Chart Patterns
Chart Patterns
Chart patterns are the foundational building blocks of technical analysis. They repeat themselves in the market time and time again and are relatively easy to spot. These basic patterns appear on every timeframe and can, therefore, be used by scalpers, day traders, swing traders, position traders and investors. There are 3 types of patterns, depending on how price is likely to behave after completion: reversal patterns, where price is likely to reverse, continuation patterns, where price is likely to continue its course and bilateral patterns, where price can go either way, depending on whether it breaks to the upside or to the downside.
The measurements of the chart pattern can be used to project the next price movement and what target to aim for. These patterns can either be traded aggressively (with less conformation) or conservatively (with more conformation) so the rules of entry and exit can vary. It's easy to calculate the reward / risk for them, which is important to know before entering a trade.
Reversal Patterns
Reversal patterns are those chart formations that signal that the ongoing trend is about to change course. If a reversal chart pattern forms during an uptrend, it hints that the trend will reverse and that the price will head down soon. Conversely, if a reversal chart pattern is seen during a downtrend, it suggests that the price will move up later on.
To trade these chart patterns, simply place an order beyond the neckline and in the direction of the new trend. Then go for a target that’s almost the same as the height of the formation. For instance, if you see a double bottom, place a long order at the top of the formation’s neckline and go for a target that’s just as high as the distance from the bottoms to the neckline.
In the interest of proper risk management, don’t forget to place your stops! A reasonable stop loss can be set around the middle of the chart formation. For example, you can measure the distance of the double bottoms from the neckline, divide that by two, and use that as the size of your stop.
Continuation Patterns
Continuation chart patterns are those chart formations that signal that the ongoing trend will resume.
Usually, these are also known as consolidation patterns because they show how buyers or sellers take a quick break before moving further in the same direction as the prior trend.
Trends don’t usually move in a straight line higher or lower. They pause and move sideways, “correct” lower or higher, and then regain momentum to continue the overall trend.
These are the continuation chart patterns, namely the wedges, rectangles, and pennants. Note that wedges can be considered either reversal or continuation patterns depending on the trend on which they form.
To trade these patterns, simply place an order above or below the formation (following the direction of the ongoing trend, of course).
Then go for a target that’s at least the size of the chart pattern for wedges and rectangles.
For pennants, you can aim higher and target the height of the pennant’s mast.
For continuation patterns, stops are usually placed above or below the actual chart formation.
For example, when trading a bearish rectangle, place your stop a few pips above the top or resistance of the rectangle.
Bilateral Patterns
Bilateral chart patterns are a bit trickier because these signal that the price can move either way.
This is where triangle formations fall in. Remember when we discussed that the price could break either to the topside or downside with triangles?
To play these chart patterns, you should consider both scenarios (upside or downside breakout) and place one order on top of the formation and another at the bottom of the formation.
If one order gets triggered, you can cancel the other one. Either way, you’d be part of the action. Double the possibilities, double the fun!
The only problem is that you could catch a false break if you set your entry orders too close to the top or bottom of the formation.
Reversal Chart Pattern
Double Top or Bottom
The double top is one of the most popular patterns in trading. It's a reliable reversal pattern that can be used to enter a bearish position after a bullish trend. It consists of 2 tops at nearly the same level with a valley in between, which creates the neckline. The second top does not break the level of the first top, so the price retested this level and tried to make a higher high, but failed. Price breaking the neckline and closing below it would complete the pattern.
Conservative traders look for additional confirmation and aggressive traders may enter a bearish position from the second top. The target can be estimated by measuring the height of the pattern and projecting this downwards from the neckline. Common stop levels are just above the neckline, halfway between the neckline and the tops or above the tops. The double bottom is the bullish version of this pattern that can form after a downtrend.
Head and Shoulders
The Head and Shoulders pattern is an accurate reversal pattern that can be used to enter a bearish position after a bullish trend. It consists of 3 tops with a higher high in the middle, called the head. The line connecting the 2 valleys is the neckline. The height of the last top can be higher than the first, but not higher than the head. In other words, the price tried to make a higher high, but failed. The closer the 2 outer tops are to the same price, the more accurate the pattern.
If the price breaks the neckline and closes below it, the pattern has completed. Conservative traders may look for additional confirmation. The target can be estimated by measuring the height of the pattern (from the neckline to the head) and projecting this downwards. Common stop levels are above the neckline or above the right shoulder. The Inverse Head and Shoulders is the bullish version of this pattern that can form after a downtrend.
Broadening Formation
A broadening formation is an example of a consolidation pattern and a highly useful tool in the prediction of the likelihood of a reversal in the direction of a current trend. When found in an uptrend it indicates not a continuation of that trend, but a near-term reversal of the price action.
The broadening formation occurs when the fluctuation within the price produces a series of higher highs and of lower lows that steadily widen over time and are generally thought to be found only in found in topping formations where they are considered to be the result of unrealistic expectations of bullish investors.
