How to Use Stock Chart Patterns
T he aim of any good trader is to see trends as they happen in the market and act more rationally than the crowd. Knowing how stock chart patterns work can help make technical analysis understandable. Past trends form a few basic shapes on stock charts, giving you a visual tool to guide your investments. While Raging Bull is not a stockbroker or an advisor and cannot make specific recommendations, we can provide an education into the basics of technical analysis so that you’ll be better informed when you invest.
Here are some of the visuals or graphics usually involved in technical analysis of the chart patterns for the stock market:
- Bull flag.
- Ascending triangle.
- Double bottom.
- Cup and handle.
- Bear flag.
- Descending triangle.
- Double top.
- Head and shoulders.
- Candlestick hammer.
What Is a Stock Chart Pattern?
A stock chart pattern is a shape formed from rises and falls in the price of a stock over time.
The length of time could be short or long, and you could look at different periods depending on what type of trading you’d like to do. For example, you might be looking at short-term trends in penny trading. Technical analysts usually associate certain patterns of rise and fall in price with bearish or bullish tendencies in the market, breakthroughs, or other price events.
Types of Stock Chart Patterns
Common stock chart patterns that it can help you to understand include:
Image via Flickr by dflorian1980
A bull flag is a stock chart pattern that shows a steep, pole-like rise, followed by a flag-like horizontal period of leveling off. A stock with climbing value followed by leveling could indicate that some investors have reached their set points where they sell high. In other words, they’re cashing in and profiting on a successful stock. Unlike a rise followed by a fall, a rise followed by leveling is a pattern that could indicate a common stock pattern with potentially lower risk of loss.
Doing technical analysis of the ascending triangle stock market pattern can help you get an inkling of an improving stock without making the mistake of buying excessively high. You may have heard the advice ‘buy low, sell high’ before, but found it hard to implement, since successful stocks that look good might already seem high. However, with ascending triangle chart patterns in the stock market, the lowest prices that people are willing to sell at are getting higher. Meanwhile, the highest prices that people are willing to buy for remain steady, reducing the risk that this buy would be a ‘buy high’ failure, while giving a subtle indication that the stock might improve.
The W-shaped double bottom stock pattern is another one you could buy on. Like the ascending triangle, the double bottom indicates that there is a limit on how low stock owners are willing to sell, meaning that a damaging circumstance might actually have limited damage and leave room for growth. While a stock that shows this pattern would have undergone two dips, both dips would be level, rather than the second dip being even lower than the first. So this could be a good choice for someone who wants to buy low but still get a good chance at owning an improving stock.
Cup and Handle Going Up
Similar to the W pattern of the double top, the cup and handle going up also shows that investors are willing to limit how low they sell their stocks for, indicating that they consider them to be worth more. However, the cup and handle going up shows a curved pattern indicating a gradual move. Because the ‘handle’ shape has a much higher low than the cup, this could be seen as having positive potential on a stock chart. The key takeaway is that even when the stock dips down, it’s at a level that has potential to limit your risk if it follows the gentle curve of the cup and handle and doesn’t have its low point dip beneath the lowest point of a cup on the stock chart.
A bear flag is a reverse pattern shape to the bull flag. Comparing bear flags over time can give an investor information about whether the lowest price investors sell at is dropping or not. When investors decide whether to set stop losses in place, and if so, where to place those stop losses, bear flag patterns in the chart can give an idea of how low a drop is desirable or within risk range.
A descending triangle pattern indicates that the market is having ups and downs, but in a way that appears to be getting worse over time. You’ll see the stock go up, forming a triangle when it goes down again, and you’ll see it go up again, but not as high, and then down even lower than it was previously. While advanced traders might consider short-selling in a descending triangle pattern, it’s generally not considered a strategy suitable for beginning traders.
The bearish M-shaped double top stock market pattern requires the reverse technical analysis from the bullish W-shaped double top. This stock would show a trend of buyers having a top level that they just don’t want to pay beyond, indicating that there may be growth limits to the stock in question.
When a major shift in the market price of a stock happens suddenly, you will see what looks like a gap on the stock chart as the value changes in a short time period. The circumstances surrounding a gap, such as whether it took place at a breakaway point and the price grew higher abruptly or at an exhaustion point where the price plummeted, will determine what you should do.
Head and Shoulders
When you see a head and shoulders pattern on a stock market chart, it’s a reasonable indication that a formerly successful stock could be about to drop into a less bullish, more bearish mode. This pattern indicates that the stock hit a ceiling, followed by a higher ceiling, followed by a drop down to the same lower ceiling as before, so that the highs of the stock look like two shoulders with a head in between. While no pattern is perfect, this stock chart pattern could indicate that the stock is not about to take off in explosive growth.
A candlestick is a type of stock chart that originated in Japan and shows the high point and low point of a day’s trading, along with the opening and closing price for the day. If you have multiple days of candlesticks, you can look for patterns such as the hammer, a bullish pattern where the stock price rises as the day ends.
When an event or emotional selling causes stocks to fall, you’ll see a dip shape on the stock market charts. Since dips could be temporary, they offer some investors what they believe is a chance to buy stock while the price is low.
However, because dips could result from more permanent or lasting downward trends in the stock, investors should take care to monitor other patterns that have taken shape by looking at the stock’s history and considering factors for its future. This is where fundamental analysis and technical analysis meet. Aside from what just happened with the dip event, you need to know whether the business you’re interested in can balance its books.
Fundamental vs. Technical Analysis
Whether you’re counting on investing with industry disrupters or dipping your toes in the penny stocks marketplace, learning how to combine technical analysis with fundamental analysis could help you increase your chances of gaining more than you lose in the stock market.
Fundamental analysis tools like earnings statements and filings can give you an idea of the long-term stability of a company. You can use them in combination with technical analysis tools like stock market chart patterns to decide what risks you’re willing to take. While one involves documents and the other involves patterns, you can use both to help you make informed decisions about your investments.
Y ou’ll be glad to familiarize yourself with stock market chart patterns if you’re planning to become an active investor. Looking at these patterns in both the long-term and the short-term can be helpful, since many patterns might repeat over time in the same company or over multiple investments you hold. By keeping a calm head and looking at dips and rises rationally, you can avoid being blindsided by fear or an impulsive desire to make quick money. Instead, you can apply your technical skills to your marketplace choices.