Chartists use these patterns to identify current trends and
trend reversals and to trigger buy and sell signals.
In the first section of this tutorial, we talked about the
three assumptions of technical analysis, the third of which was that in
technical analysis, history repeats itself. The theory behind chart patters is
based on this assumption. The idea is that certain patterns are seen many
times, and that these patterns signal a certain high probability move in a
stock. Based on the historic trend of a chart pattern setting up a certain
price movement, chartists look for these patterns to identify trading
opportunities.
While there are general ideas and components to every chart
pattern, there is no chart pattern that will tell you with 100% certainty where
a security is headed. This creates some leeway and debate as to what a good
pattern looks like, and is a major reason why charting is often seen as more of
an art than a science. (For more insight, see Is finance an art or a science?)
There are two types of patterns within this area of
technical analysis, reversal and continuation. A reversal pattern signals that
a prior trend will reverse upon completion of the pattern. A continuation
pattern, on the other hand, signals that a trend will continue once the pattern
is complete. These patterns can be found over charts of any timeframe. In this
section, we will review some of the more popular chart patterns. (To learn
more, check out Continuation Patterns - Part 1, Part 2, Part 3 and Part 4.)
Head and Shoulders
This is one of the most popular and reliable chart patterns
in technical analysis. Head and shoulders is a reversal chart pattern that when
formed, signals that the security is likely to move against the previous trend.
As you can see in Figure 1, there are two versions of the head and shoulders
chart pattern. Head and shoulders top (shown on the left) is a chart pattern
that is formed at the high of an upward movement and signals that the upward
trend is about to end. Head and shoulders bottom, also known as inverse head
and shoulders (shown on the right) is the lesser known of the two, but is used
to signal a reversal in a downtrend.
Figure 1: Head and shoulders top is shown on the left. Head
and shoulders bottom, or inverse head and shoulders, is on the right.
Both of these head and shoulders patterns are similar in
that there are four main parts: two shoulders, a head and a neckline. Also,
each individual head and shoulder is comprised of a high and a low. For
example, in the head and shoulders top image shown on the left side in Figure
1, the left shoulder is made up of a high followed by a low. In this pattern,
the neckline is a level of support or resistance. Remember that an upward trend
is a period of successive rising highs and rising lows. The head and shoulders
chart pattern, therefore, illustrates a weakening in a trend by showing the
deterioration in the successive movements of the highs and lows. (To learn
more, see Price Patterns - Part 2.)
Cup and Handle
A cup and handle chart is a bullish continuation pattern in
which the upward trend has paused but will continue in an upward direction once
the pattern is confirmed.
Figure 2
As you can see in Figure 2, this price pattern forms what
looks like a cup, which is preceded by an upward trend. The handle follows the
cup formation and is formed by a generally downward/sideways movement in the
security's price. Once the price movement pushes above the resistance lines
formed in the handle, the upward trend can continue. There is a wide ranging
time frame for this type of pattern, with the span ranging from several months
to more than a year.
Double Tops and Bottoms
This chart pattern is another well-known pattern that
signals a trend reversal - it is considered to be one of the most reliable and
is commonly used. These patterns are formed after a sustained trend and signal
to chartists that the trend is about to reverse. The pattern is created when a
price movement tests support or resistance levels twice and is unable to break
through. This pattern is often used to signal intermediate and long-term trend
reversals.
Figure 3: A double top pattern is shown on the left, while a
double bottom pattern is shown on the right.
In the case of the double top pattern in Figure 3, the price
movement has twice tried to move above a certain price level. After two
unsuccessful attempts at pushing the price higher, the trend reverses and the
price heads lower. In the case of a double bottom (shown on the right), the
price movement has tried to go lower twice, but has found support each time.
After the second bounce off of the support, the security enters a new trend and
heads upward. (For more in-depth reading, see The Memory Of Price and Price
Patterns - Part 4.)
