MoneyVidya.com Investor Essentials:

Basic price patterns for identifying trend reversals

Tuesday, 07 April 2009    Page 1 
 
  
 

Introducing the concept of price patters

One of the underlying assumptions of technical analysis is that stock and index prices follow trends.
The direction of these trends are determined by the interplay between numerous forces which can
be broadly split into four categories; economic, monetary, technical and psychological.

Depending on the direction of these forces, traders in any particular stock fall into one of two
groups; Firstly the “bulls”, who believe that prices will rise and who plan to buy the stock now and
profit from selling later at a higher price. Secondly the “bears”, who believe that prices will fall and
who plan to sell now and buy the stock back in the future, profiting from a lower price.

During a rising trend demand for a stock is high and the bulls, who dominate the market, are
constantly bidding the price up. During a downward trend the bears dominate the market, and drag
the price of the stock down by forcing sellers to reduce their asking price.

In a reversal period, where the trend is changing from an upward one to a downward one (or vice
versa), there is a temporary balance between the two groups and neither dominate. These
transitional periods are often characterized by recogniseable price patterns which can be used to
identify when a prevailing trend is reversing.

The rectangle

The rectangle represents a sustained period of balance between buyers and sellers where the price is
range bound between two horizontal lines. The rectangle can form either a reversal pattern or a
continuation pattern. When a reversal pattern is broken the trend is ‘reversed’ and the price moves
in the opposite direction to that which it was moving in prior to the pattern forming. A continuation
pattern is one where the price trend continues in the same direction once the pattern ceases to hold.

As a rule one should always assume a continuation pattern until the price breaks below the support
level or unless a reversal is confirmed by some other indicator. It is also prudent to wait for a 3-4%
breach of either the price support (lower) or price resistance (upper) lines before concluding that
the pattern has broken.

Tuesday, 07 April 2009    Page 2 
 
  
 

Typically the closer the support and resistance lines, and the longer they remain in tact, the stronger
the break-out of the pattern is likely to be. Volume should also be watched closely and you typically
see volumes decline as the pattern becomes stable and increase at the point of breakout. Volume can
therefore be used as a signal that a genuine break-out of the pattern has occurred.

The Head & Shoulders pattern

The Head & Shoulders pattern is one of the most reliable indicators of a reversal and can come at
either the top of an uptrend or the bottom of a downtrend. The Head & Shoulders distributive
pattern (at the top of an untrend) is characterised by three rallies, the second being greater than the
first, but the third being a similar size to the first (smaller than the second). The line which joins the
two troughs either side of the head is called the neckline.

Tuesday, 07 April 2009    Page 3 
 
  
 

Volume is a key indicator of a Head & Shoulders pattern with an expansion of volume at the peak of
the first rally and then a smaller expansion on the peak of the head; indicating the uptrend is
running out of steam. The third rally (shoulder 2) is then characterised by low volume.

The reversal is confirmed only after a significant price break below the neckline. The strength of the
breakout, how far you can expect prices to correct, is often determined by the distance between the
peak of the head and the neckline. The larger the distance between the two the more dramatic the
breakout is likely to be.

Despite the reliability of the Head & Shoulders pattern in identifying reversalss, if the price fails to
break the neckline or temporarily breaks it and then rises back above it, the Head & Shoulders
pattern is said to have failed and a dramatic continuation breakout often follows.

The accumulative Head & Shoulders pattern (at the bottom of a downtrend) looks the same but
flipped upside down with the head and shoulders being three troughs (second one lowest) and the
neckline being the line which joins the peaks either side of the largest trough (the head).

Double top and double bottoms

Double tops and double bottoms patterns are similar to Head & Shoulders Patterns. The distributive
double top pattern (top of an unptrend) is characterised by two peaks separated by a trough. The
key identification method is that the second high is achieved with significantly lower volume.

Tuesday, 07 April 2009    Page 4 
 
  
 

The distance between the top of the two peaks and the trough in between (like the neckline) gives an
indication of how far the price is likely to fall before finding a new resistance level, the higher the
peaks the greater the drop.

The double bottoms pattern, which signals the reversal of a downward trend is characterised by two
equal troughs, separated by a peak.

Triangles

Triangle patterns are characterised by converging peaks and troughs showing the trading range
narrowing and the lines of support and resistance converge. Triangle patterns come in many
different forms and can be difficult to interpret. The most clear cut triangle pattern is the right angle
formation where either the support or resistance line is parallel to the horizontal axis. Right angle
triangles are typically signals of a reversal whereas other triangle formations are often be
continuation patterns. The common right angle distributive pattern, signalling the reversal of an
uptrend is shown below.

Using price patterns

The key to using price patterns is not the identification of the pattern, which is relatively easy, it is
identifying when the pattern has broken and therefore if it represents a reversal or a continuation.
Prudence is to be advised as significant money can be lost by assuming the breakdown of a pattern
too early, only to see the pattern hold and then the price dramatically breakout in the opposite
direction.

Tuesday, 07 April 2009    Page 5 
 
  
 

To avoid mistakes the following principles should be adhered to;

1) Always assume a pattern is a continuation until a reversal is confirmed

2) Wait for a significant break below the key support or resistance line

3) Look for confiirmation of the breakout from volume and other indicators before
considering the breakout to be confirmed

Tuesday, 07 April 2009    Page 6