Chart pattern analysis can be quite intimidating especially for newcomers to trading. In fact even the most successful chart pattern analysts have spent years perfecting the art. While it might seem simple enough, know that success with chart pattern analysis is directly based on your experience. While it might be easy to get discouraged trading with chart patterns analysis, with patience and practice, you can find this method of trading the markets a very successful way.
There are many types of chart patterns. All of them fall into two major categories: Reversal patterns and Continuation Patterns. As the name suggests, these chart patterns can help you to understand the market context. Chart pattern analysis, in a way falls under trend trading. This is because based on the chart pattern in question, you are either trading in the direction of the trend or you are trading a reversal or a correction to the trend.
A common theme with all chart patterns is that they project the next price move. This is also known as measured move. A measured move is nothing but measure the distance from the peak to the trough and projecting the same distance on the breakout. Some traders also prefer to use the 1.618% Fibonacci extension level for the measured move. Let’s look into more details of these types of patterns.
a. The Reversal Chart Patterns
Reversal patterns as the name suggests deals with patterns that signal a reversal (change of trend or correction to a trend) in prices. There are bullish and bearish reversal patterns that you can use.
Below are the most common type of reversal patterns and also the easiest of reversal patterns that you can master.
The Head and Shoulders Pattern
The Head and Shoulders pattern, as the name suggests is a pattern that is in the form of a head and shoulders. This is the easiest of reversal chart patterns can be found at the top end of a rally or at the bottom end of a decline. Therefore, you have a bullish and a bearish head and shoulders pattern. The chart below shows these two patterns. Typically, the head and shoulders pattern is used alongside volume, especially in the stock markets. But you can also simply make use of price itself to analyze and trade the head and shoulders pattern.
When the neckline support (in bearish H&S pattern) or the neckline resistance (in bullish H&S pattern) is broken, price is expected to rally the same distance as it did when it previously posted a high or a low.
Double Top and Double Bottom
The double top and double bottom patterns often form when price falls or rallies to the same level twice and then falls. The double top and double bottom prices occur at the top or at the bottom of a rally.
Similar with all chart patterns, the double tops and bottoms can signal a reversal in the direction of price. The chart below illustrates a double top and a double bottom chart pattern in action. These patterns work similar to price breaking out from a range. Typically you can expect price to retest the breakout level before it moves higher. Thus buying on the dips is very ideal for these types of patterns.
Triple Top and Triple Bottom
The triple top and triple bottom patterns, work similar to the double tops and bottom patterns. The main difference here is that price tends to form a triple top or a triple bottom before breaking out. These patterns are usually quite rare in occurrence, compared to the more common double tops and bottoms.
V Shaped Pattern
The v-shaped pattern, as the name suggests occurs when price first posts a sharp rally and then promptly posts a sharp decline. When price breaks past the previous low, the v-shape pattern is formed. The v-shaped pattern occurs in a downtrend and signals a change in direction.
For the v-shape pattern, traders must look to key swing highs that are formed in the rally. Using this as a reference point, long positions can be taken when price breaks out from the resistance level. At times you can also expect prices to dip back to the breakout level before rallying higher.
As with other chart patterns, the v-shape pattern can also be traded with the measured move method. Simply measure the distance, from the resistance to the low point, and project this distance from the breakout level.
Cup and Handle Pattern
The cup and handle pattern is another unique and interesting pattern. This usually takes a long time to form but is a strong reversal pattern. As the name suggests, the cup and handle pattern is visually seen by a cup and the handle.
The bullish cup and handle is formed when price breaks the cup’s resistance. You can then measure the distance from the resistance to the low and project the same from the breakout level.
The wedge pattern comes in two forms. A rising wedge pattern occurs in an uptrend and signals a bearish decline and a falling wedge which occurs in a downtrend and signals a bullish break out.
The wedge patterns are marked by steep rallies or declines in price followed by a brief period of consolidation. Similar to other chart patterns, the peak to the low point or vice versa is taken following which this distance is measured from the break out level.
The wedge pattern has five reference points, making higher highs and higher lows in a rising wedge pattern and the reversal is marked by a lower high just before the breakout. Similarly in a falling wedge pattern you can expect to see lower highs and lower lows being formed with a higher low coming just before the breakout.
