Introduction
Technical analysis is the practice of interpreting prices, volume and other trading data, with the goal of forecasting future price movements. Essentially, it relies on the premise that past price action tends to repeat itself in predictable ways.
As a fundamental trader, I would never recommend that someone place a trade based purely on price action. However, technical patterns are very useful way of interpreting the momentum in the market. (For more on the benefits and limitations of using technical analysis, read this article).
One of the key ways that traders use technical analysis to predict prices is by identifying patterns that signal possible reversals or continuations of market trends.
[Looking for valuable coffee market insights? Sign up for a free trial of our Premium Coffee Market Reports and get the information you need to succeed]
While there is legitimate debate about the effectiveness of technical analysis, it has proven itself to be an important tool for physical traders, specs, and producers and consumers of commodities.
In this article, we will examine 5 of the most common chart reversal patterns and how to trade them.
Reversal Patterns
Reversal patterns are chart formations that signal a potential change in the direction of a price trend. They occur when a prevailing trend—that can be either upward or downward—loses momentum and is likely to reverse.
The official way of trading many technical analysis patterns is to identify the pattern components, the breakout point, the price target and stop loss point.
Pattern components: These are the key identifying parts of a technical analysis pattern, such as support and resistance levels or trendlines. Identifying them helps traders recognize which pattern they are dealing with, and where the other key components are.
Breakout point: This is the price level at which the commodity's price breaks out of the established pattern, and shift into a new trend direction.
Price target: This is the projected price level that traders target after a breakout occurs, based on the size or other characteristics of the identified pattern. This serves as a minimum goal for taking profits.
[Get insider knowledge on the coffee market with our Premium Coffee Market Reports. Subscribe now for industry insights]
Stop loss point: This is the price level where a trader will exit a position to minimize losses if the trade moves against them. It is typically set on the outset of the pattern components to limit risk in the case that the pattern is invalid.
With these definitions out of the way, lets look at the 5 patterns.
Head and Shoulders
Pattern Components: Two shoulders, a higher middle peak (head), and a neckline connecting the troughs between them.
Breakout Point: Trend reversal is confirmed when the price breaks below the neckline (or above in the inverse pattern).
Price Target: Measure the height from the head to the neckline and subtract it from the neckline's breakout point.
Stop-Loss Point: Typically placed just above the second shoulder to manage risk.
The head and shoulders pattern is probably the most popular reversal pattern due to its reliability and easily recognized shape.
The pattern itself consists of three main components: two shoulders, a head, and a neckline. The middle peak (the head) is higher than the two side peaks (the shoulders). The neckline connects the lowest points of the two troughs that form between the head and the shoulders, representing a key psychological support level.
When the price breaks below the neckline after forming the second shoulder, it is considered a strong signal of a trend reversal.
[Looking for valuable coffee market insights? Sign up for a free trial of our Premium Coffee Market Reports and get the information you need to succeed.]
Volume can also assist in confirming the pattern. As the price rises to form the first shoulder, volume typically increases, followed by a decrease in volume as the head forms. The final shoulder is often accompanied by significantly lower volume, indicating weakening buyer interest.
A substantial spike in volume when the neckline is broken adds further confirmation that the trend reversal is legitimate.
In addition to the traditional head and shoulders pattern which denotes a trend shift from bullish to bearish, this pattern can also be inverted, which indicates a reversal from a bearish trend to a bullish one. The structure remains the same, but this time, the price breaks upward through the neckline, signaling the start of a bullish trend.
Double Top and Double Bottom
Pattern Components: two peaks at the same level separated by a trough.
Breakout Point: price breaks below the trough.
Price Target: Measure the distance from the peaks (or troughs) to the support (or resistance) and project that distance from the breakout point.
Stop-Loss Point: Typically placed above the second peak for double top, or below the second trough for double bottom, to manage risk.
The double top is another highly useful reversal pattern.
This pattern consists of two peaks at approximately the same level, separated by a trough. The pattern is considered complete when the price breaks below the support level formed by the trough. The double top indicates that buyers are losing strength, and the price is likely to fall.
The logic with this pattern is that the double top illustrates a loss of momentum by the traders.
After a rally, bulls find a resistance point and fail in both their first and second attempts to break through that resistance. When prices fall below previous support from the trough, the bears are able to take control.
Like the head and shoulders pattern, confidence in the double top is confirmed by volume.
When the price rises to form the first peak, volume tends to increase, and as it approaches the second peak, volume falls, signaling the diminishing buying momentum. This pattern can be confirmed with an increase in volume as the price breaks below the support line.
[Ready to up your coffee game? Sign up for a free trial of our Premium Coffee Market Reports and gain a competitive edge in the market!]
The inverse of this pattern is also valid. The double bottom is a bullish reversal pattern that occurs after a downtrend.
Triple Top and Triple Bottom
Pattern Components: Three peaks at approximately the same level, separated by two troughs.
Breakout Point: The pattern is confirmed when the price breaks below the support level formed by the troughs.
