Stock chart patterns
Stock chart patterns can signal shifts between rising and falling trends and suggest the future direction of an asset’s price based on its previous movements. These patterns are often established when price action pauses, signifying areas of consolidation (fluctuations between support and resistance lines) that can bring about a continuation or reversal of the existing trend. A continuation chart pattern occurs when the trend continues in its current direction following a brief break, whereas a reversal chart pattern signals a change in trend direction. Trading volume plays a vital role in these patterns, often declining during the formation and increasing as the price breaks out of the pattern. Investing for beginners:
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Types of chart patterns
There are two types of chart patterns: In general, for both continuation and reversal patterns, the longer the pattern forms, and the larger the price movement within it, the more significant the predicted move once the price breaks out. During the development of a price pattern, there is no way of knowing whether the trend will continue or reverse. Therefore, traders must pay close attention to trendlines (used to formulate the price pattern) and which way the price eventually breaks. However, traders are best to assume a price trend will continue in its current direction until it is confirmed that it has reversed. Note: Below, we have classified the chart patterns by whether they are typically continuation or reversal, but many can indicate either a continuation or a reversal, depending on the circumstances.
1. Continuation patterns
Continuation patterns occur in the middle of a prevailing trend, indicating that the price action will likely resume in the same direction even after the continuation pattern completes. However, not all continuation patterns will result in the continuation of the trend — many will also result in reversals. Many traders look for increased volume when the price breaks out of a continuation zone since a small volume on a breakout typically suggests the pattern is likely to fail. Technical analysts use several continuation patterns to signal that the price trend will continue. Common continuation patterns, including:
Pennants; Flags; Triangles; Rectangles; Cup and handle.
Below are descriptions of these continuation patterns.
Pennant
A pennant is a continuation pattern represented by two trendlines that eventually meet. It is often formed after an asset experiences strong upward or downward movement, followed by consolidation before the trend continues in the same direction. Typically, trading volume will decrease during the pattern formation, followed by a significant increase during the breakout.
Flag
The flag is a continuation chart pattern formed using two parallel trendlines that, in a shorter time frame, move opposite to the dominant trend observed on the longer time frame price chart. As a signifier of a possible trend continuation, the flag offers the trader an entry point at which the price has drifted against that trend. Then, should the trend resume, the price increase could be rapid, giving anyone that can notice the pattern a massive advantage to time their trades appropriately. Flag patterns can be either bullish or bearish. The flag’s formation is often accompanied by declining volume, which recovers as the price breaks out of the flag formation.
Ascending triangle
The ascending triangle is a bullish continuation chart pattern created by placing a horizontal line along the swing highs (resistance points) and an ascending trendline along the swing lows (support points).
Descending triangle
Contrary to the ascending triangle, the descending triangle is a bearish continuation chart pattern in which the support line connecting swing lows is horizontal, and the resistance line connecting the swing highs is descending.
Symmetrical triangle
A symmetrical triangle is a continuation chart pattern in which two trend lines converge in an equal slope. The support line connects the lower highs, and the resistance line is drawn, connecting the higher lows. The breakout can happen from either direction. However, one from the lower trendline signifies the beginning of a new downward trend, while a breakout from the upper trendline marks the start of a new upward trend.
Rectangles
Rectangles are continuation chart patterns in which the price moves up and down between parallel support and resistance lines, indicating the absence of a trend. The rectangle ends with a breakout as the price moves out of the rectangle.
Cup and handle
The cup and handle is a bullish continuation chart pattern where an upward trend has paused but will continue once the pattern is confirmed. The pattern consists of a cup in the shape of a “U” with equal highs on both sides and a handle with a slight downward drift (resembling a flag or a pennant pattern). Once the handle is complete, the market will likely break into a bullish upwards trend.
How to read stock chart patterns: continuation
Continuation patterns are signals traders look for to indicate that a price trend is likely to remain intact. Investors should take the following steps to trade continuation patterns:
Identify the prior trend direction; Wait for the pattern to form; Identify the continuation pattern; Find the breakout point; Enter the trade when the price breaks out of the pattern: Most traders will only take a trade if the breakout happens in the same direction as the existing trend. Yet, some traders will take trades in the breakout direction even if it’s moving against the existing trend. Though much riskier, they pay off if the trend reverses direction.
2. Reversal patterns
Reversal patterns signal change in the prevailing trend. This is characterized by a pause in the established trend and a subsequent move in the new direction as fresh energy surfaces from the other side. For example, a downtrend supported by avid sellers can pause, revealing even pressure from both the bears and the bulls, eventually giving way to the bulls, resulting in a change in trend to the upside. Reversals at market tops are distribution patterns where the asset becomes more vigorously sold than bought. Contrarily, reversals at market bottoms are accumulation patterns, where the security becomes more fervently bought than sold. Technical analysts use several reversal patterns to signal that the price trend will change. Common reversal patterns include:
Wedges; Head and shoulders; Double tops and bottoms; Triple tops and bottoms; Gaps; Rounding tops or bottoms.