Triangles
Triangles are some of the most well-known chart patterns
used in technical analysis. The three types of triangles, which vary in
construct and implication, are the symmetrical triangle, ascending and
descending triangle. These chart patterns are considered to last anywhere from
a couple of weeks to several months.
Figure 4
The symmetrical triangle in Figure 4 is a pattern in which
two trendlines converge toward each other. This pattern is neutral in that a
breakout to the upside or downside is a confirmation of a trend in that
direction. In an ascending triangle, the upper trendline is flat, while the
bottom trendline is upward sloping. This is generally thought of as a bullish
pattern in which chartists look for an upside breakout. In a descending
triangle, the lower trendline is flat and the upper trendline is descending.
This is generally seen as a bearish pattern where chartists look for a downside
breakout.
Flag and Pennant
These two short-term chart patterns are continuation
patterns that are formed when there is a sharp price movement followed by a
generally sideways price movement. This pattern is then completed upon another
sharp price movement in the same direction as the move that started the trend.
The patterns are generally thought to last from one to three weeks.
Figure 5
As you can see in Figure 5, there is little difference
between a pennant and a flag. The main difference between these price movements
can be seen in the middle section of the chart pattern. In a pennant, the
middle section is characterized by converging trendlines, much like what is
seen in a symmetrical triangle. The middle section on the flag pattern, on the
other hand, shows a channel pattern, with no convergence between the
trendlines. In both cases, the trend is expected to continue when the price moves
above the upper trendline.
Wedge
The wedge chart pattern can be either a continuation or
reversal pattern. It is similar to a symmetrical triangle except that the wedge
pattern slants in an upward or downward direction, while the symmetrical
triangle generally shows a sideways movement. The other difference is that
wedges tend to form over longer periods, usually between three and six months.
Figure 6
The fact that wedges are classified as both continuation and
reversal patterns can make reading signals confusing. However, at the most
basic level, a falling wedge is bullish and a rising wedge is bearish. In
Figure 6, we have a falling wedge in which two trendlines are converging in a
downward direction. If the price was to rise above the upper trendline, it
would form a continuation pattern, while a move below the lower trendline would
signal a reversal pattern.
Gaps
A gap in a chart is an empty space between a trading period
and the following trading period. This occurs when there is a large difference
in prices between two sequential trading periods. For example, if the trading
range in one period is between $25 and $30 and the next trading period opens at
$40, there will be a large gap on the chart between these two periods. Gap
price movements can be found on bar charts and candlestick charts but will not
be found on point and figure or basic line charts. Gaps generally show that
something of significance has happened in the security, such as a
better-than-expected earnings announcement.
There are three main types of gaps, breakaway, runaway
(measuring) and exhaustion. A breakaway gap forms at the start of a trend, a
runaway gap forms during the middle of a trend and an exhaustion gap forms near
the end of a trend. (For more insight, read Playing The Gap.)
Triple Tops and Bottoms
Triple tops and triple bottoms are another type of reversal
chart pattern in chart analysis. These are not as prevalent in charts as head
and shoulders and double tops and bottoms, but they act in a similar fashion.
These two chart patterns are formed when the price movement tests a level of
support or resistance three times and is unable to break through; this signals
a reversal of the prior trend.
Figure 7
Confusion can form with triple tops and bottoms during the
formation of the pattern because they can look similar to other chart patterns.
After the first two support/resistance tests are formed in the price movement,
the pattern will look like a double top or bottom, which could lead a chartist
to enter a reversal position too soon.
Rounding Bottom
A rounding bottom, also referred to as a saucer bottom, is a
long-term reversal pattern that signals a shift from a downward trend to an
upward trend. This pattern is traditionally thought to last anywhere from
several months to several years.
Figure 8
A rounding bottom chart pattern looks similar to a cup and
handle pattern but without the handle. The long-term nature of this pattern and
the lack of a confirmation trigger, such as the handle in the cup and handle,
makes it a difficult pattern to trade.
We have finished our look at some of the more popular chart
patterns. You should now be able to recognize each chart pattern as well the
signal it can form for chartists.
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