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How to trade reversal chart patterns

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Forex trading
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Lesson 5

The reversal patterns are technical chart patterns that are widely used by traders to employ price action analyses on the forex and crypto markets. These patterns are formed based on past historical data and often signal a potential reversal in the price.

While many different types of reversal patterns can be identified, some are known for their consistency in showing a reversal to the trend.

The reversal patterns, when they appear, can signal a reversal to the previous trend. This could either be a correction of the price trend or could mean a potential change in the trend. Analysing pure chart patterns keeps your forex and crypto charts clean of any indicators and helps you understand the evolving price action.

The reversal patterns are formed merely as a result of the market buying and selling activity because activity near the top end of the rally or near the bottom end of a downtrend typically follows familiar patterns.

Buying activity is exhausted at the top or selling activity is exhausted at the bottom. This leads to technical patterns that are known to signal a reversal.

Double Top Pattern

The double top pattern is a strong reversal pattern that comes after a bullish trend. Here, price tends to post a fresh high before posting a modest decline. Following this decline, price once again attempts to rise only to post a high near the previously established high.

This creates a double top pattern as resistance is formed. A downside move is formed, which eventually leads to a breakout from the previously formed low. Upon a successful breakout to the downside, price action continues to push lower.

Double Top Chart Pattern

Typically, the downside target is set to the same distance as the previously formed low is to the double top reversal.

Notably, the double top patterns can be made either using the closing prices or the high and low. However, with enough practice, traders can be flexible enough to use either of the two prices when determining the double top pattern.

Double Bottom Pattern

The double bottom pattern is the opposite of double top and is usually formed after a strong decline in price. In this case, price initially declines to form a low and then posts a strong rebound to form a local high. Following this high, price action then declines but only to stall near the previously formed low.

This second low marks the double bottom pattern. A reversal off the double bottom leads to prices rising sharply and breaking out to the upside, above the previously formed high.

The upside target is based on the same distance as the previous high and the double bottom low, which is projected from the breakout level.

Double Bottom Chart Pattern

The above AUDUSD chart shows a double bottom pattern. We used closing prices and the line chart to make it easier to understand. Following the strong previous decline, price action falls to the same level, creating a double bottom pattern.

Upon a successful breakout from the short-term high, the distance from the double bottom to the high is measured and projected to the upside. After price breaks out from this short term high, the reversal leading to price reaches the objective.

The stop loss for a double bottom can be the recent pivot low or high prior to the breakout, but this is subjective as the stop loss will be based on the perceived risk/reward level.

Head and shoulders pattern

The head and shoulders pattern is one of the most famous and widely used reversal chart patterns in technical analysis. The head and shoulders pattern is formed after a strong rally. This pattern can be formed in any time frame and is easily distinguishable.

As the name suggests, the head and shoulders pattern is made up of right and left “shoulders”, which are lower highs. The “head” forms a higher high, and the common factor to these three highs is the neckline support from which prices bounce back and forth.

When the head and shoulders pattern is formed, price action is expected to post a reversal on a breakdown from the neckline support level. A successful breakout off this level will see prices moving the same distance as from the head to the neckline support.

In some cases, you can see prices retracing to the neckline support to establish resistance before declining further. However, it is up to the trader to either wait for this retest or go short on a breakdown of the neckline support level.

Head and shoulders pattern

The above chart shows the head and shoulders pattern with a slightly inclined neckline support. This detail is important because a head and shoulders pattern doesn’t always form with a horizontal neckline support level. As you can see, price posts the left shoulder, which is a lower high compared to the head.

Following the decline to the neckline support, the right shoulder is formed with a lower high as well. Upon a breakdown from the neckline support, price action falls the projected distance, which is the same distance from the head to the neckline support level.

Traders can set the stop loss level to the right shoulder’s high or the nearest pivot high based on the assumed risk/reward level.

Inverse head and shoulders pattern

The inverse head and shoulders pattern, as the name suggests, is the opposite of the head and shoulders pattern. It indicates a bullish reversal and is formed by left and right “shoulders” and a “head”. The head often forms the lowest low compared to the left and right shoulders.

The neckline resistance forms the key part here as a breakout off the neckline resistance could signal a bullish move to the upside. The distance from the head’s low to the neckline resistance level is projected on a breakout from the neckline resistance level.

Prices can reverse to test the breached resistance level to establish support, but this is not always the case.

Inverse head and shoulders pattern

In the above example, the inverse head and shoulders pattern formed after a strong stretch of declines. Following the left shoulder, the head and the right shoulder, price action breaks out from the neckline resistance level; the same distance from the head to the neckline resistance level is projected as the upside target.

For stop loss, traders can use the right shoulder’s low or the local pivot low.

By analysing price action, traders can benefit as the chart patterns can signal a potential reversal to the trend and open positions accordingly. That the reversal patterns can appear in any time frame suggests they can be used by both swing traders and short-term day traders.

The best way to take advantage of the reversal patterns is to practice and pay attention to the market context, such as the fundamentals.

The reversal patterns can be successfully used when trading forex and cryptocurrencies. The main aspect that will determine your success in using the reversal patterns is experience and familiarity with the markets. Building market context also helps.