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The Ultimate Guide to Chart Patterns

Chart patterns help traders understand market sentiment at any given point in time. Unlike technical indicators, identifying and analyzing chart patterns is qualitative (subjective) rather than quantitative. It’s not enough to simply recognize a pattern — you must look at the bigger picture to validate it. This means assessing the strength of a chart pattern and using other forms of technical analysis to confirm it.

Let’s take a look at what chart patterns are, some of the most popular patterns, how to trade them in practice and other important considerations.

Table of Contents

What Are Chart Patterns?

Chart patterns are simply combinations of trend lines. For example, two converging trend lines may form an ascending triangle, descending triangle or symmetrical triangle. These patterns carry insights into market sentiment. An ascending triangle is a sign that bulls are gaining momentum while a descending triangle suggests that bears are gaining momentum — both potentially leading to a breakout or breakdown.

There are three types of chart patterns:

  • Continuation Patterns – These chart patterns suggest a continuation of the previous trend. For example, price channels and pennants both suggest that the price will continue moving in the same direction as the trend.
  • Reversal Patterns – These chart patterns suggest that a trend will reverse direction. For example, the head and shoulders pattern and double tops or bottoms suggest that the price may reverse its prior trend rather than continuing it.
  • Bilateral Patterns – These chart patterns don’t predict the direction of a move, but suggest that there will be an upcoming inflection point. For example, ascending triangles and symmetrical triangles suggest an upcoming move.

Many traders combine chart patterns with other forms of technical analysis. For instance, harmonic chart patterns incorporate Fibonacci sequences to structure retracements and projections. Other traders look for specific patterns that occur over a long period of time, such as Elliott Waves, which can be used to predict a series of price movements over a long period of time.

Chart patterns are highly subjective in nature, which makes it challenging to automatically identify them. TrendSpider automatically identifies and draws trend lines on a chart to help you identify chart patterns. You can also create your own trend lines and add SMS or email alerts to them when a breakout occurs. That way, you can track many different charts without watching them every second.

There are many different chart patterns out there — after all, the  it’s possible to draw conclusions about nearly any combination of trend lines. That said, only a handful have reached widespread popularity due to their accuracy and utility.

Let’s take a look at the five most popular chart patterns.

Price Channels

Price channels are continuation patterns created with two parallel trend lines. The upper trend line indicates resistance and the lower trend line indicates support. If the trend line is sloping upward, it’s referred to as a bullish price channel, and if it’s sloping downward, it’s referred to as a bearish price channel. A breakout or breakdown from the upper or lower trend lines could indicate a reversal from the prior trend.

Let’s take a look at an example of a price channel:

 

Price Channel Example

In this chart, upper and lower trend lines create a horizontal channel where the price has remained over the course of several months. Traders using this pattern would consider buying when the price nears the lower trend line (e.g. trend line support) and selling when the price nears the upper trend line (e.g. trend line resistance), betting on a continuation of the trend.

Ascending & Descending Triangles

Ascending and descending triangles are bilateral patterns with one horizontal trend line and another converging trend line. A converging trend line with a downward slope is a descending triangle and a converging trend line with an upward slope is an ascending triangle. Traders look for a breakout or a breakdown from the horizontal trend line as an entry point for a trade.

Let’s take a look at an example of an ascending triangle:

Ascending Triangle Example

In this chart, there’s an ascending triangle forming over the course of several months with four upper trend line touches and three lower trend line touches. Traders would look for a breakout from the upper trend line on high volume with a close above that level. The price target would be equal to the distance between the upper and lower trend line at the beginning of the pattern added to the upper trend line — or $58.50 (($48 – $37.50) + $48).

Rising & Falling Wedges

Rising and falling wedges are reversal patterns consisting of two sloped, converging trend lines. Two trend lines that are sloping up are referred to as a rising wedge, while two trend lines sloping down are referred to as a falling wedge. Traders look for a breakout or breakdown from these trend lines as an indication or a reversal taking place over the near-term.

Let’s take a look at an example of a falling wedge:

Falling Wedge Example

In this chart, the falling wedge indicators that a potential reversal could take place over the near-term — and one does begin to occur in the latest two candles. Traders would look for confirmation of this reversal in other technical indicators and then consider a long position in the stock.

Double Tops & Bottoms

Double tops and bottoms are reversal patterns that occur when the price touches the same level twice before moving in the opposite direction. For example, a stock trending lower may make a low, rebound from the low and make the same low once again. Traders will look to buy the stock after it rebounds past the preceding reaction high.

Let’s take a look at an example of a double bottom:

Double Top Example

In this chart, the stock is forming a double top that could indicate a near-term reversal. Traders may want to look for a breakdown from the 50-day moving average and the reaction low as a confirmation of the reversal before entering into a bearish position. The price target for the pattern would be the height of the chart pattern minus the pattern’s initial price — or about $33 in this case (($39 – $36) – $36).

Head and Shoulders

The head and shoulders is a reversal pattern that occurs when there’s a series of three highs or lows. The first and third highs or lows are roughly equal in price and the second high or low reaches an extreme. The combined pattern resembles a head with two shoulders. Traders look for a reversal following the third high or low given the lack of momentum. The neckline is a trend line drawn using the two reaction highs or lows between the pattern.

Let’s take a look at an example of the head and shoulders pattern:

Head and Shoulders Example

In this chart, the head and shoulders pattern in this chart suggests that the stock could see a near-term reversal once the price breaks down from the neckline at about $33 on sufficient volume. Traders would look to enter a short position at that point with a price target that’s equal to the distance between the neckline and the high minus the neckline — or $24 (($42 – $33) – $33).

How to Trade Chart Patterns

Chart patterns are subjective forms of technical analysis, which means that it’s important to validate the strength of the pattern and look for confirmation. There are many different ways to assess the strength of a pattern, but most of them boil down to touch points and volume — the strongest chart patterns are those where the price has reacted to trend lines many times on high volume.

Some important tips to remember when trading chart patterns include:

  • Pattern Strength – The strength of a chart pattern depends on the number of times the price reacts to the trend line, as well as the volume of the movements during those reactions. More high volume touches translates to a stronger signal.
  • Breakout Confirmation – The most important factor to look at during a breakout from a chart pattern is volume. High volume breakouts are much more reliable and help validate the chart pattern’s projections.
  • S/L and T/P Points – Stop losses (S/L) are often placed at the lower trend line of the chart pattern, while take profit (T/P) targets differ depending on the pattern. It’s a good idea to know these points before entering a trade.

The Bottom Line

Chart patterns are a subjective form of technical analysis, but they can be very powerful when used in conjunction with other forms of technical analysis. For example, harmonic patterns have become extremely popular among many swing and positions traders.

Sign up for a free trial of TrendSpider today to see how automated trend line analysis can help improve your chart pattern recognition.


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