A previous high may act as a target for a new move to the upside or as a barrier that an uptrend may not be able to penetrate. If this resistance holds and prices turn back, the price reversal may form a double top and makes that price area a more formidable barrier to exceed in the future.
A mirror image of the double top is the double bottom: Prices drop to the vicinity of a previous low and bounce back up from this support zone. This reversal at a former low can make this level an even stronger area of support if it is tested several times.
A close cousin of the double top and double bottom are the M top and W bottom, so-called because of the letters formed when the thrust to a previous high or previous low does not reach the same level as the first high or low. The key that confirms a price reversal is a break above the interim high on the W bottom and a break below the interim low at the M top. The interim highs and lows can often be used to determine where to place entry or exit orders, depending on your market position going into the pattern.
Like some other patterns, a head-and-shoulders formation may be part of a larger continuation pattern, but it often indicates a change in market direction when the neckline of the pattern is penetrated. This pattern involves several highs and lows, forms over a period of time and may be used to make price projections after a breakout.
In the head-and-shoulders bottom shown, prices descend to a low marked by the left shoulder, rally to an interim high, then dip again to a lower low that forms the head. Then prices rally a second time to the vicinity of the first interim high and slip back again but not as far as the head, forming the right shoulder. Drawing a line across the interim highs produces the neckline.
Penetrating the neckline is the key to the reversal pattern prices move above the neckline (often with a little back-and-forth price action along the line), traditional chart analysis suggests the market will move the same distance above the neckline as the distance between the neckline and the peak of the head. In this chart example, the distance between the neckline at around 91 and the peak of the head was about 6 points. Adding 6 points above the neckline makes 97 at least an initial target projected by this formation. It doesn’t mean that’s the upside limit but can be useful in planning trades.
Just reverse the image for a head-and-shoulders top.
Rising or falling wedge patterns are modifications of a triangle and can also lead to price reversals. As with the triangle, prices move into a narrower and narrower range as the pattern progresses, looking somewhat like a coil. In a rising wedge, the price highs do not advance as much as the price lows.
When the uptrend line along the lows does give way, prices tend to spring out to the downside. In some cases after the breakout, prices will stage a little rally back to the trend line but will then submit to the loss of buying momentum by sliding into the downtrend direction indicated by the breakout. This kick back price action is a familiar occurrence with a number of breakout patterns.
Another triangle pattern that could turn into a reversal pattern, either to the upside or downside, depending upon your time frame, is the descending triangle. To illustrate that price patterns form over multiple time frames, the chart below shows a succession of lower highs on a weekly chart forming a downtrend line but with lows stalling around 80 to form the flat side of a triangle.
Prices could reverse the downtrend line by moving above 90. On the other hand, a price break below the flat side of the triangle around 80 could be an ominous sign for a further move downward, adding to the continuation pattern of the trend in place.
No one knows for sure which way the market will go. But, as traders monitor a price pattern like this to see its outcome, note the potential spots to place orders become more defined – buy a breakout above 90, sell a breakout below 80 or perhaps use those parameters in an options trading strategy. Exact orders will depend on your time reference and style of trading in using these formations.
Like the descending triangle, price action in the ascending triangle is another modification of a triangle formation but with the pressure to the upside. Higher lows produce an uptrend line but prices stall at a price level that forms the flat side of the triangle.
Depending on when and where you are viewing the chart and historical prices from the past, you might surmise that the dashed line on the chart below marks a triple top and will turn prices back down again. Or you might see prices pressing higher into a developing ascending triangle.
As the upward pressure pushes prices above the flat side of the triangle, the breakout is marked by a gap higher, a sharp move that is fairly common in triangle breakout situations. If you expected the market to respect the dashed line and turn back down, at least you had a good spot to place a stop in case you might be wrong.
What’s next? Some analysts like to set targets by looking at the width of the triangle at its base. In this case, the width at the triangle’s origination was about 6 points with the low around 39, high around 45. Add the 6 points to the point of the breakout at 45, and you have a target around 51. Time will tell whether that target will be achieved.
Not all price patterns produce sharp, distinctive turns in price direction. It sometimes takes time for a top or bottom to emerge gradually over a number of price bars/candles. These patterns include the rounding bottom or the cup-and-saucer (although it really should be the saucer-and-cup formation in the chronological sequence). These patterns are generally associated with bottoms but may occur at tops as well.
In the bottoming formation, prices drift lower and lower, sometimes with small range periods, until they begin to turn and gradually creep higher. The price reversal bottom is complete when prices move above the lip of the rounding bottom.
Sometimes the bottoming formation takes the shape of a saucer and cup, combining a rounding bottom with a little setback at the right side of the formation that becomes a “cup” (or a cup and a cup handle in some descriptions). When prices move above the lip of the cup (dashed line), the bottom is in, and prices continue to the upside.
Note the pattern of volume in connection with the pattern of prices in the chart below. When the market is ready to move, prices break higher on much higher volume, authenticating the breakout.
A reversal pattern that is relatively rare – or perhaps envisioning it is just more uncommon – is the diamond pattern, formed by a series of prices that rally into a high, drop sharply, then rally again but fall off quickly to leave a more or less isolated pattern at a market extreme. The breakout can produce a sharp turn in prices such as the gap lower move on the chart below.