Continuation Versus Reversal Patterns

Some patterns traced out by prices during a trend suggest that the trend direction that has been ongoing may be coming to an end. Seeing these patterns, for the most part, does not always depend on a trendline break. Any price or volume formation of this type is generally described as a reversal pattern. I have already described the bull and bear trap reversals which is a new low or high in a price swing, immediately followed by a strong countertrend move. However, these patterns can be seen only after they have formed. While bull and bear trap reversals do suggest a possibly strong initial move in the opposite direction from the prior trend, they otherwise have no predictive value as they are not patterns that set up before a trend reversal has already taken place.

Reversal Pattern Types
The price reversal patterns that tend to be seen before, or in the forefront of, a trend reversal include:

• double and triple tops or bottoms
• W bottoms or M tops
• V tops or bottoms
• rounding tops and rounding bottoms
• the head and shoulders pattern
• some rectangles
• wedges
• some triangles
• broadening tops or bottoms, which are traced out over an extended period
• breakaway and exhaustion gaps

The previously mentioned patterns are formed over a few or many sessions, but some reversal patterns are established after only one to two periods (e.g., hourly, daily, weekly) such as in a key upside or key downside reversal. Sometimes a price spike, where the high or low is noticeably above or below the close, warns of a trend reversal. As seen already in the discussion of candlestick charts, certain single candlesticks are anticipated to mark a trend reversal (e.g., the hanging man or hammer).

There are also situations where a volume pattern warns of a trend reversal as was described in the instance where prices surge and volume slackens or where the on balance volume (OBV) indicator line starts moving counter to the direction of prices. However, this type of pattern is better categorized as an instance of a price/indicator divergence.

Sometimes what is thought to be a continuation pattern will turn out to have an opposite aftermath, as a market reversal will occur instead— such an outcome for a continuation (or for a reversal formation also) is considered to be a pattern failure.

The categories of reversal or continuation patterns are useful general guidelines as to the most common types of pattern resolution, relative to the current trend. A resolution of a pattern is the next price move after a pattern has formed. We need also keep in mind the failure possibility. As with any risk control strategy, we should guard against the unexpected or the unusual. While chart patterns are very helpful as guidelines for trading strategies, the best rule always is to not get complacent and to recognize that any given pattern may fail to have any special significance on a particular occasion or will lead to an opposite outcome than expected. The patterns that we use in technical analysis mark some change in what is going on with an index, a stock, or other financial instrument—sometimes, the subsequent change is not a move in the direction anticipated.
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