Reversal patterns are invaluable in identifying an imminent trend reversal in the charts. Here are a few common introductory points for all reversal patterns:First, for any reversal to take place there should be a prior trend. For head and shoulder pattern, the existing trend would be an up trend. On the other hand, for inverse head and shoulders, the prior trend would be a downtrend.
Reversal patterns need to be confirmed by penetration of key trend-lines. Jumping to conclusions regarding a trend reversal prior to the penetration of a trend line can lead to disastrous consequences.
Note that topping patterns are shorter in duration and more volatile when compared to bottoming patterns. Another significant confirming aspect in the completion of all price patterns is that volume should increase in the direction of the market trend and is a significant confirming aspect in the completion of all price patterns. Price patterns also have measuring techniques to conclude minimum price objective.
One of the most commonly used reversal patterns is the head and shoulders pattern. The head and shoulders pattern has three consecutive peaks with the middle peak being the highest (head) and the two exterior peaks being lower than the middle peak (shoulders) and approximately equal. The troughs of each peak when connected is known as a neckline.
Volume plays a vital role in confirming the pattern. The advance of the left shoulder and the decline of the right shoulder should have higher volume than the advance of the head. The pattern completes its formation when the neckline is broken with increase on the volume.
If we take a close look at the chart of Bank Nifty we can find a Complex Head and Shoulders Pattern. The formation of the pattern began in late October 2007 when the index formed its left shoulders. The head was formed in January 2008. Later on, the index found support at the neckline at 8650 level and bounced off forming right shoulders. In late February, the index conclusively broke through its neckline.
Typically after break through, a return move back to the neckline is quite probable.. However, in this case it did not occur. The breach of the neck line was accompanied by a spurt in volumes as is required. As for measuring techniques, in this case, the top of the head is approximately at 10600 and the neckline is at 8650. The vertical distance from the neckline to the top of the pattern is 1950. This 1950 would be measured downward from the neckline (8650-1950=6700), giving us the price objective at 6700. The index reached this target in mid March.
The Bank Nifty formed a long-term Head and Shoulders pattern, spanning almost an year between June 2007 and June 2008.
The index broke through the neckline in early June, made a return move back to the neckline and than then continued to decline. But as the pattern is very large and the time period is also long, achieving the price objective can take more than a year.