By Sylvain Vervoort – Chart patterns are part of buying and selling rules in technical analysis trading. Chart patterns give an important confirmation for the next trend move. The art is to distinguish that you are dealing with a continuation pattern, after which the price will continue its previous trend or a reversal pattern leading to a trend reversal.
The head and shoulders formation belongs with an accuracy of about 90% to the most reliable reversal patterns. The price moves in an uptrend. Only after the pattern has formed, you will recognize the left shoulder after price falling back generally to the support of an up-going trend line. This will be a first point for the creation of the neck line. From here, the price makes a last move up, often with lower volume compared to the left shoulder. This will be the head of the pattern. Next the price drops through the up-going trend line and falls back to the level of the neck line, creating the second reference for the neck line. After that, the price will move up again to form the right shoulder. From here the price will drop below the neck line making lower lows. The shoulders and the neck line in the head and shoulders formation should be at about the same price level and at about the same distance in time from the head.
The head and shoulders pattern is confirmed when the price falls below an up-trending neck line or after the right shoulder in case of a down-trending neck line. In approximately half of the cases, there is a bounce back up to the neck line or even up to between the neck line and the right shoulder.
With the head and shoulders formation you can basically also calculate a price target. You measure the distance from the top of the head till the lowest point of the neck line and project this distance downwards. This will give you a theoretical price target.
Mirroring the head and shoulders top reversal pattern gives a head and shoulders bottom reversal pattern. Shoulder bottoms should be at around the same price level and at about the same distance from the head. The head and shoulders bottom reversal pattern with a descending neck line is confirmed breaking the resistance of this neck line, while an ascending neck line is confirmed when price turns up after the right shoulder.
A complex head and shoulders top reversal pattern will have more shoulders or more heads, but rarely both. The shoulder tops are around the same price level and at approximately the same distance from the head. The complex head and shoulders pattern is confirmed when the price falls below an up-trending neck line or after the internal right shoulder in the case of a down-trending neck line. Mirroring the complex head and shoulders top reversal pattern gives you a head and shoulders bottom reversal pattern.
Triple tops and bottoms are a variation of the head and shoulders theme. The difference is that tops or bottoms are at approximately the same level. Triple tops and bottoms offer a reliable pattern with an accuracy of about 80%. A triple top is confirmed when the price falls below the lowest valley in the pattern. A triple bottom formation is confirmed when the price rises above the highest top of the pattern.
A double top reversal pattern is formed with a large demand during the formation of the first top and a lack of demand with the second top. With daily price bars, tops are separated by about two up to eight weeks and should only have a small difference in price level. The in between reaction should have a price drop of about 10% on average. With an accuracy of 80%, this pattern is very reliable. The pattern is confirmed when the price falls below the level of the middle reaction.
For a double bottom, the reasoning is analogue to that of a double top. The trend is down, and a double bottom pattern is formed as an indication that the trend will probably reverse. With daily price bars, bottoms are separated by about two up to eight weeks and should only have a small difference in price level. The in between reaction should have an average price rise of about 10%. With 80% reversals, this pattern is very reliable. The pattern is confirmed when the price rises above the level of the middle reaction.
A rounding bottom pattern appears on daily and weekly bar charts. This pattern takes time to complete. The price can peak halfway through the pattern, but usually it retraces most of it quickly. Rounding bottoms are becoming rare because of today’s high volatility of the markets as a result of the information society. Rounding bottoms lead to a price reversal 90% of the time. The pattern confirms when the price closes above the highest peak of the pattern. There may be a saucer lip when the price drops temporarily before continuing the uptrend.
A V-formation bottom reversal creates a V-character; a top reversal creates an inverted V-character. The price at the start of the V-formation will form a one-day reversal, an island reversal, or a spark. A V-formation start can be recognized most of the time when it breaks the last possible steep trend line, together with a candle stick reversal pattern and a one-day island or spark reversal. A one-day top reversal arises if the price makes on the same day a new high, reverses and closes below the closing price of the previous day. A one-day top reversal in a candle chart is a black candle and often is part of a candlestick pattern. An island reversal occurs when a number of price bars are isolated by a window at the beginning and end of the island pattern. The island is confirmed if the second window is formed. The windows should be more or less at the same price level. The bottom V-formation spark reversal pattern arises if the price makes on the same day a very big positive move compared to the previous bars. In a candlestick chart this will be a big white candle at a bottom and a big black candle at a top. The big candle itself is the buying signal at a bottom and the selling confirmation at a top.
About the Author
Want to learn more and see some examples about stock chart reversal patterns? You can find a lot of material about basic technical analysis techniques for free at my website: http://stocata.org. Sylvain Vervoort is a trader and author with regular contributions in Stocks & Commodities magazine.
