Reversal Patterns

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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Stocks & Commodities V. 8:10 (371-376): Reversal Patterns by Melanie F. Bowman and Thom Hartle

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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