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What are Reversal Patterns?

Reversal patterns reveal that an ongoing trend is about to change direction. If a reversal chart pattern forms after an uptrend, it hints at a slump. When a reversal chart pattern is seen after a downtrend, it suggests that a potential uptrend will take place soon.

Can you name some common reversal patterns? In this lesson, we will talk about three bullish reversal patterns—morning star, wedge, and triple bottom.

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Identify and Trade with a Reversal Pattern

1. Morning star pattern

Formation

A morning star pattern is a combination of three candles with a U-shape.

The first candle is a large bearish candle at the bottom of a downtrend.

The second one is a small bullish/bearish candle.

The last one is a large bullish candle.

Trading Strategies

• Entry: Once the formation of morning star is completed, traders can enter at the opening of the next candle. They may enter at $156.34, like in the example below.
• Stop loss: Investors can place a stop loss below the second candle in the morning star pattern, which is $149.42 in this case.
• Take profit: A take-profit order can be set at the previous resistance level or consolidation area. Here, traders tend to take profit at $168.34.

2. Falling Wedge

Formation

A falling wedge pattern is a bullish chart pattern. It is comprised of two converging declining trendlines which are drawn by connecting the respective highs and lows during a period of time.

In the previous lesson, we learned about pennant patterns, which are similar to falling wedge patterns. The main difference between wedges and pennant patterns is that pennants are horizontal, while the falling wedges are descending.

Trading Strategies

• Entry: Swing traders opt to open a long position if the price passes above the upper trendline of a falling wedge. The entry point is $50.61 in the following example.
• Stop loss: Investors can place a stop-loss order as the price of the swing low closest to the breakout.
• Take profit: An expected profit target can be the height of the wedge at its thickest and then adding the breakout. In the case below, the height of the wedge is $12.91 ($61.23 minus $48.32). Trades may set the take-profit price as $63.52 (the profit of $12.91 adds a breakout of $50.61).

3. Triple Bottom

Formation

A triple bottom pattern is formed when the stock price makes three consecutive similar lows in a downtrend.

This pattern displays a battle between buyers and sellers in which the sellers are exhausted, and the buyers take over to reverse the trend. Compared to a double bottom, a triple bottom shows a stronger power of buyers, which makes it more reliable.

Trading Strategies

• Entry: Traders buy when the price breaks out from the resistance level or the neckline. The entry point is $54.41 in the following example.
• Stop loss: The stop loss can be placed at the third bottom of the pattern, which is at $52.37 in the case below.
• Take profit: The price target can be equal to the distance between the neckline and the deepest bottoms. As the picture shows, the distance between the second bottom and the breakout is $3.95, which can be translated to a take-profit point of around $58.36 ($54.41 adds $3.95) on the upside.

The Bottom Line

With the help of these patterns, investors can be alerted to the current situation and even profit in a potential reversal. Even still, patterns are not always perfect. When trading, don't always rely on charts, patterns or general strategies. You should make proper adjustments based on your own risk-ward ratio, objectives, and risk tolerance. Tap here to try your trading strategy in paper trading>>>

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