Every trader who knows the role that data plays in the success of trading takes analysis reports and charts seriously. Out of these, chart patterns are one of the more visually communicative and easily understood tools that traders refer to. The use of chart patterns is a widely accepted practice among forex traders.
As a trader, you are constantly on the lookout for high quality analyses that help you spot opportunities, identify trends and project price movements. Being able to read and interpret chart patterns gives you a distinct edge while trading.
A chart pattern presents price movements graphically to convey a clear picture of trends to give indications on future price levels. Using data based on past performance, it makes it easier for a trader to form an idea on the direction of future movement in price.
Types of Chart Patterns
There are three types of chart patterns - continuation patterns, reversal patterns and bilateral patterns.
- A continuation pattern indicates that an ongoing trend will continue.
- Reversal chart patterns let traders know that a trend is about to reverse, i.e., change its direction.
- Breakout patterns occur when an asset is trading in a range.
Here are some of the top chart patterns every trader needs to know.
Head and Shoulders
It’s all in the name!! This chart has a large peak in the middle (head) with two slightly smaller peaks on either side (shoulders) of it. The swing highs in the Head and Shoulders pattern are used to predict a reversal of a trend.
The level of support or neckline connects the two shoulders and a breakout below the neckline is considered a selling signal. A straight and slant horizontal neckline is acceptable, though there are occasions where the neckline carries an angle or the two shoulders do not align perfectly. The idea is to spot the pattern.
Note the distance from the top of the head to the neckline which is the price target. Once the right shoulder has fallen back to the level of support, chances are there will be a bearish downtrend. This bullish-to-bearish reversal pattern is considered one of the most reliable reverse chart patterns.
If the Head and Shoulders pattern occurs during a downtrend, the same pattern occurs, but in an inverse. There are three swing lows and the pattern is called an Inverse Head and Shoulders pattern.
Double Top and Double Bottom
Another reversal pattern traders use to highlight trend reversals, the Double Top and Double Bottom pattern occur around important technical levels which create a big barrier. A double top has two peaks or swing highs at about the same price, while the double bottom pattern has two swing lows.
The Double Top is a bearish reversal pattern where an asset’s price first peaks, then retraces back to a level of support only to climb up before reversing back against the prevailing trend.
On the contrary, the Double Bottom is a bullish reversal pattern where an asset’s price drops below a level of support, then retraces back to a level of resistance only drop again before reversing back against the prevailing trend.
Here, traders have to look out for a minimum of two failed attempts at a level followed by a technical break in the opposite direction.
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Triple Top and Triple Bottom
The Triple Top and Triple Bottom pattern is similar to the above-mentioned Double Top and Double Bottom pattern – the only difference is that there are three swing highs and three swing lows as against the two swing highs and two swing lows. Both are reversal patterns.
Traders have to keep an eye on the break of support and resistance lines. The target prices is the distance between the top and support line (for Triple Tops), and the bottom and resistance line (for Triple Bottoms).
This reversal pattern helps traders catch the end of a trend, signalling a potential reversal point on a long term price movement. The Rounding Top pattern shows a gradual change of the sentiment from bullish to bearish and indicates an opportunity to go short.
As the name suggests, the rounded top pattern appears as an inverted 'U'. The trigger for entering a short position is the break of the support line, with the price target equal to the distance from the top to the support line.
The pattern takes a lot longer to form – from several weeks, months or even years – and it is not a commonly found pattern.
Also known as the saucer bottom, the Rounding Bottom is a long-term reversal chart pattern that shows that the stock price is reversing from a downward trend towards a bullish upward trend.
Here the price begins with a decreasing price trend until it reaches a support point, then the price begins to trend higher. The trend line following the price’s lows will form a U shape.
The rounded bottom pattern projects an opening to go long.
Read Also: How To Analyse Candlestick Chart Patterns
A type of continuation pattern, a rectangle pattern is formed when the price moves sideways between a horizontal support and resistance levels multiple times. When the price moves between the two horizontal levels, it creates a rectangle.
Depending on the underlying trend, traders have to look out for the formation of a rectangle pattern. A bullish rectangle takes form during an uptrend when the price enters a congestion phase and trades sideways. Look out for the break of the upper line of the rectangle; the price target will be the height of the rectangle.
A bearish rectangle is formed during a downtrend when the price enters a congestion phase and trades sideways. Just like the bullish rectangle, the price will break out, but this time the break will be on the lower rectangle line. The price target is, once more, the height of the rectangle.
Rectangle patterns are used to project a breakout strategy.
Another continuation pattern, a wedge pattern is formed by converging trend lines on a price chart.
A bullish wedge is formed during an uptrend. Two converging trend lines are drawn to connect the respective highs and lows giving the appearance of a wedge. In a bullish wedge, the target prices are calculated as the maximal height of the wedge.
Similarly, a bearish wedge appears during a downtrend and the target price is the maximal height of the wedge which is then projected to the point of break-out.
The principle of the Flag pattern is similar to the Wedges, the only difference lies in the shape of the pattern. Unlike the converging trend lines in the Wedge, the trend lines here are parallel.
A flag pole is a characteristic part of the flag pattern. A bullish flag is formed during an uptrend, with parallel trend lines above and below the price action. A bearish flag is formed during downtrends and has an up slope. The price target is the lowest point of a bullish flag and the highest point of a bearish flag.
Cup and Handle
This pattern is similar to the Rounding Top, but has an additional handle. This bullish continuation pattern is formed when a period of bearish market sentiment that finally continues in a bullish motion.
The price enters a temporary retracement and finally reverses out of the handle to continue with the overall bullish trend.
When a stock opens above or below its closing price, it creates a gap in the chart. Typically, this occurs from extended-hours trading and when trading halts it can cause gaps intraday.
When a gap occurs in the opposite direction of a trend, it signals a reversal.
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Another set of patterns follows a triangular approach. These are ascending, descending and symmetrical. The difference is primarily in the trend lines and these are, otherwise, mostly similar looking.
- The Ascending triangle: The ascending triangle takes on an upward trajectory with the resistance indicated with swing highs touching a horizontally placed line just above. The bottom line is the one that is ascending and features the support as shown by swing lows. The ascending triangle is used to depict bullish patterns that represent an uptrend.
- The Descending triangle: This is the exact opposite of the Ascending triangle with the pattern here displaying a downward sloping of the resistance offered. As the triangle here is depicting a bearish trend and the effect of a market filled with sellers, the descending triangle has a drooping lower line.
- The Symmetrical triangle: This is a mix of the ascending and descending triangles indicating a pattern that could be either bullish or bearish. This shows a market that could breakout in both directions and signifies volatility. From the symmetrical nature of the triangle, there is a presence seen in the convergence of both the low peaks and the high troughs.
Chart patterns help traders to take a more informed decision on when to enter and exit a position. With the correct use of data, chart patterns can be useful, regardless of the duration. So this works for short, medium and long term trade decisions equally well.
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