Answering the Question: Will the Trend Reverse?

11/28/2008 12:01 am EST

Focus: STRATEGIES

S. Wade Hansen

Co-Founder, Profiting with Forex (PFX) and Learning Markets

As you learned in the Continuation Patterns lesson, road trips are some of our favorite vacations. You jump in the car, head out on the open highway, and soak in all of the scenery that you miss when you fly somewhere. Unfortunately, every road trip has to come to an end at some point, and you have to turn around and drive back home. Sometimes you turn straight around and head back immediately, but sometimes you delay heading home for just a little bit as you cruise around a little longer. But either way, you end up turning around.

Stocks turn around and end their road trips too. They run into support or resistance levels, and eventually turn around and start moving back in the opposite direction. Sometimes they turn around immediately, and sometimes they test the support or resistance level in front of them a few times before finally giving up and turning around. Regardless, they eventually end up turning around.

If the stock you are watching really is at the end of its road trip and is ready to turn around and head home, a reversal pattern will most likely form while the stock price consolidates. Reversal patterns, as you will see in the video on Reversal Price Patterns, tell you that the stock is going to turn around and reverse its previous trend after it breaks out of the reversal pattern.

 Reversal patterns, like all price patterns, are made of the following four pieces:

  1. Old trend - the trend that the stock price is in as it starts to form the price pattern
  2. Consolidation zone - a constrained area defined by set support and resistance levels
  3. Breakout point - the point at which the stock price breaks out of the consolidation zone
  4. New trend - a reversal of the old trend that the stock price enters as it comes out of the consolidation zone

Reversal patterns form in a few different shapes, but for the most part, they look quite similar. The only real difference you will see is in the shape of the consolidation zone. The consolidation zones of some reversal patterns have a single level of support and single level of resistance, while others have multiple levels of support and multiple levels of resistance. Every other aspect of the price pattern is identical.

The following are the most common reversal patterns you will see during an uptrend:

  1. Double tops
  2. Triple tops
  3. Head-and-shoulder tops

Double tops form during an uptrend as the up-trending stock price hits the same resistance level twice in the consolidation zone.

Triple tops form during an uptrend as the up-trending stock price hits the same resistance level three times in the consolidation zone.

Head-and-shoulder tops form during an uptrend as the up-trending stock price hits a lower resistance level, then hits a higher resistance level, and then hits the lower resistance level a second time in the consolidation zone.

 The following are the most common reversal patterns you will see during a downtrend:

  1. Double bottoms
  2. Triple bottoms
  3. Head-and-shoulder bottoms

Double bottoms form during a downtrend as the down-trending stock price hits the same support level twice in the consolidation zone.

Triple bottoms form during a downtrend as the down-trending stock price hits the same support level three times in the consolidation zone.

Head-and-shoulder bottoms form during a downtrend as the down-trending stock price hits a higher support level, then hits a lower support level and then hits the higher support level a second time in the consolidation zone.

By S. Wade Hansen of PFXGlobal.com and LearningMarkets.com

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