Reversal Pattern

The phrase « reversal patterns » is very commonly used but most people do not really understand it. Therefore, it needs explaining. Many stakeholders think that it means that a downtrend is going to change into an uptrend after news is issued or after a technical signal.

What actually happens is that such an event is often going to stop the trend momentarily and create a zone of uncertainty which has three possible outcomes:

• the current trend is going to come back

• the trend is going to reverse itself

• the uncertainty is going to go on and give rise to a trading range

This is true for current affairs, western technical analysis (double top, double bottom, shoulder-head-shoulder…) and for Japanese candlesticks analysis.

In spite of all this, studying reversal patterns remains critical in trading since positions are often taken after them. There are zones of uncertainty without apparent order that are difficult to classify and thus difficult to study and use. On the other hand, there also are patterns that resume regularly and whose chances of success are interesting enough to cause positions to be taken. The most well-known are the Hammer, the Hanging Man, the Engulfings and the various Stars.

What must be understood is that trading with reversal patterns is not the same as counter-trend trading, because reversal patterns are often not used well. A primary trend is composed of waves called secondary trends, which in turn are composed of waves called tertiary trends. Reversal patterns will occur on every level, primary, secondary and tertiary. The most interesting way to use reversal patterns is to draw on them to enter an upper trend.

Let’s take the example of the following prices evolution: a primary uptrend composed of secondary uptrends and secondary downward corrections (see chart below).

On this chart, it is obvious that reversal patterns are well-adapted to trading along with the trend. The blue arrows were excellent entry points that occurred after a reversal pattern. In comparison, the orange arrows were far less interesting since they meant an entry against the primary trend.

To be able to follow the various levels of a trend, primary, secondary and tertiary, it is interesting to study the prices evolution on different time scales; this is called time-scaling. The same asset is studied on the long run (day, H4) in order to identify primary trends, on the medium run (H1, M30) for secondary trends and on the short run for tertiary trends (M10, M5). These time units are given for information only and must be adapted to the studied market and the trading style, but the principle remains true for long-term investments as well as for very short-term scalping.