As Forex prices become exhausted after a rally, they begin to form recognizable patterns. These patterns are referred to as topping patterns, and help traders either take profits after capturing a rally, or short a currency pair to take advantage of downward momentum as a currency pair falls. One of the key elements of each of these patterns is that there is generally heavy volume once the pattern unfolds and the price begins to move lower. You can see these different patterns using the charting software provided by Rakuten Securities Australia. The most popular patterns that are used to determine a top in a market are:
- The Head and Shoulder Reversal Pattern
- Outside Reversal Day
- Bearish Engulfing Pattern
- The Double Top Reversal Pattern
- The Triple Top Reversal Pattern
The Head and Shoulder Reversal Pattern
There are short-term reversal patterns as well as the longer-term pattern that takes time to unfold. The Head and Shoulder Reversal Pattern takes a while to unfold. A Head and Shoulder pattern occurs at the end of an uptrend. You want to make sure that you establish that an uptrend is in place before you determine that a Head and Shoulder Reversal pattern is occurring. As the trend begins to weaken, the left shoulder forms which is considered the peak of the current trend. The left shoulder ends with a retracement of a currency pair which can be seen in the weekly chart of the EUR/USD. The uptrend is still intact, as the market begins to rally to the next stage of the pattern. The EUR/USD makes a new high for the trend, exceeding the peak of the left shoulder, and eventually reaches a new peak, and begins to decline. This is the head of the pattern. The retracement of the currency pair could break through the uptrend, which puts the trend in jeopardy. While the shoulders can be symmetric, occasionally they are off. The currency pair will rally from support forming the right shoulder that has a peak which is lower than the head of the pattern. The right shoulder will form as the currency pair declines to the neckline of the Head and Shoulder pattern. When the exchange rate breaks through the neckline, on strong volume, The Head and Shoulder reversal pattern is complete. Many times the exchange rate will retest the neckline only to fail and continue to trend lower. Volume plays a key role in helping you determine whether the reversal pattern has merit. While it is difficult to determine if there is a significant volume in the OTC currency markets, you can evaluate volume on futures exchanges to see if there has been a high volume day or a low volume day when an exchange rate breaks through the neckline.
Outside Reversal Day
The Outside Reversal Day is a short-term topping pattern that generally occurs at the top of a trend. As an exchange rate moves higher, a reversal can come into effect, when a new high is reached but not confirmed by the close. An Outside Reversal Day happens when the period in question (day, week, month) makes a higher high, as well as a lower low, and closes lower for that period. You can see on the daily chart of the USD/JPY that an Outside Reversal Day was formed at the top of a trend, and then ignited a downturn following the confirmation of a Reversal Day.
Another similar short-term topping pattern is called the Bearish Engulfing Pattern. This is a candlestick pattern that is a short-term reversal pattern. Candlesticks reflect the price action and provide information about the individual candle (or bar) showing where the open is relative to the close. If the close is higher than the open, the candlestick is green. If the open is higher than the close, the candle is generally red. The Bearish Engulfing Pattern consists of two candlesticks. The first is green and the second is red. The size of the first candlestick is unimportant. The second which is a red candlestick should be very long. The longer than red candle, the more bearish the reversal. Similar to an Outside Day, the Bearish Engulfing Pattern must cover the entire green candle. While the engulfing pattern should cover the wicks of the candle (the highs and the lows), it is not necessary. The engulfing pattern occurs following an advance. The second red candle begins to form when buying pressure dries up causing the exchange rate to open below the previous close. On the opening gap lower, seller step in and sell the exchange rate pushing the currency pair down. Further weakness in the subsequent periods is a confirmation of this reversal pattern.
The Double Top
The Double Top is another toping reversal pattern that generally leads to a robust selloff. Prices will generally rise and reach a peak and then correct. After a period of consolidation, prices will attempt to rally and retest the recent highs. After failing to make a higher high, prices will decline. Once the exchange rate of a currency pair pushes through the most recent low following the first top, prices continue to break down to lower levels.
A Triple Top
A Triple Top reversal pattern is very similar to a double top. Instead of breaking down following the second attempt at a higher high, prices go back and retest the peak. Once they fail at those levels, prices fall and take out support levels confirming the Triple Top reversal pattern. The Bottom Line The upshot is that there are several different types of pattern that describe a scenario where prices become exhausted and form a recognizable pattern. Some patterns take a while to unfold such as the Head and Shoulders Reversal Pattern, the Double Top reversal pattern and the Triple Top reversal pattern. The key to each of these patterns is a selloff once support is broken on strong volume. There are also several short-term topping patterns such as the Outside Day and Engulfing Pattern. These patterns describe short-term reversals after buying exhaustion is completed.