Some Rules for Trading Reversals

There are a few preliminary points considered common to all reversal patterns that you should absolutely know before trying to pick a top or bottom in stock trading, which is difficult enough:

1. A prerequisite for any reversal pattern is the existence of a prior trend.
2. The first signal of a trend reversal is a break in an important trendline.
3 . The larger the pattern, the bigger the subsequent move.
4. Topping patterns are shorter in duration and more volatile than bottoms
5. Bottoms have smaller price ranges and take longer to build
6. Volume is more important on the upside

Existence of a Prior Trend - A prior major trend is the most important prerequisite for a reversal pattern. Of course, if there is not trend, there's nothing to reverse. One of the key elements in pattern recognition is knowing where certain patterns are most likely to show up in a trend structure, as in uptrend or downtrend.

Breaking of Important Trendlines - One of the first signs of trend reversal is the breaking of an important trendline. However, the violation of the trendline may be no more than just a signal of a change in trend. It could be a sideways trend or price pattern later proving to be a reversal or consolidation.

Larger the Pattern, Greater the Potential Larger, in this case, refers to the height and width of the price pattern. Height measures the volatility, and the width measures the time taken to build and complete the pattern. The wider the price swings within the pattern (the measure of volatility) and the longer it takes to build, the more important the pattern and the greater the potential for the ensuing move.

Measuring techniques which measure the height of the pattern or vertical criteria are primarily applied to bar charts. Measuring the horizontal width of a a price pattern, used for point and figure charting, uses a device called a "count" which assumes a close relationship between the width of a top or bottom and the subsequent price target.

Differences Between Tops and Bottoms - There are distinctive differences between tops and bottoms. Tops are shorter in duration, more volatile, and their price swings are wider and more violent. Whereas, bottoms have smaller price ranges and take longer to build, making them easier and less costly to identify. It is also easier to trade bottoms than to catch tops. However, traders can usually make money a lot faster by catching the short side of a bear market because prices tend to decline faster than they go up. It is always a tradeoff between reward and risk. Greater risks capture greater rewards, and vice versa. Topping patterns may be harder to catch, but Day Trading, Swing Trading and Options Trading traders all agree that they are worth the effort.

Volume is More Important on the Upside - Volume is an important factor in confirming the completion of price patterns, and generally, it increases in the direction of market trend. Noticeable volume increases should accompany the completion of a price pattern. Note that in the early stages of trend reversal, volume is not as important at market tops. Although traders like to see an increase in trading activity as prices go down, it's not critical. However, at bottoms a volume pick up is vital. If there's no significant increase in volume during an upside breakout, the whole price pattern should be questioned.

Source : Investing Software