Price Target: Measure the height from the peaks to the troughs and subtract it from the breakout point.
Stop-Loss Point: Typically placed above the third peak to manage risk.
The triple top pattern builds on the logic of the double top, but instead of two peaks, it (as the name suggests) involves three. This pattern tends to form over a longer period and signals that buyers are repeatedly failing to push prices higher, making it an even more robust indicator of a bearish reversal than its predecessor.
Like the double top, it is considered complete once the price breaks below the support level formed by the troughs between the peaks. This is also how the trader can distinguish both patterns, since there should be no previous break of the troughs before the third top can form itself.
The psychology behind this pattern is straightforward: after multiple attempts to push the price higher have failed, the number of buyers is diminished, and selling pressure eventually outweighs buying interest.
This pattern is more ambiguous than the double top though. While a triple top can be considered to have more resistance than a double top, it also indicates that the bulls have more resilience and are continuing to push.
For this reason its essential to wait for the breakout to confirm direction.
Rounded Bottom (Saucer Bottom)
Pattern Components: A long-term, gradual concave price formation indicating a shift from bearish to bullish.
Breakout Point: Occurs when the price breaks above the resistance level formed by the initial high of the pattern.
Price Target: Measure the depth of the saucer and add it to the breakout point to estimate the target.
Stop-Loss Point: Typically placed just below the lowest point of the rounded bottom for risk management.
[Don't rely on guesswork when it comes to the coffee market. Sign up for our Premium Coffee Market Reports and make data-driven decisions]
Next, we have the rounded bottom, also known as the saucer bottom. This is a long-term reversal pattern that indicates a gradual shift from a bearish to a bullish trend. Unlike the sharp reversals seen in head and shoulders or double tops, the rounded bottom is characterized by a slow, concave price formation that resembles a saucer.
Unlike other patterns, the rounded bottom typically takes months or even years to form, making it more useful for understanding long-term price changes.
It starts with a gradual decline in price, followed by a consolidation period where the price moves sideways, and finally, a slow increase as buying interest returns. The breakout point occurs when the price breaks above the resistance level formed by the initial high of the pattern.
Just as the other patterns we have previously seen here, one key characteristic of the rounded bottom is the volume profile.
During the initial decline, volume tends to decrease as sellers lose interest. As the pattern progresses, so does volume, picking up slowly to signal growing buyer interest. A breakout accompanied by a significant increase in volume is a strong confirmation of the trend reversal.
The rounded bottom is often seen in stocks that have been out of favor for an extended period but are slowly regaining interest, which might be due to improving fundamentals or changing market conditions.
Expanding Triangle
Pattern Components: Increasing price swings between two diverging trendlines, with rising volatility.
Breakout Point: The pattern is confirmed when the price breaks decisively out of the triangle, either upward or downward.
Price Target: The target is typically set based on the widest point of the triangle added to the breakout point.
Stop-Loss Point: Strategically placed below recent lows (for bullish setups) or above recent highs (for bearish setups) to manage risk.
Finally, we come to the expanding triangle.
Sometimes called the megaphone pattern, this is a unique reversal formation characterized by increasing price swings between two diverging trendlines. It is part of the family of the triangle patterns, which contains many of the most used strategies in technical analysis, such as the horizontal triangles.
[Level up your coffee business with our Premium Coffee Market Reports. Sign up for a free trial and discover a world of market opportunities]
As the name suggests, the price moves in a widening pattern, with each subsequent high and low further apart than the previous one, with one of its main components being the rising volatility. The expanding triangle can form at the top of an uptrend, signaling a bearish reversal, or at the bottom of a downtrend, indicating a bullish reversal. The pattern is complete once the price breaks decisively out of the triangle.
Although very versatile, the expanding triangle can be difficult to trade due to its volatile nature. The increasing price swings make it challenging to determine precise entry and exit points, and traders who abuse leverage can easily get liquidated during the expansion process. For that reason, it's important to use stop-losses in strategic positions.
Conclusion
Technical analysis is not a science, but rather an art.
In other words, it is a skill about interpreting the collective psychology of the market.
For those of us in the commodity world, whether as specs, physical traders, consumers or producers, understanding market psychology is essential. This is because the market can deviate strongly from objective measures of value at any given time.
As fundamental traders, we believe that ultimately the market will come back to the value as denoted by supply and demand, but only “eventually”. However, technical analysis will help us to understand momentum and trends that take place before that “eventually”.
For traders, reversal patterns are a great tool to find trading opportunities. They provide criteria that helps traders to see when the trend is over and it's time to exit, or when a trend that seems like it will last forever has actually lost its strength.
Of course, none of these patterns are foolproof and we would never recommend that anyone trade solely on these patterns. However, if you believe a trend is about to reverse or are looking for a warning sign that a trend is fading, technical analysis reversal patterns are going to be the one of your most valuable tools in your trading toolkit.
[Don't navigate the coffee market blindly. Get access to our Premium Coffee Market Reports and make informed decisions for long-term success.]
Comments