Monitoring chart patterns is one of the most basic technical analysis activities that day traders and swing traders routinely use. This is because chart patterns can help you predict future price behavior more accurately.
Basically, the pattern shows that the price action is not as random as many traders believe, but instead follows repetitive movements and when it forms particular patterns, it tends to act in a specific manner.
What are some of the patterns that can help you to become a more profitable trader? Check this list out and try it on your own. But first, a little introduction to what these chart patterns are is in order.
What Are Chart Patterns and Why Should You Bother?
Chart patterns, also called stock patterns, are certain well-known configurations of price actions that occur within a defined period. The observation period can vary from intraday frames to a month or more. Chart patterns are also called price patterns and these play a crucial role in technical analysis.
The chart pattern can either signal the continuation of a trend or pattern or a possible reversal. If the pattern depicts a change in the trend, it is termed as a reversal pattern. On the other hand, when an existing pattern continues (albeit with a pause in between) in the same direction without any other change, it is called a continuation pattern. The popular continuation patterns include flags, pennants, and wedges.
Experts usually identify three main types of stock patterns that can be used in analysis when trading. These include traditional chart patterns, candlestick patterns, and harmonic patterns.
Chart patterns play a critical role in predicting future and current trends to some degree of accuracy.
How to Identify Chart Patterns
Trendlines are an important tool in technical analysis. These are straight lines that are drawn on the chart. You typically proceed by joining the consecutive lows or troughs which are ascending or by joining the peaks or highs that are descending.
Identifying chart patterns is an art and can only be mastered with practice. You will need to draw and redraw lines and think imaginatively to identify stock patterns. When identifying a pattern in a chart, remember to allow for some leeway; not every point will perfectly fall in line and that is fine.
You should also consider having a look at our online resources which explain the uses of technical analysis tools when making trading decisions. Your strategies should always follow a deep understanding of the charts and the insights they conceal.
That said, let’s explore some of the most important chart patterns that every trader must be familiar with.
The gap is a free space between two “candles” on the chart. It takes place when the price of a share opens visibly higher or lower than the previous day’s close. Basically, a gap can be identified in the charts when you see a void; an empty space between two periods. This is characterized by either a major increase or a major decrease in the price.
The gap is an important pattern because it comes with a new resistance/support level. Gaps higher form a new support line that pushes the price up, while the gaps lower form a new resistance line, which pushes the price down. If you combine the gaps with more technical indicators, such as volume and momentum indicators, you can get even better signals.
In general, gaps occur when there is strong buying or selling in premarket trading from institutional traders.
Some beginners do not understand that the gap is mostly a trend continuation signal. They want to profit by trading against the general trend, waiting for the price to come back. Professional traders tend to open positions in the direction of the gap, particularly when it is accompanied by high volume.
This is what the gap pattern looks like visually:
There are three kinds of gaps in trading: breakaway, exhaustion, and runaway. While breakaway gaps will be found at the start of a trend, the exhaustion gaps are near the closing of the trend. The runaway gaps, as you might have guessed, are found in the middle of the trend under consideration.
Double Tops and Double Bottoms
Double tops and double bottoms are trend reversal patterns, suggesting that they point to a future change in the price direction. Whenever the pattern is formed, the trader is expected to open positions against the trend.
The double top resembles an “M” while the double bottom is shaped like a “W.” Basically, double tops rise and fall twice in quick succession, while double bottoms fall and rise twice in quick succession.
As the name suggests, the double top is made by two regional peaks that hit relatively the same resistance level. Once the price tries to break the resistance twice and cannot do it, the double top is formed and it is time for a trend reversal.
Double bottoms are the same pattern described above but simply a mirrored version of it. Double bottom is formed by two lows that reach the same level in a downtrend. If during a bearish market the price cannot break the support level twice, then a trend reversal may come and it is time to buy.
Here is a double bottom on Amazon’s stock chart:
Head and Shoulders
The head and shoulders pattern is one of the most popular and accurate trend reversal stock patterns, which often occur in an uptrend. The pattern is formed by three successive peaks, where the middle one is the highest (the head) and the other two stay relatively at the same level (shoulders). The intermediate support line formed between the peaks is often referred to as the neckline.
Despite the fact that the main components of this figure are the three peaks (head and shoulders), you should consider additional important factors that make this pattern even more precise.
- The break of the support
- Target price
- The conversion of the support line into resistance
Ideally, the shoulders should be symmetrical and aligned. But the signal is reliable even if one of the shoulders is higher or lower than the other one. The key takeaway with a solid head and shoulders pattern is that a bullish to bearish trend is possibly on the way.
Here is an image showing the head and shoulders pattern:
Flag and Pennants
The flag and pennant stock patterns are trend continuation signals, like the gap. They suggest that you should open positions in the direction of the current trend. They are some of the most frequent chart patterns. Both flags and pennants appear after a sharp move up or down.
Now, let’s speak about their construction; the flag has two parts: the straight line, which is the flagpole, and the flag itself. The flagpole represents the sharp movement of the price, which is a short-time rally or price collapse. The flag is made of almost parallel lines. When the price breaks the flag line, you should start trading in the direction of the trend.
The pennant has the same two parts, but instead of the flag formation with parallel lines, it has intersecting lines made of peaks and lows. You can note how the highs tend to gradually reduce while the lows go up. The pattern resembles a triangle, which makes it difficult for a beginner to read it. However, you should know that a triangle needs over 30 candles and it does not come after a ‘flagpole’. The pennant has the same rules as the flag.
Here is a flag pattern (downtrend) on the S&P 500 index:
And here is a pennant pattern (downtrend) on Amazon’s share price:
Final Words – Importance of Chart Patterns
This is just a basic introduction to chart patterns and how to read certain signals in order to assist you in making better trades. We suggest reading more in-depth articles (such as on candlestick analysis, etc.) for a more complete understanding.
Technical analysis involves looking out for specific and identifiable stock patterns in the charts which can have major roles to play in determining the trading strategies. It is important for a trader to be well-versed with the major price patterns and what each of them signifies in terms of the market movements.
In particular, traders who extensively use charts in their decisions are called “chartists”. This is an activity that involves a great deal of skill and expertise. Using the charts and studying the patterns is a great way to identify opportunities to buy, sell or simply wait.
Make sure you understand how chart patterns indicate trend continuations and reversals. It is recommended to check out our technical analysis tools which will strengthen your skills and expertise in this very important area.