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Task №3 part 1. Wave analysis. Elliott wave principle

The lesson is devoted to the main principles of recognizing the patterns which emerge on the price charts. Currency rates are constantly changing and those changes are not linear by nature. An increase if often followed by a sharp decline and vice versa. It means, first of all, that supply and demand on an asset are unstable as they change greatly due to a number of factors.

The goal of every market participant is to make profit from buying or selling an asset. The forecasts of further price movements play an important part in this endeavor. Pattern analysis aims to describe all possible outcomes on the market in order to help make the right projections for the future movements. After years of monitoring the price dynamic on the market, forex experts were able to point out a number of typical graphical images, which are also known as patterns of technical analysis. The shape of those patterns can give market participants a hint about the dominating trend at a certain time.

Traditional technical analysis distinguishes between two types of graphical patterns. The first type is called the reversal patterns, and they act as a signal for the trend to change. The second type represents continuation patterns which indicate no changes in the dominating trend.

Trend reversal patterns

The most important task of every trader is to determine the prevailing trend correctly. Besides, it is crucial to take into account the signals of trend confirmation and trend reversal. Actually, it is not very easy to recognize a certain pattern on a chart. Every trader may have a different impression from the current price dynamic. Chart patterns do not always have a distinct shape and price movements can be interpreted in different ways. However, there are a number of patterns which are more likely to predict the beginning of a trend reversal.

First of all, let us touch upon the reversal patterns.
Before we start analyzing each type of reversal patterns in detail, here are several basic rules which apply to any of them.

  1. A reversal pattern occurs following a distinguished prior trend.
  2. Breaking of a major trend line is usually the first signal to indicate the approaching trend reversal.
  3. The bigger the pattern is, the more significant the movement in the market is.
  4. Top patterns are shorter in time and more inconsistent than the bottom patterns.
  5. Bottom patterns are characterized by a narrow trading range but it takes more time for them to form.
Head and Shoulders

The Head and Shoulders pattern is considered to be the most reliable chart formation. It has three peaks, which are called the left shoulder, the head, and the right shoulder. The pattern is called Head and Shoulders for its resemblance to these parts of the human body. The head is always formed by a higher peak than both of the shoulders; otherwise, it is not that chart formation.  A notable feature about this chart pattern is that it can be formed both in an uptrend and in a downtrend. In an uptrend, every new high and low is located higher than the previous high and low. When a price reaches a new high, there is a small pullback followed by one more high. However, the retracement does not allow forming a new low at a higher level, and as a result, the price falls to the prior low. That is how the neckline is formed. After the left shoulder has appeared on the chart, the next upward and downward movement produces the head. The next upturn and downturn in the price movement form the right shoulder. Besides, the last price upward movement builds the neckline. The neckline can represent either support or resistance level depending on the market situation. When the price breaks through the neckline, the trend is changing to the opposite direction.

Let us have a look at the example when the reversal takes place at the market top. At the Point A, the uptrend continues to evolve. The price reached a fresh high and the trade volume increased. Everything is just as it should be. Then the price pulled back to the lower levels (Point B). Meanwhile, an experienced analyst should spot lower trading activity at Point C as the price broke out above the A level compared to the trading activity witnessed during previous upturn. The fact itself is not of major importance but it is a sign for the trader to watch out for the further movement. Soon after, the price started to decline to the Point D, and then something crucial happened. During the next market upturn, the price did not reach the level of the previous peak at the Point A.
Remember that in an uptrend, every prior peak acts as a support level for the intermediary pullbacks, but it did not take place in our case. The price declined below the Point A and almost reached the level of the previous pullback at Point B.

The example of Head and Shoulders Top. The left and the right shoulders (Points A and E) are located around the same levels. The head (Point C) is higher than both shoulders. The pattern is formed when the price closes below the neckline (Line 2). The neckline is plotted from Point B (the first pullback of the formation) through the Point D, the second pullback. The minimum price target of the breakout is the distance between the head and the neckline extended down from the breakout point of the neckline. When prices go up the next time, they may pull up to the neckline but fail to break through it.

USD/JPY weekly chart. Head and Shoulders Top. The formation consists of three peaks with the head located higher than the two shoulders. The price had broken the major uptrend line before the right shoulder appeared on the chart. You can also see that the price is directed towards the neckline levels after the trend reversal took place.

