Reversal Patterns
Sooner or later, any trend will end up reversing direction. As a spread trader, you need to be able to spot the signs of a trend that’s running out of steam. If you’ve been riding that trend, it is an obvious time to quit while you’re ahead. And if you’re really confident that the trend is about to change direction, you might want to open an opposite trade, backing the price to go in the other direction.
If you have had any experience with trading education before, you may have heard of the head and shoulders reversal pattern – it’s probably the best known of the trading patterns, and I will be covering it in depth to explain all the nuances. Some of the other reversal patterns are just variations on a theme, so once you understand the head and shoulders it will be easier to comprehend the others.
But before we look at the pattern, there are some general guidelines that are common to all reversal patterns.
- It may be obvious, but before you can have a reversal pattern you must first have a trend to be reversed leading into it.
It’s surprising how often beginners will think they have spotted a pattern, and are gung ho for making a trade when it really isn’t appropriate. Remembering that around half the time there is no defined trend in any particular financial security, you have to realize that you need to be selective if you’re looking for trend reversals as your strategy for trading. Trending prices lend themselves to more successful trades, so it is worth looking around and finding those with a clear trend.Sometimes you will see what appears to be a pattern, but unless there was a major trend beforehand then it’s impossible to know what the formation means, if anything. You should only look for and identify patterns in the appropriate places on a chart.
- If the pattern is large, then the subsequent move will also be substantial. This sounds like common sense, although it is comforting to know that it also works out in practice. Sometimes common sense ideas do not work out in the world of trading.
There are measuring techniques to do with the size of the pattern, principally the height, which can be used to predict the future move. If the width, which is the time, is also long, then that makes the pattern more important.
- A reversal of an uptrend is usually quick and volatile, compared to
- A reversal of a downtrend which usually takes some time.
Once again, we can see this might be true using logic, and it works out in practice. If an uptrend is reversing into a downtrend, then there is the powerful force “fear” accelerating the changeover. Investors who hold the securities may feel driven to quickly divest themselves, just as soon as they realize a downtrend is setting in and they could lose money. The more people sell, the more the remaining people will be inclined to sell. On the other hand, if the downtrend reverses, there is less urgency to jump onto the increasing price. People are more scared by the thought of losing than by the possibility of gaining.
An everyday example of this thought is driving in a traffic jam, with two lanes going in the same direction. Every car that passes you in the other lane is felt deeply emotionally, yet if your lane eases up and you pass half a dozen cars at a time, there is little compensating elation. The end result is often that both lanes progress at the same speed, yet most drivers feel as though they have lost ground, and should have changed lanes.
Because of the speed, it may be harder to catch the reversal of an uptrend in time for maximum profit than it is to make money from a bottoming of the price. To set against that, prices usually drop faster than they rise, so it is still worth the effort of identifying a top so that you can go short.
- Often the first indication of an impending reversal is the breaking of a trendline, as detailed in the previous module.
Trendlines are very important in identifying possibilities of a changing market. However, just because a trend line is broken, it doesn’t mean that a reversal has started. All it means is that the trend is changing, and it might turn into a sideways pattern which could resolve to either a reversal or a continuation in the future.
- Volume is usually more important and greater for rising prices.
Speculating on trend reversals is a riskier business than trying to ride a trend. As a general rule, volume should be expected to increase in the direction of the trend. You will learn to use this as a confirming factor, and volume usually increases at the end of each pattern. However, markets also tend to fall ‘under their own weight’, so volume may not increase much when prices drop. On the other hand, if you do not see a significant increase in volume accompanying an upside breakout, then you have to question whether the breakout is real. We’ll be discussing volume more in the next module.
As a final note, it is up to every trader to decide for themselves what constitutes satisfactory confirmation that the trend has changed. A reversal pattern is simply one part of the evidence that a trader may look for. If the reversal is true, the longer you wait the more of the move you miss; but if you make a trade too quickly, and the reversal does not transpire in practice, then you may be left with a loss. Bear in mind that whatever you choose as adequate confirmation of the reversal, sometimes it will work and sometimes it will not, you are simply trying to put the odds on your side.
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