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The Ultimate Guide to Chart Patterns
Chart patterns are used within the study of technical analysis to help traders understand and interpret market sentiment as well as to develop trading plans. Unlike technical indicators, identifying and analyzing chart patterns is qualitative (subjective) rather than quantitative. One trader might see a flag pattern whereas another might see a wedge or channel. With that in mind, it’s not enough to simply recognize a pattern. A trader must look at the bigger picture to validate it. This means first assessing the strength of a chart pattern and then use other forms of technical analysis, like analyzing indicators or price action, to confirm it.
In this article, we’ll take a look at what chart patterns are, identify some of the most popular patterns, and explain how to take trades based on them, as well as other important considerations.
What Are Chart Patterns?
Chart patterns are simply combinations of trend lines that are measured based on price action. For example, two converging trend lines may form an ascending triangle, descending triangle, or symmetrical triangle. These patterns carry insights into market sentiment. For example, an ascending triangle, with its higher lows and tightening price action at a previous level of resistance is a sign that bulls are gaining momentum and suggests the potential for price to break to the upside. Inversely, a descending triangle with its lower highs and consolidation at a previous level of support suggests that buyers are weakening and that bears are gaining momentum, potentially leading to a breakdown in price.
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, as well as double tops or bottoms, suggest that the price may reverse its prior trend rather than continue in the same direction.
- 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 future price targets based on previous Elliot Wave lengths and their corresponding expectations.
TrendSpider’s Automated Chart Pattern Recognition
Chart patterns are highly subjective in nature, which makes it challenging to automatically identify them. TrendSpider has been able to automatically identify and draw trend lines on a chart for some time, and with the addition of our new ‘Automated Chart Pattern Recognition’ feature, our aim is to help traders more easily identify more complex chart patterns like the ones mentioned above. 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 patterns that are currently setting up without watching them every second.
Popular Chart Patterns
There are many different chart patterns out there, but 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 channel 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. All channels can break in either direction, but often, ascending channels will ultimately resolve to the downside whereas descending channels will resolve to the upside. Horizontal price channels can resolve in either direction, depending on whether distribution or accumulation is occurring to create the channel. A breakout or breakdown from the upper or lower trend lines could indicate a reversal from the prior trend.
How To Trade This Pattern
In the three charts pictured above, upper and lower trend lines create channels where the price has remained over a long period of time. Traders looking to profit from the current trend would use the patterns to buy near the channel lows and sell near the channel highs. Contrarian traders would be looking for a break in the trend, or price leaving the channel and then returning back to the top or bottom of the channel to retest it. Upon the retest of the top of the bearish price channel after a break to the upside, a trader would switch bias and go long. With the retest back to the bottom of the bullish price channel after a break to the downside, a trader would go short.
Ascending, Descending, and Symmetrical Triangles
Ascending and descending triangles are bilateral patterns with one horizontal, or nearly horizontal trend line, and another converging trend line. A converging trend line with a downward slope creates a descending triangle and a converging trend line with an upward slope creates an ascending triangle. Symmetrical triangles are formed by two diagonal trendlines that are either perfectly, or nearly perfectly symmetrical. This simply means that a line can be drawn through the middle of the two trendlines and the distance between the middle line and the descending and ascending trendlines is nearly equal.
How To Trade This Pattern
In all three of these formations, a hasty trader might look for a breakout or a breakdown from the triangle top or bottom as a reason to enter into a trade. If the breakout occurs on above-average volume, that would give a trader more confidence in the validity of the breakout or breakdown. A more patient trader might prefer to wait for a retest of the triangle, followed by a rejection or a bounce, to confirm that the old level of resistance is now acting as support or that the old level of support is now acting as resistance.
Rising & Falling Wedges
Rising and falling wedges can act as both reversal or continuation patterns, depending on where price is coming from before the pattern occurs and how it resolves out of the pattern. They consist of two sloped, converging trend lines. A rising wedge is formed by two upward-sloping trend lines, while two trend lines sloping down are referred to as a falling wedge.
How To Trade This Pattern
In the image above, we see instances of both continuation and reversal. On the left, price was increasing, then it pulls back and consolidates before breaking out of the falling wedge and continuing an additional leg higher. In the middle, we see the opposite. Price was decreasing, then it attempts to bounce and consolidates before breaking down from the rising wedge and making another leg lower. It is also not uncommon to see these patterns act as reversal points, like in the chart on the far right. Price was headed lower but is able to break out of the falling wedge to the upside and reverse course.
In general, falling wedges are considered to be bullish patterns while rising wedges are considered to be bearish patterns. That said, in order to determine if these patterns will resolve in continuation or reversal, it’s often wise to use additional indicators, like the Relative Strength Index, and then look for divergences between RSI and price. In the instance of a continuation, an additional indicator like volume might be used to confirm price breaking higher or lower. In the instance of a reversal, it can be tricky to buy the breakout or breakdown of the wedge, and it is often wise to let price retest the wedge before taking a position. A picture-perfect breakout and retest can be seen in the chart on the right.
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Double Tops & Bottoms
Double tops and double bottoms are reversal patterns that occur when 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, or nearly the same low once again at a later date to retest it and make sure it holds. The type of price action can occur at a previous high, also.
How To Trade This Pattern
The key point to keep an eye on in the event of a double top or double bottom is the reaction, or bounce, high or low that’s made in between the highs or lows that comprise the pattern. For a double top pattern, the active trader might want to enter into a short position once price breaks below the reaction low. This level is marked with a red line on the chart on the left. The opposite is true for a double bottom. A trader might want to enter into a long position once price is able to get above the initial bounce high. This level, too, is marked with a red line on the chart on the right.
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 events in price action resemble 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. The validity of a head and shoulders pattern is strengthened if a lower low or higher high is made on the second reaction low or high in between the two shoulders.
How To Trade This Pattern
In the chart on the left, the key moment is the new low that’s made to begin forming the right shoulder. Once that new low is made, the stage is set for an eventual retest and failure at the high of the left shoulder. As upside momentum slows, price rejects very near the high of the left shoulder and a continuation lower begins. A hasty trader could take a short position on the retest of the left shoulder high, and a more patient trader might want to wait for the pattern to confirm. This occurs when a new low is made against the reaction lows in between the two shoulders circled in the image.
In the chart on the right, the opposite setup exists. Price manages to make a new high relative to the reaction high between the left shoulder and the head. Once that new high is made, it sets up a retest of the left shoulder. In this instance, it seems buyers stepped in just before a perfect test of the low of the left shoulder, sending this name higher, above both of the reaction highs between the two shoulders. A hasty trader might try a long position on the retest of the left shoulder low, and a more patient trader might wait for confirmation, which occurs when a new high is made relative to those reaction highs.
Things To Remember When Observing 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 keep in mind when trading chart patterns include:
- Pattern Strength – In many cases, 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 translate 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.