Unlike the majority of other consolidation patterns, broadening formations feature increasingly wide ranges and are subject to much greater levels of volatility as time passes. Volume levels increase as the share price rises, which although normally indicates a bullish position rallies in this instance usually prove to be very short lived and the following declines are prone to decimating former support levels leading to an eventual collapse.
Rounding Bottom pattern
The Rounding Bottom pattern is a well-regarded reversal pattern that can be identified across various chart types. This pattern often indicates that an asset's current direction is about to shift, reversing its course and moving in the opposite direction. The Rounding Bottom is characterized by a gradual, curved decline in price followed by a steady, curved ascent, resembling a bowl or saucer shape.
Wedge pattern
A wedge pattern can be a signal for either bullish or bearish price reversals, characterized by three common features: converging trend lines, declining volume as the pattern progresses, and a breakout from one of the trend lines. The two forms of the wedge pattern are the rising wedge (indicating a bearish reversal) and the falling wedge (signaling a bullish reversal).
Continuation Chart Patterns
Flag
A flag pattern is a continuation chart pattern, named due to its similarity to a flag on a flagpole.
Although it is less popular than triangles and wedges, traders consider flags to be extremely reliable chart patterns.
A flag is a relatively rapid chart formation that appears as a small channel after a steep trend, which develops in the opposite direction.
After an uptrend, it has a downward slope. After a downtrend, it has an upward slope.
The preceding trend is crucial for pattern formation.
A “flag” is composed of an explosive strong price move forming a nearly vertical line.
This is known as the "flagpole”.
After the flagpole forms, bearish (bullish) traders, eager to capitalize on instant profits, begin selling (buying) off their holdings.
However, this doesn’t cause a rapid decline (increase) in price, as bullish (bearish) traders begin buying, hoping to capitalize on future increases (decreases) in price.
Pennants Pattern
Similar to rectangles, pennants are continuation chart patterns formed after strong moves. After a big upward or downward move, buyers or sellers usually pause to catch their breath before taking the pair further in the same direction. Because of this, the price usually consolidates and forms a tiny symmetrical triangle, which is called a pennant.
While the price is still consolidating, more buyers or sellers usually decide to jump in on the strong move, forcing the price to bust out of the pennant formation.
A bearish pennant is formed during a steep, almost vertical, downtrend.
After that sharp drop in price, some sellers close their positions while other sellers decide to join the trend, making the price consolidate for a bit.
Bullish pennants, just like its name suggests, signals that bulls are about to go a-chargin’ again.
This means that the sharp climb in price would resume after that brief period of consolidation when bulls gather enough energy to take the price higher again.
Rectangle Pattern
A rectangle is a chart pattern formed when the price is bounded by parallel support and resistance levels.
A rectangle exhibits a period of consolidation or indecision between buyers and sellers as they take turns throwing punches but neither has dominated.
The price will “test” the support and resistance levels several times before eventually breaking out.
From there, the price could trend in the direction of the breakout, whether it is to the upside or downside. A bearish rectangle is formed when the price consolidates for a while during a downtrend.
This happens because sellers probably need to pause and catch their breath before taking the pair any lower.
Cup and Handle
A Cup and Handle can be used as an entry pattern for the continuation of an established bullish trend. It´s one of the easiest patterns to identify. The cup has a soft U-shape, retraces the prior move for about ⅓ and looks like a bowl. After forming the cup, price pulls back to about ⅓ of the cups advance, forming the handle. The handle is a relatively short period of consolidation. The full pattern is complete when price breaks out of this consolidation in the direction of the cups advance.
The price will likely continue in that direction though conservative traders may look for additional confirmation. The target can be estimated using the technique of measuring the distance from the right peak of the cup to the bottom of the cup and extending it in the direction of the breakout. A common stop level is just outside the handle on the opposite side of the breakout. The Inverted Cup and Handle is the bearish version that can form after a downtrend.
Bilateral Chart Patterns
Triangle Pattern
A triangle chart pattern involves price moving into a tighter and tighter range as time goes by and provides a visual display of a battle between bulls and bears.
The triangle pattern is generally categorized as a “continuation pattern”, meaning that after the pattern completes, it’s assumed that the price will continue in the trend direction it was moving before the pattern appeared.
A triangle pattern is generally considered to be forming when it includes at least five touches of support and resistance.
For example, three touches of the support line and two for the resistance line. Or vice versa.
Symmetrical Triangle
A symmetrical triangle is a chart formation where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle.
What’s happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend.
If this were a battle between the buyers and sellers, then this would be a draw.
Ascending Triangle
An ascending triangle is a type of triangle chart pattern that occurs when there is a resistance level and a slope of higher lows.
What happens during this time is that there is a certain level that the buyers cannot seem to exceed. However, they are gradually starting to push the price up as evidenced by the higher lows.
Descending Triangle
As you probably guessed, descending triangles are the exact opposite of ascending triangles (we knew you were smart!).
In descending triangle chart patterns, there is a string of lower highs that forms the upper line. The lower line is a support level in which the price cannot seem to break.
