Trend Reversal Patterns 

Trend reversal patterns indicate that an important reversal in the market trend is taking place. A prerequisite for any reversal pattern is the existence of a prior trend.

• Confirmation: Trading volume plays a crucial role in confirming these price patterns.
• Common Patterns: Head and shoulders, double tops and bottoms, and triple tops and bottoms.

Head and Shoulders Pattern

This is a popular pattern used both for signaling the end of a trend and for identifying potential targets. The neckline is a straight line connecting the two intervening bottoms (for a top) or tops (for a bottom).

Head and Shoulders Top (Reversal of an Uptrend)

1. A rally forms the 'Head' (new high) accompanied by lower volume.
2. A subsequent rally (Right Shoulder) with lower volume fails to surpass the previous high.
3. The reversal is activated with a break below the neckline, accompanied by increased volume levels.
4. Failure to move back above the neckline confirms a new downtrend.

Target Calculation: Measure the vertical distance between the Head and the neckline, then project that distance from the point of the neckline break (this identifies the minimum target).

Head and Shoulders Bottom (Reversal of a Downtrend)

This is the opposite of the Top pattern.

1. A dip forms the 'Head' (new low) accompanied by lower volume levels.
2. A subsequent dip (Right Shoulder) on lower volume fails to go below the previous low.
3. The reversal is activated with a break above the neckline, accompanied by increased volume levels.
4. Failure to move back below the neckline confirms a new uptrend.

Double Tops and Bottoms

Double Top (Reversing an Uptrend)

• The market creates two tops at the same approximate level.
• Confirmation occurs with a break below the last bottom.
• Increased volume at the breakout level confirms the reversal.

Target Calculation: Project the height of the double top pattern from the point where the price breaks the last bottom.

Double Bottom (Reversing a Downtrend)

• The market creates two bottoms at the same approximate level.
• Confirmation occurs with a break above the last top.
• Increased volume at the breakout level confirms the reversal.

Triple Tops and Bottoms

Triple Top (Reversing an Uptrend)

• The market creates three tops around the same level.
• Confirmation occurs with a break below the last two bottoms.
• Increased volume at the breakout level confirms the reversal.

Triple Bottom (Reversing a Downtrend)

• The market creates three bottoms at around the same level.
• Confirmation occurs with a break above the last two tops.
• Increased volume at the breakout level confirms the reversal.

Target Calculation for Triple Patterns: The initial target is determined by projecting the height of the pattern from the breakout level.

Bull and Bear Traps

These patterns generate a false signal, trapping traders who acted on the initial breakout. Target measuring techniques are similar to other reversal patterns.

Bull Trap (False Upside Breakout)

• Prices break above the last top, generating a bullish signal.
• Confirmation of the trap occurs when the price fails to continue higher and then breaks below the last bottom.
• Filter Example: A common filter to avoid this trap is requiring a two-period close above the breakout level.

Bear Trap (False Downside Breakout)

• Prices break below the last bottom, generating a bearish signal.
• Confirmation of the trap occurs when the price fails to continue lower and then breaks above the last top.
• Filter Example: A price filter (a percentage drop below the level) can be used to avoid this trap.

Other Advanced Reversal Patterns

Diamond Reversal

The Diamond reversal can be thought of as back-to-back symmetrical triangles (a broadening top followed by a narrowing range), or a complex Head and Shoulders top.

• Price action initially forms higher peaks and lower troughs (broadening), then reverses and the range narrows.
• A quick rise leading into the pattern is an important identification clue.
• The formation is confirmed after a break below the trendline boundary (neckline).

Rounding Top and Saucer Bottom

These are long-term reversal patterns that can take several weeks up to several years to complete.

Rounding Top (Reversal at a Peak)

• As the price approaches the high point, upward momentum dissipates, and volume almost dries up.
• Towards the end of the pattern (when the downtrend begins), both momentum and volume increase exponentially.
• The pattern is constructed by drawing a circular line above the highs.

Saucer Bottom (Reversal at a Trough)

The price action is the opposite of the Rounding Top, but the volume characteristics are the same.

• As the price drops towards the low point, downward momentum dissipates, and volume almost dries up.
• Towards the end of the pattern (when the uptrend begins), both momentum and volume increase exponentially.
• The pattern is constructed by drawing a saucer-shaped line below the lows.