Trend Reversal Patterns
Double Top, Head & Shoulders, Rising Wedge
In our previous article we’ve described the downtrend reversal patterns and considered the best entry points, trading strategies and Stop Loss placement techniques.
Now we will analyze such trend reversal patterns referred to as Head & Shoulders, Double Top and Rising Wedge, signaling the uptrend reversal.
Head and Shoulders
The Head and Shoulders figure is a strong trend reversal signal. This pattern is formed during a clear uptrend and consists of three parts: the left shoulder, the head and the right shoulder.
The formation
The head is the top part of the figure, and the shoulders, located on both sides, are supposed to look similar to a certain extent. Another important parameter of the figure is a so-called neckline. The neckline is a level of support, which is formed from the previous two highs. The neckline is formed only after all other parts of the pattern appear.
The head and shoulders pattern depends on the timeframe and the strength of the upward movement. It is vital to pay attention to the distance between the tops when analyzing the pattern: equidistant distance between the head and shoulders indicates the higher probability of the figure’s formation. Also the more horizontal the neckline is, the higher the chances of the reversal are.
Entry point and Stop Loss placement
The break through the neckline is a signal for the formation of the pattern. There are several entry points when working with head and shoulders pattern; the choice is solely yours and depends on your trading strategy.
Entering a short position after the support line is broken: In this case you do not wait for the neckline retest to confirm the breakout. The risks lie in a chance of a false breakout and the formation of a bear trap. This could lead to the failure of the pattern’s formation and continuation of an uptrend. Stop Loss should be set at the right shoulder levels. A tight Stop Loss above the neckline would be optimal.
Entering a short position after the neckline’s retest: This strategy requires waiting for the price to return to the support line. Stop Loss in this case can be set at or above the right shoulder. When choosing this strategy, it is worth keeping in mind that price may continue its movement without retesting a neckline.
Key features
When analyzing the figure’s formation, it is important to consider other signals, such as volume. The volumes may start dropping as the price moves from the left shoulder towards the head, and as the figure forms towards the right shoulder they may start growing. These volume swings are caused by the market participants’ psychology and show the fall of buying volumes, followed by the growth of selling volumes as a result of the upward impulse exhaustion.
Tighter Stop Loss is advised and may be set above the support level to trade in a safer fashion and reduce risks. Keep in mind that in this case, the chance of Stop Loss execution caused by sudden increase in volatility is higher. Also take into consideration the specifics of the market and the asset you trade while determining when to close your position.
Double top
The Double Top pattern is an uptrend reversal figure; hence its formation indicates the beginning of a bear trend. The M-shape pattern is easy to analyze and is often seen on the popular cryptocurrencies’ charts.
The formation
The double top pattern appears when an asset rises to certain levels and rebounds to hit another high at similar levels while forming an M-shaped figure. The corresponding highs act as a resistance level. Similar to the previous pattern we described, the double top formation also has a neckline that forms a support level. The breakdown of the neckline means high probability of the figure fulfillment and trend reversal. It is also worth paying attention to the distance between the pattern’s highs; the further apart they are, the stronger the pattern is.
Opening a position
The pattern neckline retest is the optimal strategy of market entry from the point of view of risks/profits ratio. Trading more aggressively makes it possible to enter the position on the support level breakout without waiting for the re-testing of that level.
A breakout below the neckline is a signal to open a trade, but if you prefer a more steady and low-risk approach, it is suggested to wait for the retest of the support level. When opening a trade at breakout it is important to set a tight Stop Loss, just above the support line. This technique is preferable in terms of risk management.
Use additional tools and indicators to confirm the formation of the figure. Having additional information about the price behavior, you can enter a short position with a tight Stop Loss earlier (e.g., at the end of the formation of the second top), before breaking through the neckline.
Rising wedge
This pattern is both a reversal pattern and a trend continuation pattern. When such a formation takes place, it is important to determine the corresponding market conditions. If the rising wedge is formed on the downtrend, the price is likely to continue its fall. On the contrary, if the rising wedge is formed during the upward trend, the price will likely continue its downward movement.
The formation
The reversal-indicating rising wedge is formed during a clear upward movement. The price appears to be squeezed between two narrowing ascending channels.
The price should gradually get squeezed in the channel, after which a sharp impulse and a break through the support level should follow. The breakout is characterized by the increase of the trading volume, which can be a signal confirming the figure’s formation.
Entry point and Stop Loss placement
Short positions may be opened when the support level is broken through or during the retest. Depending on the strategy and the risks, the Stop Loss can be set either above the support level or at the upper resistance level of the wedge.
If you utilize additional analysis tools and have trading experience, you can try opening a short position at the upper border of the rising wedge, setting a tight Stop Loss. Volume indicators are a great example of additional tools, useful when analysing such formations. A decrease in volumes during an uptrend, also known as divergence, signals the drop in buying pressure, which can cause a trend reversal.
Conclusion
“Do not trade against the trend” is one of the basic market rules. Opening and closing profitable trades requires determining the change in trends. Mastering trend reversal patterns gives you the opportunity to enter trades that have lower risks and yield higher profits.
