Section 8:

Bearish Reversal Patterns

 

Bearish reversal patterns predict the reversal of an existing bullish trend and the beginning of a new bearish trend. Like bullish reversal patterns, bearish reversal patterns go against the grain of an existing trend. This makes bearish reversal patterns a bit more difficult in their application. Furthermore, bearish reversal patterns go against the long-term upward trend in stock prices.

Bearish reversal patterns emerge when existing bullish trends grow old, when the fundamental drivers of the trends have run their course, or when extreme levels of optimism or greed have taken hold. The bearish reversal patterns reveal equaling levels of demand for or supply of a stock; buyers complete all of their buying and sellers begin to see an overvaluation in prices.

The bearish reversal patterns point to an end of a bullish trend and the beginning of an opposite bearish trend. The reversal patterns provide entry points, offer price targets, and even suggest the time horizon in which the price target might be achieved.

It’s incredibly important to carefully measure and manage your risk when trading bearish reversal patterns because of the long-term upward trend in stock prices and the skewed risk to reward of bearish positions. The formation of a bearish reversal pattern doesn’t guarantee a new bearish trend.

The probabilities of bearish reversal patterns playing out as expected are less than the probabilities associated with trading bearish continuation patterns.

 

123 Top

 

Definition:

The 123 top is the most common bearish reversal pattern. The requirements for the 123 top are rather common, causing the pattern to frequently appear in existing bearish trends. Many 123 top reach the first two conditions, but never confirm. The 123 top, therefore, can be somewhat deceiving. That’s why it’s imperative that the pattern confirms before placing trades.

The 123 top starts when a stock sharply pulls back after an extended bullish trend. This sharp reversal is the first requirement of the pattern, or part 1. The second requirement is for the stock to rebound from short-term support, which is part 2 of the pattern. Part 3 of the pattern forms when the stock stages another sharp pullback, but from a relatively lower level than in part 1. The 123 top confirms when the stock breaks below short-term support as defined in part 2.

Nuance:

A basic definition of a bullish trend is higher highs. A basic definition of a bearish trend is lower highs. The 123 top seeks to identify when a pattern of higher highs ends and a new pattern of lower highs begins.

Another way to think of a 123 top is as a very short-term double distribution, only the 123 top occurs at the end of a bullish trend.

The 123 top occurs in most bullish trends, but it rarely confirms. When it does confirm, it’s best to take a very short-term approach to trading the 123 top. Taking profits quickly is generally a good idea after entering a 123 top. Aside from the nature of the pattern, it’s also a good idea to take profits quickly so as to mitigate the risks that bearish traders face in the form of the long-term upward trend in stock prices.

Application:

A 123 top is confirmed once the stock breaks below the horizontal support level as defined in part 2 of the definition. An entry can be taken as soon as the stock drops below its short-term support. This support level will often act as resistance in the days following a breakdown.

A 123 top is rejected if the stock fails to break down below support or rallies above the relative high traced in part 3. A rally above the relative high in part 3 reveals a very short-term pattern of higher highs, which is a bullish indication.

Figure 8.1

Example:

Shares of Freeport McMoran (FCX) traced a 123 top by first reversing from a high at $120 as shown in Figure 8.1. The stock fell to a short-term low at $105, and then sharply rebounded higher. But the stock fell just short of its previous high, and reversed lower at about $117.50. The 123 top was completed when the stock broke down below horizontal support at the $105 level. FCX proceeded to fall to a low near $85.

Notice the violent drop in FCX once it confirmed the 123 top. But the stock didn’t continue trending lower. In fact, it rebounded back to above the breakdown point of the 123 top several weeks later. This example illustrates why it’s a good idea to take profits quickly in bearish positions when trading 123 tops.