Inverse Head and Shoulders

Head and Shoulders Bottom, or Inverse Head and Shoulders, is the opposite to the abovementioned Head and Shoulders Top pattern.
As you can see in the picture, the present pattern is formed with three distinct lows and the head is lower than any of the shoulders. When the price closes above the neckline, the pattern is considered complete. The price targets are determined by the same principles as the standard Head and Shoulders pattern, but keep in mind that the price is more likely to pull back to the neckline after a bullish breakout at the market bottom than at the market top.

Example of Inverse Head and Shoulders. The pattern is opposite to Head and Shoulders Top. In this case, the neckline is drawn from the Point B, which is the first peak of the chart formation, through the Point D. It is more likely that the price pulls back to the neckline after the breakout in a bottom pattern than in a top pattern.

The thing is that the market can fall by inertia. The lack of demand and buying interest is enough to push the market down. However, it is impossible to make it move upwardly out of inertia. Prices will rise if demand exceeds supply and buyers are more active and pushing than sellers.

In the Head and Shoulders Bottom, the price growth from the peak of the head should be accompanied by an increase in trading activity. However, it is often offset by the trade volume during the previous price upturn from the left shoulder point. The decline to the right shoulder entails a considerable decrease in trade volume. The crucial moment is when the price action breaks the neckline. At this point, the market activity is booming if the breakout is not false. Here lies a huge difference between the top and inverse patterns.

For the inverse pattern, the trade volume is very important on completion.

The reversal of the price movement is more typical for the bottom pattern and should be followed by a small trade volume. However, with the renewed uptrend, the volume must inevitably increase.

GBP/USD weekly chart. The example of the Head and Shoulders Bottom pattern. The left shoulder was formed in September, and the right Shoulder was formed in December next year. The head appeared on the chart in April and represented the lower peak. Late March, the price broke above the neckline which existed over a year. In this manner, the main bullish signal for the market emerged.

It is important to wait until the price breaks the neckline in order to enter into a position in both top and bottom patterns. As soon as this either support or resistance level is broken, the pattern becomes complete. When the price breaks through the neckline, completing the formation of the pattern, it should not retreat back to the neckline. In case of the market top pattern, when the price breaks below the support level, any following close above the neckline indicates clearly that the first break was false. This is an example of the failed Head and Shoulders pattern. At the beginning of its formation, this pattern looks exactly like the reversal pattern. However, at some stage of its development, before or after the neckline is broken, the price movement continues to follow the previous trend.

Triple Top and Triple Bottom

Other reversal patterns have the same attributes as the abovementioned graphs. The Triple Top and Triple Bottom patterns are less usual than Head and Shoulders, but they have a lot in common. The distinctive feature of the Triple Top or Triple Bottom patterns is that all three peaks or lows are located around the same level.
There are a lot of arguments among technical analysts about how to differentiate between Head and Shoulders and Triple Top.

When Triple Top occurs, the trade volume usually decreases with every sequential peak and the breakout of the support level should be followed by higher volume. The pattern is completed when the price falls through the support levels of the two prior troughs. Likewise, in the Triple Bottom pattern, the price has to close above the resistance level of the earlier peaks to make the pattern complete. Alternatively, when the price breaks through the previous high or low, it can be considered a reversal signal. Extremely important factor for the formation to complete is the increasing volume of trading.

Triple Top. The pattern resembles Head and Shoulders except for the fact that all three peaks appear at the same level. The next peak is followed by a declining trade volume. The formation is completed as soon as the price breaks below the levels of both troughs while the trade volume rises.

A reversal pattern Triple Top. Please have a look at three peaks formed in June. Pay attention that when the support level is broken, it turns into the resistance level.

The Triple Bottom pattern is similar to inverse Head and Shoulders, but all three troughs occur at the same level. It represents the opposite pattern of Triple Top. The trade volume is a more important confirmation factor at the time of the breakout.

Double Top and Double Bottom

This reversal pattern appears more frequently than the previous one. It is the second most common and easily recognized formation after the Head and Shoulders pattern. The Double Top resembles the letter “M” while the Double Bottom looks like the letter “W”.
By the way, they are often referred to by the name of the letters.
General attributes of the Double Top pattern coincide with those of the Head and Shoulders and the Triple Top, but with only two peaks found in this formation.
In case of the Double Top pattern, trade volume changes the same way we have already described. The formation becomes complete similarly to the abovementioned patterns.

Example of Double Top. The present pattern has two peaks (Points A and C in the Figure), both of them are seen around the same level. The formation completes when the price moves below the level of the previous trough in Point B which is located somewhere in the middle between the two peaks. As a rule, the second peak in Point C is accompanied with a lower trade volume. In the breakout point D the volume increases. During the further movement, the price can pull back to the bottom line but does not break it.

