Lesson 4

Mastering Price Patterns: Reversal and Continuation Patterns in Technical Analysis

Price patterns describe the dynamics between demand and supply, providing a snapshot that assists investors in positioning themselves. These patterns can be beneficial over both short-term and long-term periods.

There are two types of price patterns – reversal patterns and continuation patterns.

Reversal Patterns

Head and Shoulders Pattern

The Head and Shoulders pattern comprises three peaks. The two extreme ones are identical, while the central one is higher. The first peak, the left shoulder, is the highest point in the ascending trend. At this point, it's impossible to identify the emerging Head and Shoulders pattern. The trough following the first peak will continue the upward trend. After the first peak, a higher peak ensues and its subsequent trough will break the trendline downwards, usually halting at the trough of the prior peak. The next peak, the right shoulder, is formed from another peak whose apex is more or less at the same level as the left shoulder, and its trough is more or less at the level of the first peak's trough. At this stage, the pattern is complete, and we are confident that the trend is about to reverse.

Chart A:

The Head and Shoulders pattern is typically backed by trading volumes. During the formation of the left shoulder, the trading volume remains high because it is a continuation of an upward trend. High trading volume isn't obligatory. As the head forms, the trading volume increases, but starts to decrease when the peak of the head forms and the price begins to drop. Throughout the formation of the right shoulder, the trading volume rises, peaking near the breaking point of the neckline.

Once the neckline breaks, the pattern is complete, and the trend reverses. The neckline is a support line that turns into a resistance line once the trend is reversed.

Price Target: The distance from the neckline to the head's peak, measured from the point where the neckline is broken downwards.

Chart B:

Double Top Pattern

This pattern is indicative of a transition from an upward trend to a downward trend. It comprises two peak points that are more or less equal, with a horizontal trend between them.

Identifying the Pattern:

Before checking for this pattern, one should ensure a prominent upward trend is in place. The first peak is the highest point in the current trend, with no indication of a pattern or reversal. After the first peak is formed, there will be a drop that breaks the existing upward trendline. The second peak is formed when the horizontal trendline is breached. The peaks don't need to be identical – a difference of 2-5% is acceptable, and it would still count as a pattern.

The period between the two peak points can be several weeks to several months, with an ideal timeframe of three months. The decline from the second peak will be sharper and more significant, accompanied by higher trading volumes. The support line can potentially become a resistance line.

Price Target: The distance between the support line of the horizontal trend and the peak, measured from the break point downwards.

Chart C:

Triangular Peak

This pattern is created from three peak points that are more or less equal with minor deviations. The peaks need to be distinct from one another. This pattern is more suitable for analysis in the short term, and it signifies a reversal from an uptrend to a downtrend. It is important to ensure that we are coming from a clear uptrend. The pattern completes when the support line connecting the low points of the pattern breaks downwards. [Chart D].

The trading volume during the pattern decreases, and at the breakout point of the trend line, it becomes high.

Price Target: The distance between the first low point to the support line, in the direction of the reversal.

Chart D:

Continuation Patterns

Symmetrical Triangle

This pattern is valid for both an upward and downward trend. It is formed from two peak points that come after a rise and are lower than the first peak, and two low points that are higher than the first low. [Chart E].

Identifying this pattern requires a clear uptrend that lasts over several months. For the pattern to form, at least 4 points need to occur (in Chart E – points 4, 6, 3, 5). The line connecting the top points is an upward line, and the line connecting the low points is also an upward line.

Continuation patterns indicate a period of slowing down, a convergence of the trend. The stock needs to explain itself and receive information from the perspective of investors, after which will come a breakout upwards.

The trading volume throughout the pattern will be low and decrease over time. There is uncertainty. [Chart E]. This pattern can form over several months, usually, 3 months is a reliable pattern. The breakout phase will typically occur between half and 3/4 of the pattern's time. [Chart E]. The duration is measured from the start of the base – point 1, until the intersection of the two lines. A breakout that occurs before the halfway point is not a full breakout. A breakout that occurs after the end of the triangle is meaningless because the pattern has ended.

Breakout Point – The point where the stock makes a significant move in the direction of the trend.

The pattern only completes after the breakout. It is very risky to guess what will happen before that. The trading volume at the breakout is usually higher, at least twice what it was in the middle of the pattern.

There will be instances where the trend will try to return to the triangle's vertex.

When the breakout occurs and it's sharp, it will happen with price gaps.
Note: The base of the triangle is the widest base that forms a symmetrical triangle.

Price Target: There are two ways: (1) Measure the size of the base, and take this size from the breakout point downwards or upwards depending on the direction; (2) Draw a trend line parallel to the trend line and this is the price target. [Chart E].

Chart E:

Flag Pattern

This is a continuation pattern that can occur after an uptrend or downtrend and is typically useful for short-term analysis. Due to its short-term nature, it follows sharp trends, either sharp up or sharp down. In order to identify such a pattern, a clear upward or downward trend of significant size is needed.

Flagpole: This term is used to refer to the point where the trend breaks, meaning a clear rise or fall from the start.
The flag is a horizontal trend, always opposite to the existing trend. If there was an uptrend, the flag will be bearish (downward), and if there was a downtrend, the flag will be bullish (upward).
The ideal time frame for the formation of the pattern is between a week and four weeks.

Typically, a bearish flag indicates a continuation pattern of a downtrend, while a bullish flag indicates a continuation pattern of an uptrend.
Trading volumes will be high in the area of the flagpole. The flagpole points to the last rise before the pattern. At this point, the trading volume is very high and it decreases during the formation of the pattern.
The pattern is complete when its trading range breaks, or the trendline breaks. Wait to confirm the breakout is reliable.

During the breakout, there will be relatively high trading volumes.
Price Target: The length of the flagpole is measured from the breakout point in the direction of the trendline. [Chart F].

Chart F:

Price Gap – A price range that the stock doesn't touch.