Trend Trading Report Part Nine - Trend Reversal Patterns

In this Part of the Trend Trading Report we'll cover two common trend reversal patterns. They are:

1. Wedge
2. Head and Shoulders

I introduced you to these patterns in Part Six of this Report. I'll go into more detail here.

There are three phases to note when it comes to trend following patterns. They are:

1.    The candle sticks that form the trend leading to the pattern. They may be trending upward or downward.

2.    The pattern formed by the candle sticks

3.    The candle sticks that form the trend upon exiting the pattern.

Wedge

Below is am image with a rising wedge and a falling wedge.

In the case of a rising wedge, the pattern begins with an upward trend. The pattern is wide at the left and narrows as the price moves higher with the trading range narrowing. In contrast, the falling wedge begins with a downward trend. This pattern is also wide at the left and narrows as the price action moves lower with  the trading range narrowing. The remainder of this discussion will focus on the rising wedge. It should be relatively easy for the reader to understand what is happening with the falling wedge. 

The wedge can be one of the most difficult chart patterns to accurately recognize and trade. The reason is that the price point continues to move in the original trend direction. In the case of a rising wedge the trend continues to move upward with higher highs and higher lows. In the case of a falling wedge, the trend continues downward with a series of lower highs and lower lows.

How do you trade a wedge? Looking at the rising wedge image above you'll see an entry point, a stop loss point, and a target profit level below the rising wedge. In the case of the falling wedge, the target profit level is above the wedge. In both cases the tendency is for a reversal of the original trend.

Conditions required for a wedge pattern include the following:

1.    There must be a trend in existence leading up to the wedge.

2.    The upper resistance line must touch the price action at least twice, preferably three times

3.    The lower support line must touch the price action at least twice, preferably three times.

4.    Volume should be expected to decline as prices rise and the wedge takes shape. Once the price action breaks from within the wedge pattern, the volume should be expected to increase.

Head and Shoulders

The head and shoulders pattern is one of the easier patterns to recognize once the Trader is aware of it and is looking for it. Below is an image of the head and shoulders pattern and the inverse head and shoulders pattern.

The head and shoulders pattern appears at a top in the price action. Looking at the image above, you'll see the left shoulder where the upward trend formed a peak followed by a decline in the price. When the price rises again, it forms a higher peak referred to as the head. After a price decline from the head, the price once again moves upward forming a new peak that is lower than the peak formed by the head. The formation of the head and shoulders pattern is never as perfect as the image shown above. With a little practice the Trader will be able to filter out the noise in the price action around the head and shoulders pattern.

The inverse head and shoulders pattern (see image above on the right) is formed at the bottom in the price action. The left shoulder appears in a V shape when the price moves downward and then moving higher. The upside down head is formed when the price declines to a lower level. After the price rises from the head, the price once again moves downward forming a new peak that is higher than the peak formed by the head. Once again the inverse head and shoulders pattern is never as perfect as the image shown above.

Looking at the images above, you'll see a line designated as the neckline. In the case of the head and shoulders pattern (see image above on the left), the neckline is drawn with a straight line that connects the low after the left shoulder with the low created after the head. In the case of the inverse head and shoulders pattern, the neckline is a straight line that connects the high after the left shoulder with the high created after the head.

The pattern is never confirmed until the pattern is complete.

The correct way to trade this pattern is to wait for a breakout to occur. With the standard head and shoulders pattern, the breakout will be to the downside.

Stop loss settings for the standard head and shoulder pattern should be placed just above the right shoulder or just above the head.

The profit target is calculated by subtracting the low point of either shoulder from the peak price at the head. Subtract this number from the breakout entry price to get the profit target.

Summary

Both of the chart patterns shown above are trend reversal patterns. That means that the majority of the time, the trend approaching the pattern is in the opposite direction from the trend exiting the pattern.

End of Part Nine

Part Ten of this report will be released in about one week. The topic is “Developing Your Own Trend Trading System". This will be the last report of this ten-part series. I hope you've found it to be beneficial.