. The volume should follow a similar pattern to the price graph.


Broadening Formation

A broadening formation is where the price range of the stock “broadens” through a series of reversals. It is characterized by ever larger price swings with erratic volume, signaling that the stock is out of control and is about to crash. The reversals typically follow this pattern, with each peak higher than the previous peak and each valley lower than the previous valley:

 

 

 

 

Reversal 1: change from rise to fall

Reversal 2: change from fall to rise

Reversal 3: change from rise to fall

Reversal 4: change from fall to rise

Reversal 5: change from rise to substantial fall

 

 
Rising and Falling Wedge
 

A wedge formation is the reverse of a broadening formation. A wedge is where the trading range of stock contracts into a smaller range. If the overall trend of the stock is up (the wedge points upward), then the price will decline when the chart breaks through the bottom part of the wedge. This formation will only appear in short period of time; no more than 3 or 4 weeks.

A falling Wedge is the opposite of a rising wedge. As the price condenses into the downward trend, it will break into an upward trend.

If the wedge has no direction, then it is a “consolidation” pattern, and there will be no reversal.
 

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