|
There are a few preliminary points considered common to all reversal
patterns that you should absolutely know before trying to pick a top
or bottom in stock trading (which is difficult enough!):
A prerequisite for any reversal pattern is the existence of a prior
trend.
The first signal of a trend reversal is a break in an important
trendline.
The larger the pattern, the bigger the subsequent move.
Topping patterns are shorter in duration and more volatile than
bottoms
Bottoms have smaller price ranges and take longer to build
Volume is more important on the upside
Existence of a Prior Trend - A prior major trend is the most important
prerequisite for a reversal pattern. Of course, if there is not trend,
there's nothing to reverse. One of the key elements in pattern
recognition is knowing where certain patterns are most likely to show
up in a trend structure, as in uptrend or downtrend.
Breaking of Important Trendlines - One of the first signs of trend
reversal is the breaking of an important trendline. However, the
violation of the trendline may be no more than just a signal of a
change in trend. It could be a sideways trend or price pattern later
proving to be a reversal or consolidation.
Larger the Pattern, Greater the Potential - Larger, in this case, refers
to the height and width of the price pattern. Height measures the
volatility, and the width measures the time taken to build and
complete the pattern. The wider the price swings within the pattern
(the measure of volatility) and the longer it takes to build, the more
important the pattern and the greater the potential for the ensuing
move.
Measuring techniques which measure the height of the pattern or vertical
criteria are primarily applied to bar charts. Measuring the horizontal
width of a a price pattern, used for point and figure charting, uses a
device called a "count" which assumes a close relationship between the
width of a top or bottom and the subsequent price target.
Differences Between Tops and Bottoms - There are distinctive differences
between tops and bottoms. Tops are shorter in duration, more volatile,
and their price swings are wider and more violent. Whereas, bottoms
have smaller price ranges and take longer to build, making them easier
and less costly to identify. It is also easier to trade bottoms than
to catch tops. However, traders can usually make money a lot faster by
catching the short side of a bear market because prices tend to
decline faster than they go up. It is always a tradeoff between reward
and risk. Greater risks capture greater rewards, and vice versa.
Topping patterns may be harder to catch, but Day Trading, Swing
Trading and Options Trading traders all agree that they are worth the
effort.
Volume is More Important on the Upside - Volume is an important factor
in confirming the completion of price patterns, and generally, it
increases in the direction of market trend. Noticeable volume
increases should accompany the completion of a price pattern. Note
that in the early stages of trend reversal, volume is not as important
at market tops. Although traders like to see an increase in trading
activity as prices go down, it's not critical. However, at bottoms a
volume pick up is vital. If there's no significant increase in volume
during an upside breakout, the whole price pattern should be
questioned.
Sometimes after an upward exhaustion gap has formed, prices trade in a
narrow range for a couple of days or weeks before gapping to the
downside. This is the island reversal pattern. This pattern can be
spotted readily in Swing or Options trading, but is also seen in Day
trading. The island reversal top is so called because the few days of
price actions looks like an "island" surrounded by space. An
exhaustion gap on the upside and a breakaway gap on the downside
creates the island reversal pattern and usually indicates a trend
reversal of some magnitude. However, the major significance of the
reversal depends on where the prices are located in the trend.
|
|
|
