Pattern Cycles: Reversals

No chart pattern better illustrates this slow evolution from bull market to bear decline than the Descending Triangle. Within this simple structure, the trader examines how life drains slowly from a dynamic uptrend. Variations of this destructive formation precede more breakdowns than any other reversal. And they can be found doing their dirty deeds in all time frames and all markets. 

But why does it work with such deadly accuracy? Most traders don't understand how or why patterns predict outcomes. Some even believe these important tools rely on mysticism or convenient curve fitting. The simple truth is more powerful: congestion patterns reflect the impact of crowd psychology on changes in price and momentum. 

Shock and fear quickly follow the first reversal marking the triangle's major top. But many shareholders remain true believers and expect their profits will return when selling dissipates. They continue to hold as hope slowly replaces better judgement. The selloff then carries further than anticipated and their discomfort increases. Just as pain begins to escalate, the correction suddenly ends and the stock firmly bounces. 

For many longs, this late buying reinforces a dangerous bias that they were right all along. Renewed confidence even prompts some to add to positions. But smarter players have a change of heart and view this new rally as a chance to get out. As they quietly exit, the strong bounce loses momentum and the stock once again turns and fails. Those still riding the issue now watch the low of the first reversal with much apprehension. 

Prior countertrend lows present trading opportunities for those familiar with double bottom behavior. As price descends a second time toward the emotional barrier of the last low, traders step in looking for a good DB play. Price again stabilizes near that prior value, encouraging new investors (with very bad timing) to enter final long positions. 

By this time, the stock's bullish momentum has slowly drained through the criss-cross price swings. Relative strength indicators now signal sharp negative divergences as price continues to hold up through this sideways action. Momentum indicators roll over and Bollinger Bands contract as price range narrows. 

The double bottom appears to hold as a weak rally draws a third high. But this final bounce fades and traders exit quickly. Shorts now smell blood and enter initial positions. Fear increases and stops build just under the double low shelf. Price returns for one final test as negative sentiment expands sharply. Often, price and volatility then contract right at the break point. 

SEEK sketches a perfect Descending Triangle reversal and breakdown following its 1998 rally. Sharp, parabolic rallies often set the stage for dramatic topping formations. Note how the triangle is also a variation of the Adam and Eve pattern.

The bulls must hold this line. However, odds have now shifted firmly against them. Recognizing the imminent breakdown, traders use all upticks to enter new short sales and counter any weak bull response. Finally, the last positive sentiment dies and horizontal support violates, triggering the stops. Price spirals downward in a substantial price decline. 

Stock charts print many unique topping formations. Some classics can be understood and traded with very little effort. But the emotional crowd also generates many undependable patterns as greed slowly evolves into mindless fear. Complex Rising Wedges will defy a technician's best effort at prediction while the odd Diamond pattern burns trading capital swinging randomly back and forth. 

Skilled traders avoid these fruitless positions and only seek profit where the odds strongly favor their play. They first locate a common feature found in most topping reversals: price draws at least one lower high within the broad congestion before violating a major uptrend. This common double top mechanism becomes the focus for their trade entry. From this well-marked signpost, they follow price to a natural breaking point and enter when violated. 

Flip over the Adam and Eve bottom and you'll find a highly predictive structure for trading reversals. This Adam and Eve Top provides traders with frequent high profit short sales opportunities. Enter shorts on the first violation of the reaction low, but use tight stops to avoid turtle reversals. These occur when sharp short covering rallies suddenly erupt right after the gunning of stops below a violation point. 

Each uptrend generates positive sentiment that must be overcome through the topping structure. A&E tops represent an efficient bar structure to accomplish this task. The violent reversal of Adam first awakens fear. The slow dome of Eve absorbs the remaining bull impulse while dissipating the volatility needed to resume a rally. As the dome completes, price moves swiftly to lower levels without substantial resistance. 

