Key Reversals

These occur when the price initially moves in the direction of the galloping trend presently in force, however the critical point comes when the force underlying the trend shows weakness, exhaustion.

The market recognizing that critical juncture then unleashes overwhelming counter forces so that prices now retrace; by the end of the day prices are lower than the opening price, usually close to the low of the day and accompanied by unusually massive volume.

Key reversal weeks can sometimes be recognized and are particularly potent signals. The same characteristics are true in reverse for bear markets.

Island Reversals

An island reversal is a variable period, usually of short duration, days to a few weeks, of trading over a very tight price range.

This area of compact trading is separated from previous trading by an exhaustion gap and at its termination is removed from the ensuing trading by a breakaway gap.

It is an isolated pattern of trading, an island of consolidation, invariably associated with a trend reversal but not necessarily so.

So await confirmation of the reversal before committing your resources. Such islands of consolidation often make up the top (or bottom) of a head and shoulder formation (or inverse head and shoulder formation).

Obviously if an exhaustion is recognized as having occurred, liquidate your position, conserving your profits to that level at least: whether you take a new counter position depends on other technical factors pertaining at that time, i.e. to liquidate at the termination of a trend is not necessarily a time to invest in the reversal of that trend.

Head and Shoulder Formations

These formations occur at market tops and inverse head and shoulder formations at bottoms. They frequently tell of the reversal of the trend.

Occasionally they fail; their very failure foretells of continuation of the trend but usually on a structurally less sound foundation.

To avoid being fooled by the market and the price chart pay particular attention to the associated volume. It must have the following volume characteristics. The development of the left shoulder should be accompanied by the heaviest volume, diminish on its completion and then expand again on development of the head.

This second surge of volume is usually less than that during the development of the left shoulder. Volume then contracts and this decreased volume should persist throughout the development of the right shoulder and then expand as an increase of selling make itself evident on collapse of the right shoulder and downside violation of the neckline.

This represents the selling of hopes unrealized when prices failed to reach their previous high.

The professional money has completed distribution to the herd.

Similar volume characteristics accompany the inverse head and shoulders formation of bear market bottoms.

Heavy volume on the development of the left shoulder and head, declining volume on development of the right shoulder with an increase of volume on the breakout above the neckline.

When prices failed to reach the previous low, observant investors take up early accumulative positions, willingly buying from fleeing, uninformed, disillusioned weak holders.

For the purpose of predicting price moves following the reversal of the trend it is customary to draw a line connecting the bottoms of the two shoulders—the neckline.

Then the vertical distance from the apex of the head to the neckline represents the minimum reversal to be anticipated from the neckline.

Obviously the further the head is from the neckline the larger the corrective price change to be expected. Head and shoulder patterns can be recognized with necklines at any angle not just in the horizontal plane.

They can develop in weeks, months or years. The longer they take to develop the longer the ensuing reverse trend will likely last.

Failure of Head and Shoulder Formations

Occasionally a head and shoulders formation unfolds but prices either fail to penetrate the neckline or do so only momentarily.

When this happens the previous main trend resumes, usually in an explosive manner.

However, the market structure at this point is invariably weak and the trend continuation, though energetic at the outset, is usually short lived.

A short time later, as technical forces finally win out, the trend terminates and reverses

Horizontal Triangles

Triangles are amongst the most difficult patterns to interpret and are regularly used as indicators by practitioners of the Elliot Wave System.

All triangle patterns denote imminent change.

The difficulty has been to predict if the change would be in favor of or contrary to, the main trend from whence they developed.

By careful study of when and where, in the cyclical development of stock movements they develop, Ellioticians claim that they can be 90% successful at predicting the direction of price patterns on resolution of the triangle.

Horizontal triangles are triangles of corrective stock market behaviour of the trend and they resolve in favor of continuation of the underlying trend of the stock.

They usually develop as the penultimate wave of the main trend, i.e. in wave four of the five waves that go to make up the complete wave structure of the main trend. They are indicative of continuation of the main trend to come. They also occur as B waves in corrective waves.

Diagonal triangles are far less frequent and occur as the fifth and final wave of a complete five-wave structure to terminate the main trend. They predict certain reversal ahead, more of diagonal triangles later.

Therefore, to avoid the dilemma of triangle interpretation it is desirable to have a working knowledge of Elliott Wave Theory so that triangles once recognized can be identified as to where in trend analysis they occur.

