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
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
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
Because of this, 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,
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. We’ll be discussing volume more in the next module.
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