Important Formations and Patterns

January 12th, 2013
in contributors, syndication

by Marcus Holland,

Here are some of the most common 'top and bottom' configurations that are renown for detecting price reversal accurately and, as such, will assist you greatly in improving your results and profitability while day trading.

Follow up:

1. 'Head and Shoulders' Pattern

The famous 'head and shoulders' formation is characterized by three peaks, as shown in the next diagram.

The middle peak, or 'head', is higher than the two lower shoulders. which are not usually evenly balanced. The line connecting the lowest points of the two shoulders is termed the neckline.

The neckline is seldom perfectly horizontal because of price oscillations. This structure is regarded by experts to be a strong reversal indicator that is not completely formed until price pierces beneath the neckline. A sound strategy that you should deploy, in order to verify that a true reversal has occurred, is to wait for price to close below the neckline on two consecutive days.

You can also deploy confirmation techniques based on candlestick patterns to also help you achieve this objective. Essentially, you should study the trading charts of any asset of interest, after you have detected a 'head and shoulders' pattern, for those configurations supporting bearish reversals, e.g. dark cloud cover and hanging man, etc.

Many investors often create a profit target based on the distance between the top of the head and the neckline. They perform this task by locating a target-profit for their new short position by placing it exactly the same distance below their opening price as the neckline is beneath the head top.

2. 'Double Top and Bottom' Patterns

'Double-top' or 'M' patterns are created initially by a steep increase in the price of an asset. Two tops, divided by a bottom, are then formed before the pattern is completed with sharp decline in price.

'Double-bottom' or 'W' patterns are initiated by a significant price drop. Two bottoms, divided by a top, are displayed before the pattern is finally formed by a sharp increase in price.

The key features of these configurations are now described:

  1. They are major reversal indicators that normally identify that long-term price trends are beginning to peter out.
  2. Tops are usually better structured although they tend to be shorter in length than bottoms.
  3. Double 'tops and bottoms' are exceptionally strong signals advising that a serious change in price direction is imminent.

3. 'Triple Top and Bottom' Patterns

Triple top formations are formed when the price of an asset bounces three times against a price level and are powerful indicators of strong resistance zones.

Similarly, triple bottom configurations are created when price rebounds three times against a major support level and demonstrate that a strong buying interest is prevalent.

4. V-Pattern

The V pattern is produced after a sharp price action switches very quickly from one direction to another without warning.

You will discover that trend reversals provide some of the best trading opportunities for opening positions exhibiting good profit potential. They usually indicate major changes in the price direction of assets. However, you will find that a market top or bottom is often difficult to identify.

Consequently, you are recommended to wait until price confirms a trend reversal after identifying one of the above well-tested and reliable patterns. In summary, developing trading methods to enable you to successfully detect tops and bottoms can be a very profitable activity and as such is well worth your time studying.

You must also understand that you will not master the art of detecting major reversal patterns overnight in just the same way that lawyers and doctors need time to become proficient at their professions. Consequently, you must adopt patience by implementing the most professional psychology as possible.

When trading reversals, you should not deploy stop-losses in excess of 100 pips because you could sustain serious losses if a real fakeout materializes. You should also try to advance your stop-loss to breakeven as soon as price has advanced by 50 pips in its new direction. You will then be able to trade risk-free as well as still allowing your new position to capture additional profits. If you can achieve such a desirable situation then you should allow your trades to run in order to maximize your gains.

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