Example of Double Top. Pay attention that the highs are located near the same level on the chart. Actually, the peaks can occur on slightly different levels as ideal patterns are rarely formed on charts. When the closing price fell below 136.35, the pattern was complete. The support level turned into the resistance level after the breakout, confirming the pattern and presenting a strong signal to open short positions on the currency pair.

Example of Double Bottom. The present pattern is the opposite of Double Top. Nevertheless, just as with other patterns, the volume of trading has a major importance when the price breaks out to the higher levels. The price is more likely to pull back to the breakout point at the market bottom.

Example of Double Bottom. Have a look at two troughs which are clearly seen on the chart. When the price closed above the neckline, the pattern was formed and the reversal to the upside took place. The pullback confirmed that the resistance level transformed into the support level, therefore, giving a strong signal for opening long positions.

As we have already mentioned, these graphs represent variations of the Head and Shoulders pattern that is why a trader can apply the same trading strategy. It is necessary to enter into a long or short position as soon as the price breaks the neckline, or in other words, when the pattern is completed. If the price pulled back to test the neckline and then rebounded, it is a strong confirmation signal which indicates the entry point.
Now let us elaborate on the concept of the price target which we have introduced during the lesson.
The point is that the market is believed to reach a certain price level once the formations are plotted.

The present method is based on the height of the pattern. Let’s measure the distance from the peak of the head to the neckline. Then you should extend the distance down below the breakout point. Suppose that the head is located at 100 with the neckline at 80. The difference between these two marks equals to 20. Now subtract 20 points from the breakout price and you will find the minimum expected price move to the downside, which is 60. The method is common for all abovementioned patterns. Sometimes, for Double Top it is recommended to calculate the price target by subtracting only half of the height.

V-patterns, or Spikes.

The last type of the reversal patterns we are going to talk about is V-patterns, or Spikes. A peculiar feature about these patterns is that they are most difficult to recognize at the moment of formation but quite common. Actually, V-tops and V-bottoms, which are also called Spikes, are not easily spotted because they are far from being traditional graphs. All reversal patterns that we have described earlier reflect gradual changes in trend dynamic. For some time the price moves along a horizontal channel. During this transition period, a trader can study the dynamic of the market and make some forecasts for the future or try to find some hints in the past or present movements. That is how all reversal patterns are formed except for the V-patterns. They have nothing to do with gradual changes in price action. The trend reversal happens sharply and often without any indication. Following the reversal, the price accelerates in the opposite direction. In fact, V-patterns can hardly be called patterns at all, because a trader can spot them only in retrospective. What should an investor do then? How can traders foresee these patterns and recognize them on the stage of formation in order to decide on the right trading strategy? First of all, let us look at V-top pattern more closely.

In the first place, we deal with the existing trend. Mostly, the V-pattern reversal is preceded by an excessive market growth. Meanwhile, the ongoing trend does not have intermediate corrections or if there are any, they are insignificant. Usually, a few gaps may occur in the price movement. It looks as if there is a turmoil in the market.
An experienced trader knows that he should be watchful in this moment.
V-patterns, or Spikes, are usually preceded by a steep trend line.
Sometimes, the only signal indicating the reversal is the breakout of an extremely steep trend line. The following sharp in the price movement decline occurs in a short period of time and corresponds to one third or a half of the preceding uptrend.
One of the reasons for the price movement to change suddenly its direction is the lack of support and resistance levels in the previous trend. V-patterns can be formed at both market top and market bottom. However, they are more common to take place at the top of the market.

V-pattern at the market top

V-pattern at the market bottom

We have discussed the most common reversal patterns such as the Head and Shoulders, Double Top and Bottom, Triple Top and Bottom, and V-pattern, or Spikes.
These patterns indicate that the current price trend is about to move in the opposite direction. That is why they are called reversal patterns. There is another major type of patterns which are basically short-term and point to a consolidation period.  They are called continuation patterns. We are going to cover them in the second part of the task.

Questions for revision
  1. Find and mark the Head and Shoulders pattern on the chart, specify the time frame and the currency pair. In addition, point out the meaningful price levels in this pattern. For example, the head at 1.2530, the neckline at 1.2400, and so on. Send a chart screenshot.
  2. When the Double Top is considered complete? When does a signal appear for entering a position?
  3. Suppose that the highest peak in the Triple Top is located at 1.8050 and the price broke the neckline at 1.7990. Determine the price target.
  4. Why does the price suddenly pull back when a Spike takes place?

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