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In part one we discussed the basics of reversal bars. To recap: Most reversal bars/patterns occur on significantly wider than normal price ranges with opens and closes near the extreme of the bars and on significantly higher than normal volume when viewed in the context of the recent past. In general, the wider the price spread and higher the volume, the more reliable the signal. The best signals generally occur after prolonged trends and the pattern extremes are often tested.
In practical terms there is a significant degree of overlap between the patterns. The key is to understand that the patterns represent an overt change in the balance between supply and demand. Importantly, very few patterns set up as they would in textbooks or in my examples, but the principles are consistent. Understanding why they occur and developing your analysis and trading judgement around them is a key skill. In this regard, there is no substitute for staring at thousands of bar and candle charts.
Reversal bars are common chart features. To be meaningful, they should occur at or near the culmination of a long trend (in the perspective you are trading or one higher), and are more reliable when traded in the context of overbought or oversold markets, mature trends, and other technical event confluences. A long trend on the hourly chart may not be visible on the daily or weekly chart, but will likely be important in the context of trades being developed on the 30-, 15-, and 5-minute charts.
It is also worth noting that many of the patterns have candlestick chart analogs that are worth exploring.
Multiple Bar Reversals:
Hook Reversal: The weakest of the reversal patterns is the common hook reversal. The first bar opens near a low extreme and closes near the high extreme. Bar two opens near the bar one close, may or may not make a slight new high, and then closes near the low extreme of the two-bar range. The wider the two bars are, the stronger the signal. If the bars are wide enough, they become a pipe reversal (see below). Generally, the volume on the first bar will be lower than the volume on the second bar and the volume overall will not be remarkable. I particularly like this pattern when the first day’s bar closes beyond a significant resistance or support, and the second day reverses to close back within the support/resistance boundary. In some cases, the hook reversal may be classed as an upthrust or a spring which we will cover in coming parts.
Key Reversal: In a bearish key reversal the market OPENS above the prior close, often leaving a gap, sets a new high, and then closes the day lower than the prior days close. The pattern becomes stronger if the two days comprising the pattern are wide range days (spikes) or if the spike on the reversal day is extreme. The lower in the day’s range the bar closes and the higher the volume the more compelling the reversal.
Outside Key Reversal: Adds a significant degree of reliability. This pattern opens higher, often leaving a gap, moves to a new high and reverses, not only closing below the prior close but completely overlapping the range of the prior bar. The pattern becomes stronger if the two days comprising the pattern are wide range days (spikes) or if the spike on the reversal day is extreme. The lower in the day’s range the bar closes and the higher the volume, the more compelling the reversal.
Pipe reversals, like many other traditional patterns, have become less common, but are still important features. Bulkowski in his excellent “Encyclopedia of Chart Patterns” makes the point that pipes are more compelling when they show up on the weekly chart, but in my experience that is true of all reversal patterns (the higher the perspective the more reliable the pattern). The pattern consists of two adjacent upward/downward price spikes into fresh territory with only small relative differences between the bar extremes. The bars should be wide-ranging and should easily stand out from the rest of the trend. There is usually a trend acceleration associated with the pattern. In some cases, there will be a small range bar separating the two wide range bars (the pipes). I am particularly interested when this small range bar generates well above average volume.
In future pieces we will cover springs/upthrusts, buying and selling climaxes, tests and the importance of inside bars.
Stewart Taylor, CMT
Chartered Market Technician
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.