Charts and Patterns Technical Analysis
Stock chart patterns are an important trading tool that should be utilized as part of your technical analysis strategy. From beginners to professionals, chart patterns play an integral part when looking for market trends and predicting movements. They can be used to analyse all markets including forex, shares, commodities and more.
In technical analysis, this process begins with the construction of stock price charts. After this, you need to interpret these charts. You may use tools like momentum indicators, chart patterns and trend lines for this. We have taken a look at these tools in previous sections.
In this section, we will explore some chart patterns that are used for interpreting these charts.
- How to Read Stock Charts
Candlestick, bar, line and point and figure charts. we are now aware of the different types of charts used for technical analysis of stocks. In this section, we will review these charts in greater depth and understand the various patterns that are used for understanding stock charts.
Understanding Stock Charts
The next logical step after learning how to construct technical charts is understanding these stock charts. In this segment, we will review some basic stock chart patterns that are used for stock chart analysis and drawing important conclusions. Chart patterns are divided into reversal patterns and continuation patterns. Note that these patterns can be used for all types of charts, except for point and figure charts.
Continuation Patterns
A price pattern that denotes a temporary interruption of an existing trend is known as a continuation pattern.
A continuation pattern can be thought of as a pause during a prevailing trend a time during which the bulls catch their breath during an uptrend, or when the bears relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell if the trend will continue or reverse. As such, careful attention must be placed on the trendlines used to draw the price pattern and whether price breaks above or below the continuation zone. Technical analysts typically recommend assuming a trend will continue until it is confirmed that it has reversed.
In general, the longer the price pattern takes to develop, and the larger the price movement within the pattern, the more significant the move once price breaks above or below the area of continuation.
If price continues on its trend, the price pattern is known as a continuation pattern. Common continuation patterns include:
Pennants, constructed using two converging trendlines
Flags, drawn with two parallel trendlines
Wedges, constructed with two converging trendlines, where both are angled either up or down
1.Pennants
- Pennants are represented by two lines that meet at a set point. They are often formed after strong upward or downward moves where traders pause and the price consolidates, before the trend continues in the same direction.
- Flags are constructed using two parallel trendlines that can slope up, down or sideways (horizontal). In general, a flag that has an upward slope appears as a pause in a down trending market; a flag with a downward bias shows a break during an up trending market. Typically, the formation of the flag is accompanied by a period of declining volume, which recovers as price breaks out of the flag formation.
- A wedge pattern represents a tightening price movement between the support and resistance lines, this can be either a rising wedge or a falling wedge. Unlike the triangle, the wedge doesn’t have a horizontal trend line and is characterised by either two upward trend lines or two downward trend lines.
- For a downward wedge, it is thought that the price will break through the resistance and for an upward wedge, the price is hypothesised to break through the support. This means the wedge is a reversal pattern as the breakout is opposite to the general trend.
4.Triangles
- Triangles are among the most popular chart patterns used in technical analysis since they occur frequently compared to other patterns. The three most common types of triangles are symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can last anywhere from a couple of weeks to several months.
- Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur not the direction. Ascending triangles are characterized by a flat upper trend line and a rising lower trend line and suggest a breakout higher is likely, while descending triangles have a flat lower trend line and a descending upper trend line that suggests a breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle, as shown in the figure below.
5.Cup and Handles
- The cup and handle pattern is a bullish continuation pattern that is used to show a period of bearish market sentiment before the overall trend finally continues in a bullish motion. The cup appears similar to a rounding bottom chart pattern, and the handle is similar to a wedge pattern which is explained in the next section.
- Following the rounding bottom, the price of an asset will likely enter a temporary retracement, which is known as the handle because this retracement is confined to two parallel lines on the price graph. The asset will eventually reverse out of the handle and continue with the overall bullish trend.
- The "handle" forms on the right side of the cup in the form of a short pullback that resembles a flag or pennant chart pattern. Once the handle is complete, the stock may breakout to new highs and resume its trend higher. A cup and handle is depicted in the figure below.
7.Reversal Patterns
- A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These patterns signify periods where either the bulls or the bears have run out of steam. The established trend will pause and then head in a new direction as new energy emerges from the other side (bull or bear).
