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Reversing the Trend

(This is the third in a series of articles on basic technical analysis originally published in Futures magazine.)

Some chart patterns that provide the best clues that a market will continue an existing trend are also the key to determining when a market is changing course. In fact, the best reversal signals often occur when the continuation patterns illustrated in the previous article fail.

Perhaps, the best reversal formation is also the simplest -- the breaking of a trendline, the longer and stronger the trendline, the more significant the reversal. However, the technical analyst can usually find other chart patterns that not only will provide reversal points but also may give some idea about the potential extent of an ensuing move.

This chart of Disney (DIS) may be a little cluttered and confusing -- that is one of the dangers of over-eager technical analysis -- but it shows several types of reversal action on one chart:

1. the break of a major trendline (shown in red)
2. a double top
3. the “W” bottom and “M” top and
4. the head-and-shoulders bottom and top

Sometimes, it takes a little imagination to “see” these formations, but they can be helpful aids in trying to decipher the tracks that prices leave on charts.

Like a strong trendline, a double top or bottom can be a powerful point on a chart. If prices approach a high and turn down as they do at about 36.00 on the Disney chart, that becomes a formidable barrier likely to turn back other rally attempts. Traders need to look at further price forays into that area as a reversal possibility first. However, if prices do break through a double or triple top or bottom, that is often a sign of a strong market ready to continue the move.

Sometimes a double top comes in the form of an “M” formation or a double bottom in the form of a “W” at the end of trends. They may evolve from a continuation formation such as a flag, and they may have other names such as a 1-2-3 or swing formation, but the concept is the same. In the “W” formation, prices drive to a low, rebound to form the middle of the W and then go lower again as traders test the earlier low. The second attempt may exceed the first low slightly or may fall short. The buy signal comes when prices move back up above the middle of the W (dotted line on chart).

A similar type of price action occurs at an M top. Prices drive to a high, set back, rally to a high that may or may not exceed the first high and then drop back to provide a sell signal on the breakout below the low of the middle leg of the M.

Some Ms and Ws may be part of what analysts call a head-and-shoulders formation. The DIS chart shows both a head-and-shoulders bottom and a head-and-shoulders top. The bottoming formation shows prices continuing a downtrend into a low followed by a rally, forming the left shoulder (LS); then a drive to an even lower low followed by another rally, forming the head (H); then another setback that doesn’t go as low as the top of the head followed by another rally, forming the right shoulder (RS).

The key to the head-and-shoulders is the “neckline,” the trendline formed by the tops of the rallies on the bottom or the lows of the dips on the topping formation. If prices break through the neckline, you can determine a price target by measuring the distance from the peak of the head to the neckline and adding or subtracting that amount to the neckline. On this chart, prices exactly reached the target for the head-and-shoulders top on the larger move lower in February.

Note that your definition of the shoulders and placement of the neckline could have been different on this chart. Ideally, the peaks of the shoulders should be about even and the neckline almost horizontal. It is difficult to find perfect, well-defined head-and-shoulders on the charts. Depending on where it occurs in a trend, what looks like a head-and-shoulders reversal formation could be a continuation pattern instead.

All of these formations only offer an alert that a reversal could take place but they carry no guarantees. What seems obvious in hindsight is usually not so clear as the action is unfolding, but recognizing a pattern in its development stage can give you insight into what the market might do.

Next article: One-bar signals

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