Technical analysts may look at patterns in price to determine whether a trend will continue or if a reversal in trend is possible. On a chart, a technical analyst will watch how price behaves at specific levels and as price approaches these specific levels, technical analysts watch for signals to see what price will do next.
Retracements, consolidation and continuation are all possible. The trader will use patterns to determine which next direction is most probable. The two patterns that are most recognizable for retracements are tops and bottoms.
A top is created when price creates a higher high followed by a higher high and then a lower high. A bottom, is created when price creates a low, followed by a lower low, then a higher low.
Market tops and bottoms can be the first signals that a market is reversing. Both tops and bottoms can be formed over various lengths of time, some take a few days to form and some will take weeks or even months to form. Tops and bottoms, while simple formations, happen in real-time difficult to predict until the pattern has completed and the market has moved on, requiring other pieces of information to confirm the patterns in real-time.
Traders may use these indications to form decisions about trades or look for more complex patterns like head and shoulders, double tops, double bottoms and triple tops and bottoms. These patterns are signals that a market might reverse direction in the future.
Traders look to identify a head and shoulders pattern in a bullish trend. The first part of the pattern is when the market makes a high, then pulls back forming the first shoulder. Price will then rise again to form a higher high, then pull back, this is the head. The other shoulder will form when price retraces and makes another high around the same level as the original high. A neckline is formed by an imaginary horizontal line extending from the low formed after the initial shoulder and the low formed after the head. The reversal signal is usually when price breaks through the neckline and begins to push lower.
Inverse head and shoulders are possible in a down trending market, but not as common.
Double tops and bottoms are just like they sound. The market makes two consecutive tops at around the same price level. The theory is since on the second attempt to break out the market could not make a higher high and retraced forming the second top, it may have run out of momentum and will begin to push down.
Double bottoms form in much the same way. In this pattern the market makes a low, retraces and then tries to make another low. The market cannot push down below the original low and reverses its move back up.
Triple tops and bottoms form the same way as double tops and bottoms; however it takes one more attempt at making a high or low before the pattern is confirmed.
Like any technical analysis, pattern confirmation is needed on the signal. Typically, on double and triple tops and bottoms, the confirmation signal is breaking below the low formed between the highs or above the high made between the lows on a bottom signal.
Single tops can become double tops and double tops can become triple tops. Traders should remember that patterns are only indications and not absolute rules as to what the market will do next.
Most reversal patterns are usually strengthened when volume is seen to be increasing as the pattern is being completed. For example, as this triple top is being confirmed with price moving below the lows created by the tops, volume can be seen increasing further adding strength to the chart pattern.
As with all technical analysis tools, they can be used in isolation or combined with other tools to strengthen your trading assumption.