When the average person thinks of stock trading, they think of someone running around the New York Stock Exchange with paper flying all around them. While this used to be somewhat true back before computers took over, it does not describe the entire picture and there is a lot more that goes on behind the scenes. In this blog post, we look at some of the main technical patterns traders look for when trying to look at what to buy and how these influence their decision-making.
Stock Trading Patterns
There are two approaches to stock analysis, technical and fundamental. Fundamental analysis looks at the effect of an economic change, such as the announcement of employment numbers, interest rate changes, and so on, to predict market behavior. By contrast, technical analysis looks at the company or index price charts themselves to identify patterns that predict future market direction based on a number of indicators and moving averages.
Being able to identify chart patterns, and to understand how to use them in a trading strategy can transform your approach and view of the markets. In this post, we will take a look at the most common chart patterns you will find, and what they mean for market behavior, and why they work more than you would think.
Types of Stock Trading Patterns
There are endless lists of chart patterns that you can incorporate into your trading strategy. However, there are some very common chart patterns that are the ideal place to begin. Not only do they appear relatively frequently, but have good accuracy rates too, offering a great way to master the techniques needed to see patterns emerging in real-time and use that to execute trades. A reason for these accuracy rates can be attributed to the self-fulling effect of technical analysis if enough technical traders are watching the same thing.
These six patterns below are some of the most used in the technical analysis world but this is not an exhaustive list. (To read about another widely used pattern, wedges, click here!)
- Bull flag
- Bear flag
- Bull pennant
- Bear pennant
- Head and Shoulders
- Inverse head and shoulders
Between these six patterns, you can identify possible market reversals, consolidations, and breakouts, giving you the tools to have a good idea of potential market behavior in almost all prevailing conditions. The first step to mastering technical trading is to know what these chart patterns look like, and what they reveal about potential future market movement. To do that, we can look at each pattern in turn, what to look for to confirm each pattern and what the likely market direction will be after the pattern is formed.
Stock Trading Patterns: Flags
There are two types of flag patterns, a bull flag in rising markets, and a bear flag for falling markets. They are otherwise identical, and they are perhaps the pattern that appears most frequently in any market. Flags are continuation signals, that is, they indicate that the market will continue in the direction of the previous trend. Up for a bull flag, down for a bear flag.
For a bull flag, the chart will show a high peak and then fall back, with lower highs and lower lows, forming a range with parallel upper and lower trend lines, support at the bottom, and resistance at the top.
The pattern is completed when the price breaks through the resistance trend line, forming new highs beyond the original peak as a continuation of the original upwards trend.
The bear flag occurs when a chart falls to a new low, then reverses with higher lows and higher highs, again, forming a range encapsulated by parallel upper and lower trend lines. Support is the lower trendline, resistance is the upper trend line. You are looking for the market to break through the support level, forming lower lows that the initial point and continuing the downward trend.
In both cases, you trade the breakout of the flag’s range, with an entry point after a candle has closed beyond the support (bear flag) or resistance (bull flag) trendline, buying an upward trend or selling a downward one. A stop would be placed somewhere above the high (for a sell trade) or low (for a buy trade) of the flag itself.
Stock Trading Patterns: Pennants
Another continuation pattern similar to a flag is a pennant. Bull pennants appear in a rising market, bear pennants in a falling one. As the chart is forming in real-time, pennants look much like flags but they do differ in appearance as the pattern develops.
Bull pennants, like bull flags, begin with a spike in price (creating the pole), and then the market pulls back as market participants take profits from the rapid increase in price. The difference is that here, the upper trendline(resistance) and lower trend line (support) are not parallel. Instead, a pennant forms (very similar to a symmetrical wedge) when resistance and support lines eventually converge at the tip of the pennant (apex point). The apex point is where the price should break through the resistance trendline and continue the original upward trend.
A bear pennant works the same, forming from a new low, with the consolidation of higher highs and higher lows. Again, the support (lower) and resistance (upper) trendlines form a symmetrical triangle, but this time, look for a breakthrough the support levels at the apex point for a continuation of the downward trend.
The concept of trading pennants is rather straightforward, look for the breakout upwards through resistance (in a bull pennant), or downwards through support (in a bear pennant) at or near to the apex point. Entry signals are a candle closure beyond the trendline, buying the upward trend or selling the downward trend. A stop is placed at the previous high (sell trade) or low (buy trade).
