Introduction to Price action III: Reversal Chart Patterns

What are the most common reversal chart patterns?

The most common reversal price patterns every trader should know are here: the Head and Shoulders, the Inverse Head and Shoulders, the Double Top, and the Double Bottom.
 

Head and Shoulders pattern

This pattern is one of the most reliable indicators of a trend reversal. The pattern occurs after a previous upward trend and when completed, the market often turns downwards. Sometimes the pattern is called S-H-S (shoulder-head-shoulder).

This pattern is formed by three peaks, the middle of which is the highest one. The middle peak of the pattern is the so-called head, and the two other peaks are the shoulders. In addition, the pattern is formed by a neckline line that connects the lower swings of the pattern (points A and D in Figure 1).

In Figure 1 we have an example of this pattern, from which everything will be clearer.

_{The Head and Shoulders pattern (S-H-S) in the EURCAD currency pair}
 

Chart breakdown

A pattern arises so that after the previous uptrend the left shoulder is first created when the price creates a new high and then drops to the point where it previously rose from (point A). In the second phase, the price rises and exceeds the previous peak, resulting in a higher high (point B), and then the price again falls to the central line, the so-called neckline (point D). Then the price rises again, but this time it creates only a lower high, so the uptrend structure is disrupted. The pattern is confirmed when the price crosses the neckline from top to down (see point E).
 

How to trade Head and Shoulders pattern

The pattern is traded by taking the short trade (speculation on price decrease) when the neckline is broken down. To avoid a false break during the day, it is recommended to wait for the daily candlestick to close below the neckline.

The short entry can be either on the price level where the daily candlestick, that broke the neckline, closed. Or the second option is to wait for the price to retest the neckline after its breaking and speculate short on the price drop after that. The second option offers a better Risk Reward Ratio while also confirming the validity of the break.

The stop loss can be either above the right shoulder level or above the last swing before the neckline break through (this option is shown in Figure 1).

To set a target price we have two possibilities:

The first option is to take the target price on the level where the first support level is. The second and more aggressive option is that the target price should be at the same distance as it is the distance from the top of the formation to the neckline. In our case, therefore, the length of the move BC should be equal to the length of the move CF.
 

Few important insights regarding the Head and Shoulders pattern:

1. For the pattern to be defined as the Head and Shoulders, it must be preceded by a clear uptrend.
2. No shoulder shall be higher than the top of the head.
3. The neckline must be either horizontal or ascending. For this formation, the neckline must never be descending. If the neckline is falling it is a signal of the weakness of this pattern.
4. The tops of the shoulders should be approximately on the same horizontal level.

This pattern occurs in all time frames. We recommend watching it, especially on a daily or weekly chart. The analysis may be supplemented, for example, by moving averages.

Inverse Head and Shoulders pattern

There is also an inverse form of this pattern, which arises after the previous downtrend and it signals that the market is bullish and the trend may reverse soon. This pattern is called the Inverse Head and Shoulders and its example can be seen in this figure:

_{The Inverse Head and Shoulders in the NZDSGD currency pair}
 

The pattern consists of three bottoms, where the first and third bottoms - shoulders are higher than the second bottom, where the head of the pattern is.
 

How to trade Inverse Head and Shoulders pattern:

The same principles apply to trading this pattern as to the Head and Shoulders but in the opposite direction. After breaking the neckline up (point F), we enter the long trade, placing the stop loss either below the low of the third bottom (right shoulder) of the pattern or on the last swing that was before the neckline breakout. The target price is either the closest resistance level or the distance between the highest peak of the pattern and the neckline (in this case, the CB distance is the same as the BF).
 

Few important insights regarding the inverse Head and Shoulders pattern:
 

1. The pattern must be preceded by a clear downtrend.
2. No shoulder shall be lower than the top of the head.
3. The neckline must be either horizontal or descending. In this pattern, the neckline must not be rising.
4. The tops of the shoulders must be on the same horizontal level.

In reality, there will be some deviations but the closer to the above rules, the more reliable the pattern will be. It is also possible to complement the analysis with other technical analysis tools, such as moving averages for example.

Read the previous articles about Price action

Tops and bottoms price patterns

The tops and bottoms are other important reversal patterns. The Double Top or the Double Bottom patterns are most often mentioned. Besides them, there are patterns Triple top, Triple bottom, etc.
 

Double Top pattern

The Double Top is a very popular pattern used for trend reversal identification. The pattern signals a possible end of the previous rising trend, and as the name suggests, the pattern is formed by two tops, when the first one is formed and if the other peak does not have enough strength to overcome the previous peak, the trend reverses. The pattern resembles the letter M.

In the price chart, this pattern looks like this:

_{The Double top pattern in the GBPUSD currency pair}
 

Chart break down:

We have the GBPUSD currency pair in a weekly timeframe here. First, the top A was created followed by a correction at point B. Later, the second top was formed at point C which is approximately at the same price level as point A. The pattern is confirmed by breaking the signal line which is the lowest price level of the pattern at point B.

It can be seen that at the top C, the price slightly exceeded the previous top A. This is because traders tend to put their stop losses close just behind the previous top. This is then used by big players as they use those orders as liquidity they need.
 

How to trade the Double Top pattern

The pattern Double Top is conservatively traded after breaking the signal line downwards. Therefore, an entry would be at point E. Stop loss is usually above the top of the pattern, and for the target price the distance between the signal line and the top of the pattern should equal the distance between the target price and the signal line. This gives RRR 1:1 which may not be sufficient in some cases. In order to get better RRR the alternative option is to move to stop loss closer to the signal line e.g. above the last swing on the daily chart before a breakout.

More aggressive traders could consider an entry at point D, in the case of bearish candlestick closing below the previous bullish candlestick. It is important to realize that the pattern Double Top is not confirmed at this point yet, it is only a bounce from that resistance line. Because at this moment we do not know if the price breaks through the signal line, we would set the target price to the nearest support level, which is above the mentioned signal line.

Double Bottom pattern

This pattern is the opposite of the Double Top. The Double Bottom forms a downtrend and it suggests that this trend is near the end and bulls could take over the initiative instead of bears.

Figure 4 shows an example of this formation in the SP500 index.

_{The Double Bottom pattern}

Chart break down

First, the first bottom was formed, in a downtrend see point A, and then a correction was created at point B. A few days later the second bottom C formed at the same level as point A. The price level at point B forms a signal line of the pattern.

How to trade the Double Bottom pattern

In a conservative strategy, the pattern is traded after the price breakout of the signal line upwards and the entry would be at point F.

The stop loss is below the lowest point of the pattern and the distance between the signal line and the target price at point G should equal the distance between the signal line and the pattern bottom. Alternatively, we could set a stop loss at point E which is the last swing before the breakout of the signal line.

We have also another possibility of how to trade this pattern. An aggressive entry could be at point D after the daily bullish candlestick closes above the previous candlestick. However, at this moment we do not know if the price reverses as the chart pattern is not confirmed yet. For this reason, it is recommended to target the price to the nearest resistance line, which is a signal line of this pattern.

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