There are two major ways to trade the financial markets: swing trading and trend following. Swing traders use technical analysis to look for short-term price movement and capture gains in a relative short-term period. They look for the price patterns that hint for a reversal, in order that they can pick the tops and bottoms of the trend. Trend followers pay attention to the general direction of the price movement and enter trades by following the current direction. They would look for continuation patterns on the price charts to predict the future direction of the trend, or exit the trade until the reversal patterns appear.
The following articles discussed the rules for identifying reversal patterns and continuation patterns, and introduced some well-known reversal and continuation patterns. The reversal patterns include: Head and Shoulders, Double Tops and Bottoms, Triple Tops and Bottoms and Saucers. The continuation patterns include Triangles (Ascending, Descending, Symmetrical and Broadening), Flags and Pennants, Wedges and Rectangles.
The patterns exhibit the psychology and momentum of the market. No matter which type of traders you are, it is always helpful to be aware of the patterns. Using the patterns is not a stand-alone method of trading the market, in fact, it is better to be used with a mix of trend lines and technical indicators. Beginners might first find it difficult to identify the patterns; they can familiarise the patterns by looking at the historical charts and try to identify the patterns.
Rules for identifying Reversal Patterns
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.