Using Patterns to Determine Reversals or Continuation
Markets generally consolidate within a trend and either correct or continue which can be determined by using specific continuation or reversal chart patterns. By evaluating these types of patterns, you can trade the market and enter when you are comfortable that either a correction is bound to take place or a continuation is poised to ensue.
Head and Shoulder
The most commonly used reversal pattern is the head and shoulder reversal pattern. This pattern generally occurs as the end of an uptrend. A reverse head and shoulder pattern usually occurs as the end of a downtrend. A head gets its name when because the pattern looks like a personal head and shoulders.
At the end of an uptrend, a correction occurs, as supply overtakes demand. Here prices are pushed lower as investors take profits. Volume plays a very important role here. If volume picks up as prices move lower, traders can be confident that the uptrend could be on its last legs. The left shoulder is completed as prices find support and begin to move higher. The area of support is referred to as the neckline.
Demand then begins to exceed supply as is usually the case in an uptrend. Prices break out to fresh highs, but generally volume is declining. If volume in increasing, it can be hard to determine if a head and shoulders is forming. Once a fresh high is formed, the head is complete, and prices begin to decline back through the left shoulder and down to the neckline.
Traders are still bullish when the head pattern occurs, and the higher high generally reflects this scenario. At the neckline, traders will purchase the security with the hopes that the market will again move higher. Resistance is hit as the right should is formed which is always lower than the head and generally lower than the left shoulder. Volume begins to pick up as prices move lower toward the neckline. When prices break through the neckline, volume generally surges reflecting the completion of the reversal pattern.
A continuation pattern is a pause that refreshes. Flag patterns are continuation patterns that form the shape of a flag. After a security breaks out to fresh highs, it will consolidate moving lower forming inside days, as traders take stock of the recent break out. For a bull flag pattern, prices will edge lower for a couple of days as the consolidation takes hold. For a break flag patter, prices will generally edge higher. A flag pattern is complete when prices either hit a new fresh high for a bull flag pattern, or a new low on a bear flag pattern.
A triangle pattern represents indecision. Attempts to push a market higher are met with resistance and attempts to drive the market lower are met with support. The movements become shallower as further indecision takes hold. As price action consolidates, energy starts to build which is released once a new high is breached or a new low is hit. Generally, the break out or break down is met with increasing volume. Triangles can be symmetrical or ascending or descending.
Patterns generally occur during consolidation periods, and can help you determine if a market is poised to reverse or pauing before refreshing.
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