Chart Patterns Part 1 of 3: Bullish Reversal Patterns

A large part of reading price involves identifying reoccurring patterns that tend to reflect investor/trader psychology. While spotting and trading patterns is not perfect, it is usually a good way to determine the general strength or weakness in a stocks' movement. Typically all moves in a stock price will reflect a price pattern forming at some point in the trend.

Generally there are 2 types of patterns that we look for depending on the current trend of a stock. The 2 such pattern types are Reversal Patterns and Continuation Patterns. Reversal Patterns can fall into 2 sub-groups depending on the trend they are changing, Bullish Reversals and Bearish Reversals. Continuation patterns tend to move price in the direction that it was currently moving prior to the new pattern forming.

For the sake of keeping your interest and not bombarding you with too much information I am going to break this pattern lesson into 3 parts: Bullish Reversal Patterns, Bearish Reversal Patterns and Continuation patterns. So lets get started looking at some Bullish Reversal Patterns (my personal favorite!).

Bullish Reversal Patterns

Generally speaking there are only a couple major Reversal Patterns that I look for, Inverse Head and Shoulders, and Double Bottoms. There are a few others but they are more rare and I am all about having a simple trading method, so I will just be focusing on the big patterns.

1. Inverse Head and Shoulders

This is a pattern that we are seeing a lot of right now in the markets, it indicates a major shift in trend direction is beginning to take place (steady down trend is going to become an uptrend again). The Head and Shoulders pattern is the strongest and most reliable in technical analysis.

From Investopedia:
1. The price falls to a trough and then rises. 
2. The price falls below the former trough and then rises again. 
3. Finally, the price falls again, but not as far as the second trough. 

Read more: http://www.investopedia.com/terms/i/inverseheadandshoulders.asp#ixzz2LCSNhtcZ

Our first example is from one of our watch list stocks, Mosaic (MOS)

You can see here the 3 peaks and each corresponds with the criteria stated above. What we will need to see for this to confirm is next to see the price break decisively above the resistance line formed by the "arm pits"; the place where any rally attempt has struggled and rolled back over. With a strong Head and Shoulders pattern the "arm pit" peaks should be roughly in the same price area. Once price confirms the pattern and breaks out from the "neckline" resistance, there is a simple way to measure the projected move the stock should make. Simply we measure the price at the lowest peak and price at the "neckline". We take those two prices and subtract them from each other and that gives us our projected measured move target. In the case for our example above the head peak was at $44 and the neckline resistance is at $62.50. We subtract the difference between the two and we get $18.50. We then take the $18.50 pattern size and add it to the neckline resistance giving us ($62.50 + $18.50 = $81.00) Basically if this stock can move above the 62.50 level, our expected gain on this trade would be up to the $81 mark. That's almost a 30% gain from current prices!

Another example of an Inverse Head and Shoulders is seen here in Annie's (BNNY)

Double Bottom
The second Bullish Reversal pattern we like to look for is a Double Bottom. A Double Bottom is formed when a stock makes two successive lows to the same price support and then clears above the peak in between the lows. The price should form a W like formation; once price clears the "peak" resistance, the pattern has triggered. Another thing I like to see in a Double Bottom formation is for momentum to be showing strength vs price (this can be seen with a momentum indicator such as MACD or RSI). We want to see price make two successive lows while momentum shows a low and a higher low. This indicates that strength is building under the surface.

Here is a look at another one of our watch list stocks Ford (F)

Ford looks to have put in a Double Bottom pattern on this longer time frame. We are looking at a weekly bar chart here. $12.90 seems to be the resistance level for this double bottom, so as long as price can hold above that level, I think this one is in play right here. Momentum is also confirming the Double Bottom, shown here by the MACD. While price tested the $9.00 area twice, the MACD set a higher low, indicating more strength the second time the 9.00 level was tested.

The projected move of this Double Bottom is measured the same way the Head and Shoulders pattern is; take the price of the lows, subtract it from the peak level and add the difference to the breakout level. So looking at Ford here this pattern should have a target of:
$12.90 - $8.90 = $4.00 move.
Target: $16.90

Double Bottoms are not as prevalent as Inverse Head and Shoulders, but they do have a pretty strong track record of successfully fulfilling their price objectives.

Basically what we are trying to do with reversal patterns is identify a shift in direction of a stock that has fallen from previously high levels. It's usually a bad idea to go diving into a stock that has consistently been falling (known as catching a falling knife), but using simple, proven price patterns can give us a much better indication that we are seeing a bottom and price is nearing a reversal of trend.

Next time we will cover the concept of Bearish Reversal patterns:
The Head and Shoulders Top and Double Top formations.