REVERSAL
PATTERNS IN SHARE PRICE
Technicians
watch for price clues that can alert them to a shift in market psychology and
trend. Reversal patterns are these technical clues. Western reversal indicators
include double tops and bottoms, reversal days, head and shoulders, and island
tops and bottoms.
Yet the term "reversal
pattern" is somewhat of a misnomer. Hearing that term may lead you to
think of an old trend ending abruptly and then reversing to a new trend. This
rarely happens. Trend reversals usually occur slowly, in stages, as the
underlying psychology shifts gears.
A trend
reversal signal implies that the prior trend is likely to change, but not
necessarily reverse. This is very important to understand. Compare an uptrend to a car traveling forward at 30 m.p.h. The
car's red brake lights go on and the car stops. The brake light was the
reversal indicator showing that the prior trend (that is, the car moving
forward) was about to end. But now that the car is stationary will the driver
then decide to put the car in reverse? Will he remained stopped? Will he decide
to go forward again? Without more clues we do not know.
Exhibits 4.1
through 4.3 are some examples of what can happen after a top reversal signal
appears. The prior uptrend, for instance, could convert into a period of
sideways price action. Then a new and opposite trend lower could start. (See
Exhibit 4.1.) Exhibit 4.2 shows how an old uptrend can resume. Exhibit 4.3
illustrates how an uptrend can abruptly reverse into a downtrend.
It is prudent
to think of reversal patterns as trend change patterns. I was tempted to use
the term "trend change patterns" instead of "reversal patterns"
in this blog. However, to keep consistent with other technical analysis
literature, I decided to use the term reversal patterns. Remember that when I
say "reversal pattern" it means only that the prior trend should
change but not necessarily reverse.
Recognizing
the emergence of reversal patterns can be a valuable skill. Successful trading
entails having both the trend and probability on your side. The reversal
indicators are the market's way of providing a road sign, such as "Caution—Trend
in Process of Change." In other words, the market's psychology is in transformation.
You should adjust your trading style to reflect the new market environment. There
are many ways to trade in and out of positions with reversal indicators. We shall
discuss them throughout the blog.
An important
principle is to place a new position (based on a rever sal signal) only if that
signal is in the direction of the major trend. Let us say, for example, that in
a bull market, a top reversal pattern appears. This bearish signal would not
warrant a short sale. This is because the major trend is still up. It would, however,
signal a liquidation of longs. If there was a prevailing downtrend, this same
top reversal formation could be used to place short sales. I have gone into
detail about the subject of reversal patterns because most of the candlestick
indicators are reversals. Now, let us turn our attention to the first group of
these candlestick reversal indicators, the hammer and hanging-man lines. (continue.)
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