Observant traders recognize the mechanics of Descending Triangles and Adam & Eve formations in more complex reversals. The vast majority of tops contain characteristics of these familiar patterns. Crowd enthusiasm must be eliminated for a decline to proceed. Through the repeated failure of price to achieve new highs, buying interest eventually recedes. Then the market can finally drop from its own weight. 

Pattern Cycles: Tops

No trend lasts forever. Inevitably, crowd enthusiasm outpaces a stock's fundamentals and rallies stall. But topping formations do not end uptrends all by themselves. These stopping points may only signal short pauses that lead to higher prices. Then again, they could be long-term highs just before a major breakdown. 

What hidden patterns can you use to identify and trade reversals before your competition sees them? Successful short-term traders get in the reversal door early and allow the herd to trigger sharp price movement. Familiar trend-change formations, such as the Head & Shoulders and Double Tops, take so long to develop that many profitable entries pass before they finally signal an impending break to the waiting crowd. 

First Rise/First Failure offers traders an early method to identify reversals following new highs or lows in any time frame. FR/FF identifies the first 100% retracement of a dynamic trend move within the time frame of interest. In order for any trend to continue, price movement should find support near a 62% retracement, measured from the starting point of the last thrust that pushed price to the new high or low. From this pullback, trend must base and test its extension before it can break out to further continuation highs or lows

Cross-verification rings a loud bell. Note how the uptrend line broke on the same bar as the violation of the 62% fib retracement following this late 1998 AMZN explosion. The familiar triangular shape of First Rise-First Failure makes identification easy when flipping through many price charts.

100% retracement violates the major price direction and terminates the trend it corrects. Completion also provides significant support/resistance, where bounce trades can be initiated with low risk. From this point, continuation trends may reawaken in the next larger time frame by a new break through the 38% (prior 62%) S/R and continued push past the 62% retracement, toward a test of the high/low extension. 

Bounce reversals represent superb entry points when the 100% violation coincides with a 38% or 62% retracement of the next higher dynamic time frame. However risk: reward requires careful measurement, as the trade may develop more slowly than expected. In other words, a successful position must be held through expected congestion at the 38%-62% zone before it can access a profitable retest of the double top/double bottom extreme. 

Allow minor testing violations for all major Fibonacci retracements before taking positions. Specialists and Market Makers know these hidden turning points and conduct stop-gunning exercises to take out volume just beyond the breaks. And watch out for trend relativity errors. Bull and bear markets exist simultaneously through different time frames. Limit FR/FF trades to the time frame for which the retracement occurs unless cross-verification supports other setups. 

Every popular topping formation has its own unique pattern features. But all tell a common tale of crowd disillusionment. Whether printed in the manic highs and lows of the Head & Shoulders or the slow capitulation of the Rising Wedge, the final result remains the same. Price breaks sharply to lower levels while unhappy shareholders unload positions as quickly as they can. 

Early in a rally, value and improving fundamentals attract knowledgeable holders. But as an uptrend develops, the motivation for new participants becomes vastly different. News of a stock's rise generates excitement and attracts a greedier crowd. These momentum players slowly outnumber the value investors and stock movement becomes more volatile. The issue continues upward as this frantic buying crowd feeds on itself well beyond most reasonable price targets. 

Both fire and ice will kill uptrends. As long as the greater fool mechanism holds, each new long allows the previous one to turn a profit. Eventually changing conditions force a final end to the upside action. A shock event can suddenly kill the buying enthusiasm, forcing a sharp and immediate reversal. Or the trend's fuel just runs out as the last interested buyer enters one last position. 

Many traders mistakenly assume bulls turn into bears immediately following a dramatic, high volume reversal. They enter short sales well before the physics of topping and decline rob the crowd of its momentum. In fact, these early shorts provide fuel for the sharp covering rallies seen in most topping formations. 

Skilled traders wait and measure the process of crowd disillusionment before they enter large short sales. Decline characteristics can be predicted with great accuracy using pattern analysis. While they wait, the repeating character of the topping event provides a natural playground for swing positions.