Author: shyam

Cover via Amazon

This is a review of the fifth chapter of John J. Murphy’s Technical Analysis of the Financial Markets.

Major Reversal Patterns

The 5 most commonly used reversal patterns are:

1. Head & Shoulders
2. Triple Tops & Bottoms
3. Double Tops & Bottoms
4. Spike (or V) Tops & Bottoms
5. Rounding (or Saucer)

Things to keep in mind while looking at reversal patterns:

1. A prior trend should exist (the market should have something to reverse)
2. The first sign of impending reversal is the breaking of a trendline
3. The larger the pattern, the greater the impending move
4. Topping patterns are usually steeper and more volatile than bottoms
5. Bottoms have smaller price ranges and take longer to build
6. Volume is more important on the upside

We will examine each of the 5 patterns above in subsequent posts.

Last part of the review of the 4th chapter of John J. Murphy’s Technical Analysis of the Financial Markets.

Reversal Days

A reversal day happens either at the top of an uptrend (top reversal day) or at the bottom of a downtrend (bottom reversal day). A top reversal day is the setting of an intraday high for the uptrend followed by a close below the previous day’s close. A bottom reversal day is the setting of an intraday low for the downtrend followed by a close above the previous day’s close. The wider the intraday range, the higher the probability of a near term trend reversal.

A reversal pattern can form on monthly and weekly charts and usually bears greater significance compared a reversal day.

Price Gaps

Price gaps are areas in the chart where no trading has taken place. There are three types of gaps:

1. Breakaway: the penetration of a resistance level usually occurs through a Breakaway Gap and signifies a major move. It occurs on heavy volume and upside gaps usually act as support levels. Its important that prices do not fall below these gaps during an uptrend.
2. Runaway: formed after a trend is in play for a while (usually the halfway point), these are prices leaping upward on moderate volume. If these gaps are filled, then its usually a sign of weakness.
3. Exhaustion: as the name suggests, it usually occurs at the end of a trend. After the identification of both the Breakaway and Runaway gaps, one should start expecting the Exhaustion gap. The filling of this gap during an uptrend is a bearish signal.

The Island Reversal Pattern

Sometimes, after an upward exhaustion gap, prices trade within a narrow range before gapping to the downside. This leaves the few days of price action looking like an “island” and indicates a trend reversal that needs to be confirmed with the overall trend structure.

Up Next: Chapter 5: Reversal Patterns

Continuation of the review of the 4th chapter of John J. Murphy’s Technical Analysis of the Financial Markets (prev.)

The Fan Principle

Sometimes, after an uptrend breaks down, prices will go down a bit before rallying up to the bottom of the old up trendline (now a resistance). A 2nd & 3rd trendine can now be drawn. If the 3rd trendline doesn’t hold, it shows that prices are headed much lower.

Most important up trendlines usually have a slope of about 45^*. If the trendline is too steep, then it usually indicates that the prices are rising too rapidly and may not sustain; too flat, then it should not be trusted.

Sometimes, based on prices movements, trendlines need to be redrawn. Here’s an example of a steep uptrend becoming a flatter one:

Trendlines are drawn and redrawn based on both the market as well as the trader’s time horizon.

Here, you have the major trend (1), a bunch of medium-term trends (2, 3, 4) and a short term trend (5).

The important thing to note is that in all of these cases, there is always retracement. These countertrend moves typically happen in either 50%, 1/3rd and 2/3rd moves before it goes back to following the trend. If you are looking for a buying area under the market, you can compute a 33-50% zone under the chart and use it a reference for putting on longs.

Note that if the prior trend has to be maintained, the correction must stop at 2/3rd (66%). If the prices move beyond this point, then the chances of a trend reversal are higher.

Speedlines

Speedlines measure the rate of ascent or descent of a trend (its speed). These lines act as support during market corrections. To construct a speedline for an uptrend:

1. Find the highest point in the uptrend
2. From the highest point, drop a vertical line to the bottom of the chart from where the trend began
3. Divide the vertical line into thirds and draw a line from the beginning of the trend through these points.

Speedlines need to be redrawn every time a new high (during an uptrend) or a new low (during a downtrend) is set. And these might go right through the price action.

Up Next: Reversals and Price Gaps