Below are descriptions of these reversal patterns.
Wedge
Wedges are drawn using two converging trendlines advancing in the same direction: up or down (i.e., rising or falling wedges). Wedges can indicate a reversal as well as the continuation of a trend. A falling wedge illustrates a pause during an uptrend, whereas a rising wedge shows a temporary interruption during a downmarket. Similar to pennants and flags, trading volume generally wanes during pattern formation, only to increase once the price breaks above or below the wedge pattern.
Head and Shoulders
Head and shoulders is a reversal chart pattern consisting of three components: a large peak (head) and two smaller peaks on either side (shoulders). The line connecting the first and second lows (top pattern) or highs (bottom/inverse pattern) to form an area of support or resistance is called a neckline. A head and shoulders top pattern (in an uptrend) indicates a bullish-to-bearish trend reversal. Conversely, an inverse head and shoulders pattern (in a downtrend) predicts a trend reversal to the upside.
Double Top
A double top is a bearish reversal pattern that resembles the letter M, forming after the price reaches a high two consecutive times with a moderate decline between them. It is confirmed once the price drops below the support level (the low between the two prior highs) and signals a medium or long-term trend change.
Double bottom
The opposite of a double top is a double bottom, a bullish reversal pattern that looks like the letter W, in which two consecutive lows, unable to break through the support level, form. After unsuccessfully spearing through the support line twice, the market price shifts towards an uptrend.
Triple tops and bottoms
Triple tops and bottoms are reversal chart patterns that act similarly to double tops and bottoms, consisting of three peaks (bearish reversal pattern) or bottoms (bullish reversal pattern), respectively.
Gaps
Gaps are reversal chart patterns that typically occur when a news story or an event invites a torrent of buyers or sellers into an asset resulting in the price opening substantially higher or lower than the previous day’s closing price. There are four types of gaps: common, breakaway, runaway, and exhaustion. Depending on the kind, gaps can mark the beginning of a new trend or a reversal of an earlier trend.
Rounding top or bottom
A rounding bottom is a chart pattern in which price movements form the letter U and usually indicates a bullish upward trend. In comparison, a rounding top is a chart pattern whereby price movements on a graph form the shape of an upside-down U and signifies a bearish downward trend.
How to read stock chart patterns: reversals
Reversal patterns are signals traders look for to indicate that a price trend is likely to change. The following steps should be taken to trade reversal patterns:
Identify the prior trend direction; Wait for the pattern to form; Identify the reversal pattern; Find the breakout point; Enter the trade when the price breaks out of the pattern: Traders get out of positions aligned with the trend before the reversal or after seeing the reversal underway. Traders can profit from a bullish reversal by placing long positions that will benefit from a rising price. Bearish reversals, on the other hand, present the opportunity to profit from selling the stock.
Note: Reversals aren’t always easy to differentiate from noise, consolidation, or brief pullbacks. And while reverse patterns can be highly effective when identified correctly, they can be enormously destructive when misinterpreted. As a result, traders must take extra care and patience in confirming signals before jumping to conclusions.
Limitations of chart patterns
The primary disadvantage to trading chart patterns is the risk of a false breakout. This happens when the price moves outside the pattern but immediately returns within it or to the other side. Unfortunately, it can occur multiple times before the pattern experiences a breakout and a continuation or a reversal occurs. Furthermore, patterns can also be subjective, as what one trader perceives as a pattern is not always how another trader would see or draw them in real-time. So while it can provide traders with a unique point of view on the market, it will also require additional practice to develop their skills in finding and drawing patterns, as well as formulating a strategy for using them.
Crypto chart patterns
Similarly to stock chart patterns, crypto chart patterns predict potential shifts and price changes, showing whether the current prices (price trend) might continue in the existing direction or signal that the existing trend is about to reverse. For example, the price of Bitcoin (BTC) has been steadily increasing. Chart patterns can indicate whether this rising price trend is about to switch course and start going down or continue in the same direction.
Chart patterns cheat sheet
As a beginner to technical analysis, it can be overwhelming to know or remember all the different chart patterns; this is where a chart patterns cheat sheet can come in handy. A chart patterns cheat sheet is a printable sheet that defines and visualizes the most popular chart patterns used in chart analysis. It can help you when trading chart patterns and identifying them more easily.
In conclusion
All in all, chart patterns are helpful technical indicators that can assist traders in how or why a security’s price has moved in a certain way and how its price might behave in the future. This is particularly helpful for identifying profitable entry and exit points or setting up stop-loss levels. Yet, while recognizing chart patterns can provide you with a competitive advantage in the market, before starting your chart pattern analysis, it is essential to familiarise yourself with the set rules and strategies of each pattern you wish to use. Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
