- 1999: Volume 8, No. 6 Chartist Corner: Reversal Patterns

We can start this issue by stating the obvious-markets go up, they go down or they stay the same. Technical patterns that form on charts are grouped into categories that fit this statement. For example, in rising and falling markets, the shapes that bars, candlesticks or point and figure columns form over time are called continuation patterns. In flat markets, they are simply called trading ranges. The only thing missing is a pattern type that tells the technician when the market is going to change directions, namely, reversal patterns.

Congestion Zones

Most technical patterns form when the market trades in the same price range over several time periods (minutes, hours, days, etc.). The bars (or candles, etc.) temporarily stop trending in either direction and tend to bunch up in a small region. This is called congestion. The shape of the congestion zone gives the technician clues on where the market will head next, either in the same direction or in the opposite direction. Once the shape has been determined, the technician waits for confirmation in the form of a breakout from the zone (prices leave the congestion zone) and possibly from a technical study such as RSI or Stochastics.

Head and Shoulders

One of the most widely recognized reversal patterns is the Head and Shoulders. It is named for its resemblance to a head with two shoulders on either side. In candle charting, it is known as the Three Buddhas and is named for its resemblance to the large central Buddha and two smaller Buddhas in a Buddhist temple. Aside from appearances, these patterns demonstrate several technical factors such as failing momentum, support/resistance breaks and trend breaks.

For example, in a rising market prices make higher highs and higher lows as the trend continues up. The left shoulder is simply part of this pattern. Prices rise to the top of the shoulder and fall in a normal retracement (correction). The bottom of the shoulder is called the "neckline" but it is too early in the analysis to determine this yet.

Next, prices rise to the top of the "head." The significance here is that this is the final push in the rally. All buyers have bought by now and sellers are beginning to take control. A momentum or relative strength indicator will most likely be falling at this time, setting up a divergence with the price. As prices fall back, they now fail to set a higher low and should fall back to the neckline.

Let's summarize what has happened so far. Momentum is falling, prices failed to make a higher low and the retracement after the head has most likely broken a trend line. At minimum, it has formally defined the neck line as a support line.

Now, as the market once again attempts to make a higher high, momentum decreases further. Prices fail to even reach the previous high (the head) and fall to the neck. The weaker the market, the smaller the right shoulder. When the neck line is broken to the down side, the pattern is completed and a reversal occurs. It is important to note that we used many technical indicators (RSI, trendbreak, etc.) to reach this conclusion, not just a shape on the chart.

The daily chart of the cash Australian Dollar shows an inverted head and shoulders in a falling market. Note that the RSI is rising. The right shoulder had broken the down trend line in mid-July and currently has broken above the neck line, completing the pattern.

Double Tops and Bottoms

Another important reversal pattern is the double top (or double bottom). This is essentially a head and shoulders without the head. One important difference is that while a head and shoulders is more dramatic, it is also less strict in its definition. The neck line need not be horizontal but can be on an angle. The double top and bottom requires that it be based on a true support or resistance level.

The weekly chart of the Australian Dollar shows a double bottom that formed over the past eight months. Prices corrected from their January lows to their April highs. Note that these highs met resistance at a previous congestion zone formed a year earlier (support becomes resistance). The June lows matched those from January and prices are currently rising. The technician would wait until the two year old down trend line is broken before buying. Other confirming indicators are an increasing RSI and the inverted head and shoulders bottom in the daily chart which formed the second bottom in the weekly chart.

This pattern requires patience because prices have two hurdles to overcome before a long-term trend can be established. First, the current down trend must be broken. If it does, this market is likely to rise to the previous highs of April. Next, it must break that resistance level. If it does not, the double bottom did not do its job. Remember, chart patterns by themselves can be misleading. They require confirmation.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.