Stock Education (Rich Dad's Education)

Reversal Patterns: Topping Patterns

Reversal Patterns: Topping Patterns

By Tyler Craig

Reversal patterns can be used to indicate a pending reversal in an existing up or downtrend. The quicker we are to spot the beginning of a trend, the sooner we can establish a position in the stock to profit from the trend. Anyone can identify an up or down trend that's been established for six months, but wouldn't it be more lucrative to jump in a trend at its inception? As you become more astute in identifying these patterns, it will be easier to spot and profit from trend reversals.

Reversal patterns can be divided into two camps: topping and bottoming patterns. This month's article will feature topping patterns. Topping patterns consist of double and triple tops, head and shoulders, and slowing momentum. Although this is not a comprehensive list, it contains the most commonly occurring topping patterns. While each pattern is unique, the one commonality that exists between them is that they are all confirmed and completed when the stock breaks below a support level. Consequently, when you identify one of these topping patterns, it may be wise to wait for this breakdown prior to entering into a trade.

HEAD AND SHOULDERS PATTERN:

The head and shoulders pattern forms within the context of an uptrend. Remember, an uptrend consists of higher pivot highs and higher pivot lows. A head and shoulders occurs when the uptrend forms a lower pivot high and then breaks below a support level. This lower pivot high implies that the strength of the uptrend is diminishing, and thus is ripe for a reversal. A head and shoulders pattern is completed and confirmed when the stock breaks support. This break of support is commonly referred to as a break of the neckline. Volume also plays an important role in confirming the head and shoulders pattern. We like to see the breakdown of the neckline accompanied by high volume.

Potential Entries:

Those looking to profit from the anticipated fall that typically follows a head and shoulders pattern have three potential entry points for bearish trades. Aggressive traders will enter on the lower pivot high that forms the right shoulder. These traders are essentially jumping in at the first signs of weaknesses, and although they could be handsomely rewarded for their courage, the drawback is that the pattern has not yet completed itself; therefore, the probability of success is lower. Those seeking more confirmation will enter when the stock breaks below the neckline. And yet a third valid entry point would be entering on the first retracement after the break of the neckline. One of the axioms of technical analysis is that prior support becomes new resistance. Consequently, the neckline first provides support, and then acts as a resistance level.

DOUBLE AND TRIPLE TOPS:

A double top is formed by an uptrending stock retesting a prior resistance level and failing to break through to a higher high. In other words, the uptrending stock forms an equal pivot high. Furthermore, a double top shows that the uptrend is in peril and lacks the momentum to continue forming higher pivot highs. A double top looks similar to the letter "M." An easy way to remember this is that "M" is for murder because a double top kills an uptrend. On the other hand, a triple top is formed by an uptrending stock retesting a prior resistance level twice and failing to break through to a higher high. The psychology behind the pattern is exactly the same as that of the double top; namely, the bulls lack the power to drive the stock higher!

Potential Entries:

Aggressive traders will look to enter at resistance as the equal pivot high forms. This entry is anticipatory in nature because the stock has not yet broken support and completed the double top pattern. Those seeking more confirmation will wait for the stock to breakdown below a support level, and then enter.

SLOWING MOMENTUM:

Momentum is commonly expressed as the distance between pivots. To determine the momentum of an uptrend, analyze the distance between the last several pivot highs. If the distance between the pivots is expanding, the trend is increasing in momentum and has a higher probability of continuing. If the distance between the pivot highs is diminishing, the trend is decreasing in momentum; consequently, the trend has a higher probability of reversing. As with the previous topping patterns, we look for a break of support to confirm the slowing momentum reversal.

Potential Entries:

The two potential entries for the slowing momentum pattern are similar to the entries for the double top pattern. In anticipation of the breakdown and reversal, traders desiring to make a more aggressive entry would enter the trade as the stock is forming a pivot high. Those seeking more confirmation could enter once the stock has broken below a support level.

Terms You Should Know:
Capital Gains: The profit you make on the sale of an investment.

Cash flow: Money that comes in on a regular basis (monthly, quarterly, annually) from an investment that you hold onto and don't sell.
Momentum: Commonly expressed as the distance between pivots. To determine the momentum of an uptrend, analyze the distance between the last several pivot highs. If the distance between the pivots is expanding, the trend is increasing in momentum and has a higher probability of continuing. If the distance between the pivot highs is diminishing, the trend is decreasing in momentum; consequently, the trend has a higher probability of reversing