Stock Trading Patterns: Head and Shoulders
The head and shoulders pattern is probably the most well-known of all trading patterns and indicates a potential reversal of the current trend. They are found in an uptrend, forming three peaks, the central one the highest (the head), with two either side lower, but at roughly equal levels (the shoulders). The lows between these peaks can be connected by a trendline, known as the neckline, and this becomes the key support level that when broken through would indicate a reversal of market direction towards a downtrend.
Before: Head and shoulders setting up on Twitter
After: Twitter dropped 8% in about 20 days.
An inverse head and shoulders pattern appears in a downtrend and signifies the potential reversal point to an uptrend. It works in the opposite way, the head a lower low in the center, with two higher lows either side. Here, the neckline becomes the resistance level to look for a breakthrough to start an uptrend.
Trading an inverse head and shoulders pattern means watching for a close above the resistance neckline for an inverse head and shoulders, or below a support neckline for head and shoulders patterns. A stop would be placed above the high of the head (for sell trades) or below the low of the head (for buy trades).
Trading a Head and Shoulders Pattern
The first thing to understand when trading a head and shoulders patterns is being able to spot them, and that means knowing that they don’t always look like the textbook versions. The shoulders may not be perfectly level, there may be a few small movements between a shoulder and the head, the key is to use historical charts and practice so that you can identify the pattern quickly.
Once identified, first see where the pattern is forming, is it corresponding to a supply or demand zone? If it is, this strengthens the validity of the pattern. Next, drawing the neckline accurately is also important, you must wait for the pattern to complete before you do so, trade in what is there, not on what you think might be there. Many traders rush to get into a trade, and they are often looking to sell the market as soon as the support neckline is broken by the price action, but this can be a bad choice, resulting in many false signals.
Instead, be patient, and combine all the technical knowledge you must confirm every trading choice. This means firstly waiting for a candle to close below the neckline, rather than simply cross it (or above the neckline for an inverted head and shoulders) as the first entry signal. Check volumes to see if there is a corresponding rise in volume with the new price move to confirm the validity of the new direction.
Entry into the trade can then be made more confidently. A stop above the head allows plenty of room for the trade to breathe, although it can present a higher level of risk. Some traders prefer to use a stop just above the right-hand shoulder to lower the risk on the trade.
Profit targets are important, what they depend again is based on your trading style. Some take the difference between the shoulder low and the head (shoulder high and head low for inverted) and then use that as the target value to reach. Others prefer to look for the opposite demand or supply zone, and trade to those values. Others watch volume levels and wait for the new trend volumes to fall and then exit.
Stock Trading Patterns: The Statistics
While the patterns are used as ways to spot trend changes, continuations, and reversals, it is important to understand the underlying technical details of supply and demand that create them, and just how effective each one can be.
Flag trades show a pause in a trend, and this is usually a sign that a market has reached a pressure area. This could be a minor support or resistance point, or some other area where traders are looking to take some profit. As we know, no market goes straight up or down, during trends as resistance or support points are reached. In an uptrend, that means an increase in selling as traders take profit from long positions. In a downtrend, that would increase buying as traders do the same to take profit from short positions.
This behavior appears in the pattern as the consolidation area, and once the selling or buying positions are exhausted, the support or resistance level is broken, and the trend continues. Like all technical analysis, not every pattern is created equal, and the best flag patters feature a strong price run beforehand, as near to vertical as possible, along with a tight flag very close to the top. The narrower that flag range, the more likely the trend will continue upon a breakout.
Flags are averagely performing technical patterns, with both bull and bear flags around 67% accurate.
The underlying supply and demand behavior behind pennants are very similar to flags. The main difference is the variation is the volume of traders taking profits, which sees a faster reduction in the range of the consolidation, which is revealed in the converging trendlines.
However, there is an important difference, and that is in the accuracy of these patterns. At around 55% correct, the pennant patterns are significantly lower than the flag that they are a variation of, or the head and shoulders. The reason is that because it can be generated by a rapidly diminishing number of profit takers, it is more prone to show up on even minor price stalls than the flag pattern, which requires a much more solid occurrence of profit taking to appear.
