Technical Analysis – Price Patterns (Reversal)

As mentioned in earlier materials, technical analysis is the analysis of repetitive patterns that were forged in the past and are forged currently. If we are able to find such patterns then why not earn money on them. What has to mentioned is that such patterns could be a signal to trend continuation but they could also be a signal to trend reversal.
I would like to begin with two reversal (trend change) patterns, which also happen to be one of my favorite patterns to opening a position on the market.

Double Top

This price pattern is also known as formation “M “due to its shape. It is made up of two tops where the second top should not be higher than the first one. A perfect “M” is where both tops are exactly on the same level, but these types of situations cannot be always found. Most often this pattern is formed, where the second top is lower than the first, though the difference between the two tops should not exceed 10% counting from the support break (green horizontal line in example below). Before explaining how you could make money on this pattern, let’s take a look at the shape itself.

Example:






In this pattern the market forms one top and later forms a corrective movement, after which another top is formed. On the minimum of the bottom formed (correction), we should draw a horizontal line which will be called the support break. If the market breaks the support break then we could open a short position. What is interesting in this price pattern is that we can actually expect how far the market can go after breaking the support break. After breaking the support break the market should decrease by the distance counting from the first top to the support break itself.

X (distance) = Top 1 – Support Break





More Examples:

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Double Bottom

This price pattern is also known as formation “W “due to its shape. It is made up of two bottoms where the second bottom should not be lower than the first one. A perfect “W” is where both bottoms are exactly on the same level, but like in the previous patter, it is not always easy to find a perfect “W”. Most often this pattern is formed, where the second bottom is higher than the first, though the difference between the two bottoms should not exceed 10% counting from the resistance break (green horizontal line in example below).

Example:






In this pattern the market forms one bottom and later forms a corrective movement, after which another bottom is formed. On the maximum of the top formed (correction), we should draw a horizontal line which will be called the resistance break. If the market breaks the resistance break then we could open a long position. In this price pattern we can obviously also expect how far the market will increase. This distance is counted as follows:

X (distance) = Bottom 1 – Resistance Break

More Examples:







An interesting fact in double tops and bottoms is that when making a prognosis to where the market may move to, we automatically find a significant level of resistance or support for the next few weeks and sometimes even months. So keep in mind that the eventual range of both formations could be relevant information for making decisions in the future.


Conclusion:

Double tops and bottoms are not only easy to find, but they are also very effective. Many investors stray away from them stating that they are just too simple to make money on. That is only half true. They are simple but as mentioned before, they are also very effective if managed well. Managing your transactions is very important, sometimes even more important then the position you choose to take. More about capital management will still be mentioned in further materials where we will once more come back to double bottoms and tops and explain how to open a position well and not worry what the market does.

Omar Arnaout
X-Trade Brokers Dom Maklerski S.A.
Omar.arnaout@xtb.com