So armed one can not only predict that change is imminent but the direction of that change. The four different formations of horizontal triangles are illustrated. It is readily recognizable that if the main trend is correctly identified and the triangle formations correctly placed in the pattern of price movements, then the triangle resolves by continuation of the main trend.

The horizontal triangle is a protracted wave of sideways price movement reflecting a conflict between buyers and sellers and is associated with overall and progressive reduction of volume.

On resolution of the conflict the main trend is resumed with a sudden energy and greatly increased volume. Prices usually move at least the distance of the widest part of the triangle, i.e. the base.

Multiple Tops and Bottoms

Multiple tops and commonest of these reversal formations is the double top and double bottom; however, triple, quadruple, or multiple patterns may occur.

They are invariably patterns of distribution (at market tops) or accumulation (at market bottoms).

Necklines are similarly drawn on charts, for measuring and predictive purposes, as for head and shoulder formations. These patterns have characteristic volume activity associated with them and must be observed to have predictive value for trend reversal.

Volume should be high on development of the first top, reduced on the second top and expanded on the break down of the second top.

Similarly with double bottoms. Volume on emergence from the double bottom may well be explosive as a surge of accumulation comes forward to welcome the end of the bear trend and its reversal.

In these double or multiple formations the ensuing tops (bottoms) are not always at exactly the price level of the first apex, they may exceed or fall short of it a little but they are valid signs of trend reversal.

Saucers and Inverse Saucers

Saucers are a characteristic market bottom formation and inverse saucers are a market top formation. Both are reliable reversal patterns.

A saucer traces out a saucer shaped pattern or ellipse through daily lows on price bar charts. Associated volume will give a similarly shaped silhouette with volume being at its lowest at the price bottom.

Volume slowly expands on development of rising prices leading into an explosive exponential pattern as early accumulation gives way to more widespread accumulation of the stock.

Inverse saucers are charted by connecting the highs on the price bar charts. The inverse saucer formation of a market top has similar volume characteristics with volume being lowest at the apex and increasing as the right hand curve develops leading to massive selling as the price cascades from the previous high.

Saucers and inverse saucers represent a gradual termination of a trend, an area of consolidation of supply and demand, and the emergence of a reversal of trend.

As the realization of the change in trend becomes apparent to increasing numbers of investors the price and volume of the new trend gather momentum.

The new trend is likely to remain in force in direct relation to the duration of the previous trend, i.e. if the previous trend was of long duration, the new trend will likely be enduring with periods of consolidation occurring at previous resistance levels which will now act as support levels.

Saucers and inverse saucers may take weeks, months or even years to develop. Recognition is worthwhile as they are reliable and offer not only directional information but often substantial price movements as the new trend expands.

Pennants, Flags and Wedges

Pennants look like pennants, flags look like flags and wedges look like wedges. Each are short lived periods of correction and consolidation of well established trends. Pennants and flags usually last from days to a few weeks so they are often seen on daily price charts, seldom on weekly charts and virtually never on monthly ones.

Wedges are longer lasting periods of consolidation usually lasting from weeks to several months so are recognizable on daily and weekly price charts and even monthly charts on occasion.

Usually volume dries up during the formation of these patterns of price consolidation, particularly with flag formations.

In terms of their development, significance and prognostic value they are to be considered similarly. They are invariably brief, midpoint interruptions of the main trend.

Wedges look like triangles with the apex of the triangle pointing counter current to the main trend, i.e. in bull markets the wedge is made by connecting a series of lower highs and a series of lower lows of daily prices and vice versa in a bear market.

Wedges can give the appearance of rallies against the trend and can appear as trend reversals, but they are not, they are periods of correction and consolidation during the relentless progress of the main trend, so beware.

They are invariably associated with overall and progressive reduction of volume.

On completion the volume expands rapidly, often explosively, and prices may progress rapidly, sometimes creating gaps on the breakout.

It is essential that you study the volume accompanying these patterns of correction and consolidation.

They should show distinctly lower volume on their development, almost drying up as they approach their termination.

If volume is unchanged or increases as these patterns develop beware, you may well be observing a period of major distribution prior to a reversal of the trend

Rectangles

A rectangle is a period of consolidation lasting two to three weeks or longer, during which price fluctuation is 5% or less.

A rectangle is associated with decreased volume.

The conflict between buyers and sellers finally resolves with a price breakout on increased volume.

Usually the breakout is in favour of the main underlying trend.

However this is not as often as correct as the other continuation patterns we have discussed.