- For example, an uptrend supported by enthusiasm from the bulls can pause, signifying even pressure from both the bulls and bears, then eventually giving way to the bears. This results in a change in trend to the downside.
- Reversals that occur at market tops are known as distribution patterns, where the trading instrument becomes more enthusiastically sold than bought. Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the trading instrument becomes more actively bought than sold. As with continuation patterns, the longer the pattern takes to develop and the larger the price movement within the pattern, the larger the expected move once price breaks out.
- When price reverses after a pause, the price pattern is known as a reversal pattern. Examples of common reversal patterns include:
- Head and Shoulders, signaling two smaller price movements surrounding one larger movement
- Double Tops, representing a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level
- Double Bottoms, showing a short-term swing low, followed by another failed attempt to break below the same support level
8.Head and Shoulders
- Head and shoulders patterns can appear at market tops or bottoms as a series of three pushes: an initial peak or trough, followed by a second and larger one and then a third push that mimics the first.
- An uptrend that is interrupted by a head and shoulders top pattern may experience a trend reversal, resulting in a downtrend. Conversely, a downtrend that results in a head and shoulders bottom (or an inverse head and shoulders) will likely experience a trend reversal to the upside.
- Horizontal or slightly sloped trendlines can be drawn connecting the peaks and troughs that appear between the head and shoulders, as shown in the figure below. Volume may decline as the pattern develops and spring back once price breaks above (in the case of a head and shoulders bottom) or below (in the case of a head and shoulders top) the trendline.
9. Double Top
- Double tops and bottoms signal areas where the market has made two unsuccessful attempts to break through a support or resistance level. In the case of a double top, which often looks like the letter M, an initial push up to a resistance level is followed by a second failed attempt, resulting in a trend reversal.
- A double bottom, on the other hand, looks like the letter W and occurs when price tries to push through a support level, is denied, and makes a second unsuccessful attempt to breach the support level. This often results in a trend reversal, as shown in the figure below.
- Triple tops and bottoms are reversal patterns that aren’t as prevalent as head and shoulders or double tops or double bottoms. But, they act in a similar fashion and can be a powerful trading signal for a trend reversal. The patterns are formed when a price tests the same support or resistance level three times and is unable to break through.
10. Double bottom
- A double bottom chart pattern indicates a period of selling, causing an asset’s price to drop below a level of support. It will then rise to a level of resistance, before dropping again. Finally, the trend will reverse and begin an upward motion as the market becomes more bullish.
- A double bottom is a bullish reversal pattern, because it signifies the end of a downtrend and a shift towards an uptrend.
11. Gaps
- Gaps occur when there is empty space between two trading periods that’s caused by a significant increase or decrease in price. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or other news.
- There are three main types of gaps: Breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps for near the end of the trend.
12. Ascending triangle
- The ascending triangle is a bullish continuation pattern which signifies the continuation of an uptrend. Ascending triangles can be drawn onto charts by placing a horizontal line along the swing highs the resistance and then drawing an ascending trend line along the swing lows the support.
- Ascending triangles often have two or more identical peak highs which allow for the horizontal line to be drawn. The trend line signifies the overall uptrend of the pattern, while the horizontal line indicates the historic level of resistance for that particular asset.
13. Descending triangle
- In contrast, a descending triangle signifies a bearish continuation of a downtrend. Typically, a trader will enter a short position during a descending triangle possibly with CFDs in an attempt to profit from a falling market.
- Descending triangles generally shift lower and break through the support because they are indicative of a market dominated by sellers, meaning that successively lower peaks are likely to be prevalent and unlikely to reverse.
- Descending triangles can be identified from a horizontal line of support and a downward-sloping line of resistance. Eventually, the trend will break through the support and the downtrend will continue.
Chart patterns summed up
All of the patterns explained in this article are useful technical indicators which can help you to understand how or why an asset’s price moved in a certain way and which way it might move in the future. This is because chart patterns are capable of highlighting areas of support and resistance,
which can help a trader decide whether they should open a long or short position; or whether they should close out their open positions in the event of a possible trend reversal.