Fundamentals of Technical Analysis: Reversal Patterns

The main goal of analyzing a financial security with technical analysis is to find trends in the security’s past and current price and volume data.  The easiest way to see these trends or patterns, which will be used to forecast future price movements, is to look at the data on a chart.  There are two main types of patterns, reversal patterns and continuation patters.  Knowing the difference between these will be helpful if you want to invest on your own, or are studying for any section of the CFA exams.  This article will discuss reversal patterns.  Remember, if there is no clear trend before the suspected pattern starts, the pattern has no predictive value.  Also, one challenge of technical analysis is that analysts cannot be sure of which pattern will form until after the fact.

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Reversal patterns are patterns on a chart that signal an end to a current trend and a change in direction of the security’s price. It is important for analysts to know if the security’s price will change direction because it will allow them to either exit their current position if they are holding it, or enter into a short position.

Head and Shoulders Pattern

The most recognizable reversal pattern is the head and shoulders pattern, which gets its name because the pattern is broken up into three main segments: the left shoulder, the head, and the right shoulder.  The left shoulder starts with a strong rally, with the slope of the rally being greater than the previous uptrend, with high volume. The rally then reverses to the level of where the slope of the uptrend has changed.  After the left shoulder’s rally reversal, there will be a new rally, called the head, with a new high that will be greater than the left shoulder.  After reaching the new high, the trend will reverse again and end where the left shoulder ended.  This price level is called the neckline.  Trade volume will typically be lower in this rally compared to the rally of the left shoulder.  Finally, once the trend of the head reverses to the neckline, the right shoulder trend will begin, and mirror the left shoulder.  When the rally ends, the trend will reverse to below the neckline.  It should be known that a perfectly formed head and shoulders pattern is very rare.  Some variations of this pattern include several tops to the shoulders, and multiple tops of the head.

Inverse Head and Shoulders Pattern

The regular head and shoulders pattern is a reversal of an uptrend.  The inverse head and shoulders pattern is the opposite; it is the reversal of a downtrend which means the price is expected to increase.  Just like the normal head and shoulders pattern, the inverse head and shoulders pattern is made up of a left shoulder, the head, and the right shoulder. The left shoulder is a continuation of a downtrend on high volume.  The down trend then reverses to form a V.  Once the V has been completed, the head part of the pattern will start to form and a new price low will be visible on lower volume.  The head will then reverse to the neckline and form a larger V.  Lastly, the right shoulder will form, roughly mirroring the left shoulder but on less volume.  Instead of reversing at the neckline, the price will break through signifying a reversal of the beginning downtrend.

Significance of the Neckline

The price level at which the neckline is at can be used to set a price target.  Once the price goes under the neckline in a regular head and shoulders, or above the neckline in an inverse head an shoulders, the security’s price is expected to decline, or increase, by the price difference between the neckline and the head.

Regular head and shoulders:  Price Target = Neckline – (Head – Neckline)

Inverse head and shoulders: Price Target = Neckline + (Neckline – Head).

Example: the price a security reached at the high point on the head segment of a regular head and shoulders pattern was $117.  If the neckline is at $94, what price can the security be expected to drop to?  The security’s price is expected to drop to $71 (94 – (117- 94) = 71).

Example: the price a security reached at the low point on the head segment of an inverse head and shoulders pattern was $793.  If the neckline roughly formed at $867, what is the target price?  The security’s price is expected to increase to $941 (867 + (867 – 793) = 941).

Double Tops and Double Bottoms

A double top occurs when an uptrend reverses twice at relatively the same price level.  Usually, volume is lower on the second high than on the first, which shows diminishing demand from buyers.  The price of a security that shows a double top pattern is expected to decline below the price level between the two highs by at least the difference between the high and the low.  A target price can be calculated similarly to how a target price would be calculated for a head and shoulders pattern: the low between the two highs of the pattern can be treated as the neckline, and the target price is equal to the neckline price minus the difference between the high and the neckline.  Not only are there double tops, a double bottom pattern also exists.  These patterns are formed when the price of a security reaches a new low, rebounds, and then decreases again to the first level.  Analysts using technical analysis use the double bottom pattern to predict the change of a downtrend to an uptrend. A target price can be calculated for a double bottom just as the target price would be for an inverse head and shoulders pattern.  The high point of the pattern between the two lows can be treated as the neckline, and the target price equals the neckline plus the difference between the neckline and the low in the pattern.

Triple Tops and Triple Bottoms

Triple tops and triple bottoms are very similar to double tops and double bottoms, but they have one additional pattern segment: the triple top has three peaks at roughly the same price level, and the triple bottom has three troughs at roughly the same price level.  These two patterns are more significant than double tops and bottoms because traders have stepped in three times to either stop increasing or decreasing prices by purchasing or selling shares.

Summary 

Reversal patterns show technical analysts that a trend in a security’s price/volume data will soon end and reverse. There are several different reversal patterns that are important to understand if you are in the investing field or are studying for any of the CFA exams. These patterns, including the head and shoulders, the inverse head and shoulder, the double top and bottom, and the triple top and bottom, are all signs that a current price trend will reverse.  After recognizing one, it is up to the analyst to determine how to take advantage it.