Time Tested Chart Patterns in Trading
Chart patterns are widely used in technical analysis of stocks. Chart patterns are formed when price travels through time. These are 2-D patterns that depicts the psychology of participants in a market as prices are being explored. These chart patterns have been studied and observed to have repeatedly occurred in charts and hence have become a must for trading.
Chart patterns can be identified on the basis whether they show continuation of trend, reversal of trend or indecision in trend. These patterns are widespread and are available on internet. My approach to reading chart combines these chart patterns with common sensical approach. However, we need to know the basics here first and then we can build upon that. This list is not exhaustive and there are other patterns that have been published and are studied by analysts. However, these are some of the most well known patterns that occur repeatedly in markets.
Reversal patterns
Head and shoulder pattern: This is a reversal pattern which might occur when an up trend is about to reverse and start a bearish move. As you can see in the diagram below that this pattern consist of three peaks with the central peak being higher than the other two peaks. In the standard setup the two peaks on the sides usually have same height. However, the variations of this pattern might have slight difference in their heights.
The logic behind the pattern is as follows. During an uptrend the prices face resistance and it takes support on the neckline tries and try to push the prices up. In the second attempt the prices did create a new high but again it was rejected and prices took support on neckline again. In the third attempt price try to create a new high but was unable to do so. after the third failed attempt, the support is tested again. As the neck line is crossed the prices might fall. The entry should be when the support gets broken. The target should be equal to distance between central peak and the neck line.
Inverted head and shoulder: This is a bullish reversal pattern that is similar to head and shoulder pattern but is inverted. The logic behind the formation of inverted head and shoulder is similar to the head and shoulders but from a selling perspective.
Rounding Bottom: Rounding bottom is a bullish chart pattern that might occur when the prices, after a fall, consolidate gradually and show a shallow concave shaped recovery. The concave shape of the bottom is much shallower than the cup and handle pattern and with a lot of zig zag price action at the bottom. The entry should be above the consolidation zone with minimum target equivalent to the depth of bottom. Stop loss can be taken as the swing low.
Rounding Top: This is a bearish chart pattern that indicates reversal after an up move. The prices start consolidating near a resistance with a concave shaped retracement of prices. the top is flatter than inverted cup and handle. The entry should be below the consolidation zone with target equivalent to peak of the top to neckline distance.
Triple top: This is a bearish pattern similar to head and shoulders with the variation of the head being at the same level as the shoulder. This pattern represent three attempt to break a resistance but instead eventually breaking the support (neckline). The entry should be after the support breakdown with a minimum target equivalent to distance between neckline and the top.
Triple Bottom: This is bullish pattern which might occur when the price tries to break the support thrice and fail eventually and break the resistance. This is technically inverted triple top. The target and stop loss would be similar to triple top.
Double Bottom: This is a bullish chart pattern with two attempts to break a support but then breaking the last swing and thus the resistance. This is also called the W-pattern due to the shape of it. The entry should be above the swing high close and minimum target should be the same as the distance between the bottom and the neckline.
Double Top: This is a bearish chart pattern and with two equal highs. The pattern indicate the failure to break the high and instead breaking the swing low. This chart pattern is also called M-pattern. The entry should be below the swing low with target equal to distance of top from the neckline.
Falling Wedge pattern: This pattern is a bullish pattern with prices converging between two trendlines that looks like a falling wedge. The pattern shows how the down move is gradually weakening and then eventually the down trend ends and bull trend starts. Entry should be above the resistance trendline breakout.
Rising Wedge pattern: This is a bearish chart pattern that forms when during an uptrend the price moves between two trendlines that converge and appears like a rising wedge. This move is characterized by weakening bullish moves and eventually breaking down.
Continuation Pattern
Cup and Handle pattern: This is a bullish chart pattern created as prices recover in a concave shape to the resistance (neckline). On the resistance there is slight retraction of prices allowing for profit booking and inviting sellers to take position. However, when the prices did not go down to the support and again approaches the resistance, more buyers enter and sellers square off their position. This creates the bull trend continuation with high reward to risk ratio. The target should be the distance between the cup bottom and neckline. The logical stoploss should be the handle bottom.
Inverted Cup and Handle: This is a bearish trend continuation pattern. The logic is similar to the the cup and handle chart pattern only with sellers in perspective. After an up trend there is a concave retracement of price near to the support( neck line). At the neckline, buyers try to enter the trade but sellers were able to bring the prices again to the neckline while forming forming the handle. The target is same as it was in cup and handle (distance from cup peak to neckline).
Bullish Pennant: This is a bullish continuation pattern. This chart pattern might occur when after an up move, the price starts consolidating between two trendlines that are converging. The two trendline form a pennant kind of shapes that is slightly tilted downwards. The entry for a long trade can be at the breakout of upper trendline.
Bearish Pennant: This is a bearish continuation pattern that might occur after a strong down move and then a consolidation between two converging trendline. This forms a pennant kind of shape tilted upwards. The entry should be at breakdown of the lower trendline.
Descending Triangle: This is a bearish chart pattern that might occur as a continuation of a trend or as a reversal of trend as well. The characteristic of this pattern is that the price will be moving between a horizontal support and a declining trendline resistance. The price action forms lower highs and testing the support time after time. The breakdown is supposed to come before the convergence of the support and the trendline.
Ascending Triangle: This is a bullish pattern and might occur as a continuation pattern or as a reversal pattern. The price is being pressed against the horizontal resistance by the rising trendline. Lower lows are formed and a breakout is expected to the upside. A breakout with a retest is supposed to be a better entry.
Bearish Flag and Pole: This is a continuation pattern after a strong down move. This is similar to a bearish pennant with the variation of both the trendline being parallel to each other. The entry will be at the breakdown of the lower trendline.
Bullish Flag and Pole: This is a bullish continuation pattern. This pattern might occur when after a bullish move the price consolidate between two parallel trendline. This channel kind of formation will look like a flag on pole. The entry will be at a breakout of upper trendline.
Bilateral chart patterns
Symmetrical Triangle: This pattern is formed when price is consolidating between two trendlines that are converging. This pattern indicates a indecision in market. The breakout might happen in either side. A breakout with retest is a better entry in this setup.
Rectangle: This is also a bilateral chart pattern. The indecision is visible with price trading between a horizontal support and resistance. This creates a pattern that looks like a rectangle. The breakout might happen in any direction.
As clarified earlier the chart patterns mentioned here are not exhaustive and there are many other chart patterns that are being used. However, the chart pattern shown here are some of the most common and effective chart patterns. These patterns have been studied and are widely used and hence are important to build a strong foundation to technical analysis. The PDF file for charts pattern is being provided below for your quick reference.
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