The diamond pattern is a rare pattern but when it occurs you can expect price reversal on the horizon. This is usually formed at the top end of the rally and as the name suggests the consolidation leads to a diamond shape pattern.
Broadening Formation or Broadening wedge
The broadening wedge is where prices consolidate and in the process form higher highs and lower lows, thus expanding the range. At the end of the consolidation, the broadening wedge pattern breaks by forming a lower high before price fall sharply. The broadening wedge pattern occurs in a bullish trend. Similar to a rising or falling wedge pattern, the broadening wedge pattern is formed by five reference points.
b. Continuation patterns
Continuation patterns are those that form within the trend. These patterns occur when price consolidates after a sharp rally or a decline. Soon, the breakout from the consolidation level signals a continuation to the trends. Continuation patterns are safer to trade as you are trading in the direction of the trend. Below are some of the common continuation patterns.
The symmetrical triangle as the name suggests occurs within a downtrend or an uptrend. With the symmetrical triangle prices consolidate into a triangle form, starting with wider swings but soon moving into a tight range. The chart below illustrates a triangle pattern.
Ascending and Descending Triangles
The ascending and descending triangles occur in the direction of the trend. These are usually marked by a horizontal support or resistance level while price makes either lower highs or lower lows. This is then followed by price breaking out strongly from the support or resistance level. An ascending and descending triangle patterns can be visually similar to that of a wedge pattern.
Flag and Pennant Pattern
The flag and pennant patterns work on the same concept. They occur after a strong trend can the consolidation can be either in form of a flat or a pennant.
Both these methods signal a continuation following the breakout from the flag or the breakout from the pennant. The chart below shows the bullish flag and pennant pattern. The inverse of these become the bearish flag and pennant pattern.
Rectangle or Channel
The rectangle or channel pattern as the name suggests occurs when price moves within a channel. Here, the rectangle or the channel merely suggests a brief period of consolidation before the break out occurs. Most breakout trades that one comes across are nothing but continuation patterns to the previous trend.
Gaps are quite a common phenomenon in forex markets nowadays. Gaps are broadly categorized into a runaway gap which occurs at the start of a trend. Prices initially gap before posting strong moves. Following the runaway gap is the continuation gap. This occurs in the middle of the trend and suggests the continuation in the trend. Finally, the exhaustion gap occurs near the top where prices gap for the final time before the trend is reversed.
The flatbase pattern moves horizontally and can extend for prolonged periods of time. This is a powerful pattern as the previous trend is already formed. Following a flat movement, price then breaks out stronger. The flatbase pattern is somewhat similar to the rectangle pattern that is formed.
The parabolic chart pattern is formed based on the curve of the chart. This is a most sought after chart pattern and this is formed near the end of a bullish rally. The parabolic chart pattern is formed by multiple bases that are formed during the tenure of this pattern.
Key Factors in Chart Pattern Analysis
When analyzing the price of a security with chart patterns, it is important to pay attention to volume as well. Thus, chart patterns are ideally more suited to trade securities that are centralized as volume is measured more accurately. Typically lower volumes as price makes new highs or new lows are an indication of a looming correction in prices. Likewise, increased volumes based on key continuation patterns can be used as an additional form of validation for trading the chart patterns.
Besides volume, the time frame for which you are analyzing the chart also plays an important role. Sometimes you might find a continuation or a reversal pattern on an intraday chart. It is ideal to look at the major trend as well so as not to get trapped into fake patterns that might form. Remember that despite the chart patterns signaling the direction of the trend, they do not work 100% of the time. Therefore focusing on different time frames is a must when looking at chart pattern analysis.
The trend lines, support and resistance levels are all part of the chart pattern analysis. Come to think of it, a head and shoulders neckline is nothing but a support or a resistance level. Similarly, a trend line break is not very different from price breaking out from a rising or a falling wedge.
Why it’s important to Recognize Continuation and Reversal Patterns Early
Recognizing chart patterns early can be beneficial for your trading. You can identify the patterns and position yourself ahead of the crowd. Combining chart patterns alongside trend analysis ca give the traders great insight into what to expect from the markets. Although there is no such thing as 100% certainty… these chart patterns occur over and over again. If you can take time to learn how to recognize and trade these patterns, then the riches in world of trading is within your reach. Early recognition of these patterns equals anticipation. Good luck and stay safe out there…
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