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Technical Analysis: Chart Patterns

Basic introduction to Chart Patterns and the meaning they carry

Chart patterns give an overall picture of future price movements. They help to identify trading signals by consolidating the forces of supply and demand into a concise picture. More importantly, chart patterns and other technical analysis concepts must be used together to get an understanding of the future price movements and to conform a trend.

Chart patterns work based on the assumption that certain patterns consistently reappear and they essentially result in the same outcomes. Formed as a result of the cumulative trading activities between bulls (buyers) and bears (sellers), they serve as powerful signals.

Types of Chart Patterns

Chart patterns can be broadly categorised into reversals and continuations

  • A Reversal Pattern signals that a prior trend will reverse upon the completion of the pattern. It indicates a change of trend and can be broken down into top and bottom formations.
  • A Continuation Pattern signals that the trend will continue once the pattern is complete. It indicates a pause in trend and indicate that the previous direction will resume after a period of time.

Chart pattern analysis can be used to make both short-term and/or long-term forecasts. The time period can range from intraday to years.

Head and Shoulders

The lows between these peaks are connected with a trend line (neckline) that represents the key support level to watch out for a breakdown and trend reversals.

A Head and Shoulder Bottom (Inverse Head and Shoulders) is simply the inverse of the Head and Shoulders Top. Here,the neckline represents a resistance level, hence watch for a breakout higher.

Cup and Handle

The Cup and Handle is a bullish continuation pattern. An upward trend sees a temporary pause. It will continue when the pattern is confirmed.

The ‘cup’ portion of the pattern should be a “U” shape that resembles the rounding of a bowl rather than a “V” shape with equal highs on both sides of the cup.

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.

Double Tops and Bottoms

The Double Top or Double Bottom pattern are both easy to recognize and one of the most reliable chart patterns. The pattern is formed after a sustained trend tests the same support or resistance level twice without a breakthrough. The pattern signals the start of a trend reversal over the intermediate- or long-term.

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
  • Descending triangles

These chart patterns can last anywhere from a couple weeks to several months.

  • Symmetrical triangles occur when two trend lines converge toward each other. It signals that only a breakout is likely to occur. But not the direction of the breakout.
  • Ascending triangles are characterized by a flat upper trend line and a rising lower trend line. It signals that a breakout higher is likely.
  • Descending triangles have a flat lower trend line and a descending upper trend line. It signals that a breakdown is likely to occur. The magnitude of the breakdowns is typically the same as the height of the left vertical side of the triangle.

Flags & Pennants

Flags and Pennants are short-term continuation patterns. They represent a consolidation following a sharp price movement and continuation with the prevailing trend.

  • Flag patterns are characterized by a small rectangular pattern that slopes against the prevailing trend.
  • Pennants are small symmetrical triangles that look very similar.

 

The short-term price target for a flag or pennant pattern is simply the length of the ‘flagpole.’ These patterns typically last for a few weeks.

Wedges

The Wedge pattern is a reversal or, less commonly, continuation pattern. It is similar to the symmetrical triangle except that it slants upward or downward.

  • Rising wedges are bearish chart patterns that occur when trend is moving higher and the prices are converging. It signals that the prevailing trend is losing momentum.
  • Falling wedges are bullish chart patterns that occur when the trend is moving lower and prices are converging.  Signals that bearish trend is losing momentum and a reversal is likely.

The wedge pattern can be very difficult to identify hence, watch for a diverging relative strength index or moving average convergence-divergence trend line that confirms a reversal is likely to occur.

Gaps

Gaps occur when there is empty space between two trading periods that’s caused by a significant increase or decrease in price. There are three main types of gaps:

  • Breakaway gaps, which form at the start of a trend
  • Runaway gaps, which form during the middle of a trend
  • Exhaustion gaps, which are formed near the end of the trend

Triple Tops & Bottoms

Triple Tops and Triple Bottoms are reversal patterns. They are not as prevalent as Head and Shoulders or Double Tops/Bottoms. But, they do act in a similar fashion. They represent a powerful trading signal for a trend reversal. These patterns are formed when a price tests the same support or resistance level three times and yet is unable to break through.

Rounding Bottom

The Rounding Bottom is a long-term reversal pattern that signals a shift from a downtrend to an uptrend. It can last anywhere from several months to several years.

The chart patterns looks similar to a Cup and Handle pattern but without the handle. The long-term nature of the pattern and lack of a confirmation trigger (such as the handle) makes it a difficult pattern to trade.

Conclusion

Chart patterns are an important part of technical analysis. A number of elements come into play together and a judicious judgement is the way forward when it comes to predicting the price movements. Chart Patterns are used to identify potential trades. They can confirm these trends using other forms of technical analysis to maximize their odds of success. It is essential to remember that chart patterns are a continuation to trend lines, support & resistance and channels. A good understanding of those concepts is a must for chart patterns technical analysis.

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