One of the premises of tecnical analysis is that price patterns tend to repeat themselves. But what are these patterns? Today, we’re going to lookat reversal patterns, i.e. where a change of trend is indicated.
Perhaps the most famous of these is the Head and Shoulders pattern.
Here is the Dow weekly candlestick chart, showing how this topped out in 2007.
The general picture behind the Head and Shoulders is as follows: we start off with an uptrend, which proceeds as normal creating higher highs and higher lows.
The initial warning sign is a failure to create a higher high. This is the top of the “Right Shoulder” on the above chart.
Our technique then is to connect the two most recent lows. This isn’t a proper trendline (which should really connect three points) but instead is the “Neckline” of what is still only a potential Head and Shoulders pattern.
The Head and Shoulders pattern is completed by the break through the Neckline. Sometimes, the bulls will have a go at recapturing it, just as they did in the case of the Dow. What really strengthens the bear story, and is something you can look for, is if the broken Neckline then turns resistance. This happened with the Dow, making this a textbook case of the Head and Shoulders pattern.
Note that the Neckline was broken briefly on the retest; the danger of getting a false signal in this way is limited by placing certain conditions on what sort of a break is required. For example, demanding two consecutive closes above the Neckline (the “Two Day Rule”) would have prevented us from getting whipsawed by thinking that the Head and Shoulders pattern was being negated.
The above chart shows the standard method for constructing measuring targets with the Head and Shoulders pattern. Find the height of the head and then target that distance below the Neckline, measuring from where it broke (so we would target the red horizantal line in the above case).
The Inverse Head and Shoulders is based on the same idea, reversing a downtrend. Here’s Light Sweet Crude Oil changing direction in this way in 2007. Observe the broken Neckline providing support twice:
Now let’s look at Double Tops and Double Bottoms. The Double Top is formed when, in an uptrend, we run into resistance twice at the same level. We then fall through the intermediate low, completing the pattern and providing a sell signal. The broken Neckline can turn resistance, as it did with the DAX futures between 2007 and 2008; see the weekly candles chart below
Here’s an example of a Double Bottom, this time on a bar chart. It’s Vodafone at the bottom of the bear market in 2009, finding support at the same level twice, then beating the intermediate high and continuing the move.
In this case, our measuring target would be similarly calculated as with the Head and Shoulders patterns, i.e. the height of the pattern projected from the breakdown point. In this case, it’s 123.60 plus 12.40, i.e. 136.00.
Here’s an example of a Spike, or V-Reversal.
The Spike is really just the name for a market which reverses direction without giving any proper clue in tertms of hte preceding pattern that this was likely. This is the market turning “on a dime”, and the most difficult to trade.
The only clue at the top of the above chart that Wheat was turning was the “Harami Cross” candlestick pattern at the top (that’s the Doji contained within the range of the long green candle). When a Spike happens, our only recourse is to short-term signals such as candlesticks.
Finally, here’s a Saucer Bottom in Corn futures (the Saucer Top is the equivalent reversal of an uptrend). This is the opposite to the Spike, the price very gradually changing direction.
As technicians we much prefer to see a Saucer Bottom or Top than a V Reversal, with the slow move giving us lots of time to change skew.
Volume
One thing we haven’t mentioned much so far in this article is the role of volume in all of these patterns. Volume – the level of trading activity taking place over any period – is an essential component of technical analysis and an important part of pattern recognition.
The general principle is that volume accompanies movements with the trend. In terms of trend reversals, then, we should see the volume faltering during those final movements with the old trend, and eventually picking up as the new trend takes over.
In the case of the Head and Shoulders pattern, for example, volume should be weakest during the Third Shoulder, as enthusiasm for the dying bull market begins to evaporate.
A distinction can be made here between tops and bottoms. It is generally recognised that volume is not so important for tops as it for bottoms: at tops, market can “fall of their own weight” with buyers simply failing to show up, and volume not increasing.
Bottoms, on the other hand, generally involve mass participation, with active buyer enthusiasm being the main driving force behind the move.
Variations
There are several variations on the patterns mentioned here, in particular the Complex Head and Shoulders, the Triple Top and Triple Bottom. The Triple Top and Triple Bottom are fairly self-explanatory, while the Complex Head and Shoulders generally involves multiple shoulders on one or both sides of the Head.
The principles of volume analysis and the measuring techniques for these patterns are much the same as for the patterns already described here.
Conclusion
These patterns, without being infallible, help us to map out major changes in trend. They are generally medium and long-term patterns, with their significance and measuring targets in proportion to their size.
We incorporate these patterns into our daily analysis of the futures and FX markets. If you would like to sign up for a trial of our services, click here. For a free trial, click here.
Graham Neary MSTA (graham@futurestechs.co.uk)