Head and Shoulders
Head and shoulders patterns, whether normal or inverted, are the most reliable chart patterns there are. At 83% accuracy, it is easy to see why they are also the most popular for traders all over the world. The pattern shows a battle between buyers and sellers, and if we look at head and shoulders specifically, we can see how this works. The uptrend is caused by demand as buyers push prices higher, but as they hit a resistance level or other pressure point, sellers become dominant, whether simply taking profit or other strategies, causing a dip in price. However, as demand is still high, this dip is short-lived, with buyers quickly asserting dominance again, sending the price up to the high that forms the head. Again, sellers take over as the market reacts to the high, taking profits or entering at resistance levels in short positions, the market dips again.
This is repeated for the right shoulder, and those three together show that the demand (buyers) is not strong enough to overcome the sellers. Eventually, as the neckline resistance is broken, sellers become the dominant force and the market turns downwards. This process works in reverse for the inverse head and shoulders.
Trading Supply and Demand
As we can see, these patterns show us a great deal about what is actually happening in the markets; the constant battle between buyers and sellers. In market terms, this is supply and demand. You can clearly see this on a chart, supply zones are where supply overwhelms demand, that is, there are fewer buyers than sellers, and prices struggle to go higher. Conversely, a demand zone is where buyers outnumber sellers, forcing the price upwards.
This matters to chart pattern trading, as both flag and head and shoulders patterns are formed in these areas. The head and shoulders form at the top an uptrend as it reaches the supply zone, with the price falling back down. AN inverse head and shoulders form at the edge of the demand zone, forcing the price back up.
Flags can also occur in both supply and demand zones, but in this case, the prevailing trend continues, breaking that level and forming new supply and demand zones. The combination of supply and demand zones, identified by constant turns of price over a period of time, and the chart patterns, can make exceptional trading strategies. By establishing the supply and demand zones on a chart, as patterns form, you can make trading choices not just relying on patterns, but with confirmation from a supply or demand zone for improved accuracy.
So far, we have concentrated on the supply and demand aspects of the chart patterns. However, there is another way to look at them. Chart patterns show us price action, that is, how the price is moving due to the underlying activity. We can also use the trading volume to confirm the movements that chart patterns are predicting.
Trading volume is simply the number of shares being traded on a particular instrument, and it can be useful in understanding the strength of a price trend. If the trend is strong with rapid price changes, you should also see increasing volume levels as well. If there is a strong movement without a corresponding increase in volume, then that move may be a short spike that will not continue.
When combined with chart patterns, you can see how volume could be used to confirm a trade. For instance, as a head and shoulders pattern is forming, you may see volume decrease as the uptrend reaches its limit. As you wait for the entry signal, a close below the neckline, if you also watch volume, you can see how well any reversal move is supported, and then know if it is more likely the trend will continue. With any trading strategy, having as many confirmations as possible is a good thing, and volume can be an easily seen and followed indicator to do just that.
In addition, trading volume can be used to help identify exit points in the trade, as volume falls, the trend is more likely to fail, allowing you to exit early and be ready for the next trade.
When trading, rules are important. When trading in the moment, it is easy to let excitement, greed, or fear take over and make the trading choices for you. The best traders follow rules that eliminate the emotional aspect of trading, at least as far as actual trading decisions are concerned. You can do this too, with your list of trading rules, which should look something like this:
- Establish supply and demand zones for your chosen stock or index.
- Let any pattern form before making any decisions.
- Always trade what you see, not what you believe.
- Check if the pattern is forming at or inside your support or demand zone.
- Draw the neckline accurately.
- Wait for the price action to cross the neckline.
- Wait for a candlestick to close below (or above) the neckline.
- If the volume suggests the trend will continue, enter the market.
- Use stops as appropriately.
- Have an exit strategy before the trade begins.
With all that in place, you can combine price action, volume, supply, and demand, as well as technical analysis and accurate chart patterns like the head and shoulders pattern, to trade effectively without requiring endless indicators and clutter that so many books tell you are necessary.
Technical pattern trading is a process of finding patterns on a price chart and acting on the chart based on the statistical chance price may up or down. By using chart patterns, supply and demand, volume and price, we can identify likely price movements with high levels of accuracy, and trade profitably as a result. However, the only way to truly be a successful trader is to remove emotion from the trade and stick to a plan that has worked consistently (years). As many traders will see, it will actually take years to master the trade, and even then, it is just not for everyone.