Lesson 10.4 – Reversal Patterns
A reversal pattern is just that, a pattern on the price chart or a currency pair that would indicate an interruption in the overall trend and that a reversal in the price’s general direction is ready to ensue.
Along with continuation patterns, reversal patterns make up some of the most widely watched configurations seen on price charts.
Of course, traders will want to remain mindful that picking tops or bottoms can be challenging and that appropriate stop-loss orders are strongly recommended when trading any of the reversal patterns.
A number of typical reversal patterns which technical analysts have come to identify and categorize include those described briefly in the following sections.
Major Tops and Bottoms
These are formed when, after a prolonged period of advances or declines, the price chart has achieved a major high or low price.
Generally, a period of consolidation subsequently takes place in which the currency pair will form either a base off of the low or a pronounced area of resistance near the level of the high price on the price chart.
Head and Shoulders Top or Bottom Pattern
This classic reversal pattern generally signals that a major top or bottom is developing on the price chart. Typically, the pattern is more common and reliable in an uptrend.
For a head and shoulders top pattern, the head consists of the price peak (head), with another lower peak to the left (left shoulder), and another lower peak to the right (right shoulder).
Figure 1: This schematic diagram depicts a classic bearish Head and Shoulders reversal pattern and its breakout. The pattern’s measured move is illustrated with white arrows.
The break of the pattern’s neckline signals a measured move equal to the distance from the head to the neckline drawn through the two price extremes located between the head and the shoulders.
Classic Double Top or Bottom
Typically, these reversal patterns will appear like Ms or Ws, sometimes with wide bases and extended in time. They can also have a third peak or trough, making the pattern a triple top or bottom.
Figure 2: This schematic diagram depicts a classic bullish double bottom reversal pattern resulting in a Forex trend reversal. The pattern’s measured move is illustrated with white arrows.
The break of the pattern’s neckline signals a measured move equal to the distance from the extreme peaks or troughs to the neckline drawn through the respective dip or rally price seen between the extremes.