With markets touching new peaks, interest in guessing the next move of the indices and individual stocks is running high. Will an index ,or a stock, continue its current trend? Or will it reverse?
Technical analysis could come in handy here, where chart patterns can help us identify the next move.
Chart patterns signal traders that the price of a security or stock is likely to move in one direction or another when the pattern is complete. Thus, charts can be studied to formulate trading strategies. There are two types of chart patterns — reversal and continuation patterns— of which we will discuss the former in detail here.
Head and Shoulders: One of the most commonly noticed and reliable reversal patterns is the head and shoulders pattern. As the name suggests, the pattern looks like a head with two shoulders.
It is a bearish or top-reversal pattern that occurs at a peak, or after a prolonged uptrend.
When formed, it signals that the security/stock price is likely to move against the previous trend.
The construction of the head and shoulders chart pattern involves four main parts — a head, two shoulders and a neckline. The pattern is confirmed when the neckline — a level of support — is decisively broken downwards when the formation of the second shoulder is complete.
The left shoulder is the first step in the formation and is shaped when the stock price reaches a new high and retraces to form a base that is a support level. The next step is the formation of the head — this happens when the stock price records a higher high and then retraces back almost near to the support formed by the left shoulder.
The third step in the formation of the pattern is the creation of the right shoulder, which is formed with a high almost equal to the left shoulder but is lower than the high formed in the head.
This again retraces back to the low of the left shoulder, that is, the base or support formed almost in the same level. The support level is known as the neckline.
A clear break below the neckline will be complete the pattern, and a minor pull-back or throwback move to the neckline is possible sometimes before the downmove resumes.
The move occurs when the stock price breaks below the neckline and touches a new low below it, followed by a retreat back to the neckline before resumption of the downtrend. The pull-back move helps fortify the pattern.
Large volume accompanied by breakout of the neckline is important to complete the pattern.
Finally, the pattern price target is calculated based on the measurement of the pattern height, which is from the neckline to the head.
Being a bearish reversal pattern, the stock has potential to decline maximum to the calculated height.
Double Top: In this pattern, the security/stock price reaches a high price two consecutive times with a reasonable decline between the two highs, or tops. It roughly resembles an ‘M’ shape.
The pattern is confirmed once the stock price slumps below the neckline or support level that is equal to the low between the two prior highs.
Similar to the head and shoulders pattern, the breakthrough of the support line in this pattern should occur with an increase in volume.
The pattern price target, which is the distance from the support line to the peak, or top, can be subtracted from the support line for a downward price target.
Notably, bigger the formation of the pattern, larger the potential decline.
For instance, following a long-term uptrend, the stock of Maruti Suzuki recorded a first high at around ₹9,900 in December 2017 and a second high at around the same level in July 2018. The stock formed a double top pattern with a neckline at ₹8,250, and breached it downwards in September 2018. The downward breakthrough reversed the major trend in the stock in September 2018, and it had been on a long-term downtrend from then on, until it bottomed out in March 2020.
Rising Wedge: This bearish reversal pattern starts with a wide formation from the top to the first bottom and contracts, or compresses, as the security/stock price moves higher and the trading movement narrows. The pattern has a clear upward slope and a bearish reversal or bias. It is formed over 3-6 months; the subsequent reversal can be a medium-term one.
As the stock moves higher, it should at least form two reaction highs to form the upper resistance and at least two lows to form the lower support line. Both the upper resistance and the lower support line should be higher than the respective previous high and low. During contraction, the rallies are unconvincing and fail to keep pace with the support line. The confirmation of the pattern occurs when the price convincingly declines below the support line.
Volume will diminish as the price pattern increases, and the break-down of the support line with good volumes confirms the pattern.
Here is a classic example of a rising wedge pattern that occurred in the Nifty 50 index chart before the sharp fall in February and March 2020. On the weekly chart of the Nifty 50, the rising wedge pattern is evident between August 2019 and January 2020. The pattern conclusively breached the support line in late February 2020 and the index plunged sharply thereafter, reversing the prior uptrend.
Bullish reversal patterns
Inverted Head and Shoulders: This is the exact opposite of the head and shoulders pattern. It indicates that the security/stock is ready to trend upwards. The pattern occurs at the bottom of a prolonged downtrend. After the completion of the pattern, the stock starts to move higher.
Similar to the bearish head and shoulders pattern, the stock again follows the four steps, but in the opposite direction. First, the formation of the left shoulder happens when the stock price declines to a new low and then rallies to a high to the resistance level. Thereafter, the stock price once again declines and records a new low below the left shoulder, and bounces back to the neckline to the formation of the head. The formation of the right shoulder is the third step.
Finally, the breakthrough of the inverse head and shoulders pattern will complete the pattern and the subsequent pull-back to the neckline will confirm the pattern.
In this pattern, too, volume plays a crucial role.
On the weekly chart of the BSE stock, the inverse head and shoulders pattern is evident between August 2019 and December 2020 with the neckline at around ₹570.
The bullish reversal pattern ended the downtrend that had started from the July 2017 high of ₹1,178. During the formation, an increase in weekly volume supported the pattern formation.
The stock decisively broke out of the neckline of ₹570 in the first week of December 2020 by gaining 7 per cent, accompanied by extraordinary volume. Also, it witnessed a subsequent pull-back to the neckline and continued to trend upwards in late December. The pattern price target is ₹840 over the long term, which is approximately calculated based on the distance between the neckline and the head.
Double Bottom: This pattern is the opposite chart pattern of the double top as it indicates a reversal of the downtrend to an uptrend, and roughly resembles a ‘W’ shape. It occurs at the end of a downtrend.
Often, text books present ideal chart patterns, but in reality, the patterns don’t always look as perfect.
In double tops and double bottoms, the price on the second test does not always essentially reach the same length as the first test.
For instance, following a sharp fall in early 2020, the stock of Equitas Holdings found support at around ₹36 in March and formed the first bottom. A resistance line at ₹60 limited the upside and the stock recorded the second low at around ₹40, slightly higher than the first bottom. The conclusive breakthrough of the resistance at ₹60 with extraordinary volume in late November completed the pattern, and the subsequent pull-back to the neckline happened in December. Thereafter, the stock resumed the uptrend and is now near the price target of ₹85.
Falling Wedge: This is the opposite of the rising wedge and is a bullish pattern that indicates that the stock price is expected to break upwards of the pattern to form an uptrend.
(All charts illustrated here are sourced from TradingView. )