Chart Patterns II: Rules for identifying Reversal Patterns

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The following are the three basic tenets about identifying reversal patterns. While they may seem obvious and even simplistic, they are important for successfully using these patterns.

A Trend Must Exist – A trend must exist before a reversal of the trend. There can be no reversal if a trend does not exist in the first place. A reversal pattern that follows a large trend will have much more movement to retrace, and so the strength of the move after the reversal pattern will likely be stronger.

Trend Lines – The first precise signal that the trend is ending is often the failure of a trend line, that might also come along with oscillators that show overbought or oversold before a reversal pattern occurs. Note that the intraday break of the trend line is not significant until a daily candle closes through the line. The chart below shows a trend line that is broken on an intraday basis before the price recovers. The first strong signal that a reversal may be coming appears when the price closes below the green support line. The price subsequently rallies to form a double top, but it does not hold these gains.

Time Frame – Like relative highs/lows and trend lines, reversal patterns gain greater significance if they occur over a longer time frame. A head and shoulders pattern that takes months to develop will of course signal a reversal of a much larger trend than a head and shoulders that takes place intraday.