Chart Patterns II: Rules for identifying Reversal Patterns

The following are the three basic tenets about identifying reversal patterns. While they may seem obvious and even simplistic, they are important for successfully using these patterns.

A Trend Must Exist - A trend must exist before a reversal of the trend. There can be no reversal if a trend does not exist in the first place. A reversal pattern that follows a large trend will have much more movement to retrace, and so the strength of the move after the reversal pattern will likely be stronger.

Trend Lines - The first precise signal that the trend is ending is often the failure of a trend line, that might also come along with oscillators that show overbought or oversold before a reversal pattern occurs. Note that the intraday break of the trend line is not significant until a daily candle closes through the line. The chart below shows a trend line that is broken on an intraday basis before the price recovers. The first strong signal that a reversal may be coming appears when the price closes below the green support line. The price subsequently rallies to form a double top, but it does not hold these gains.

 

 

Time Frame - Like relative highs/lows and trend lines, reversal patterns gain greater significance if they occur over a longer time frame. A head and shoulders pattern that takes months to develop will of course signal a reversal of a much larger trend than a head and shoulders that takes place intraday.