What are chart patterns? Part 1

What are chart patterns? Part 1

Chart pattern
Image by @KEN_G

Chart patterns are a popular technical analysis technique, whereby you identify patterns on a chart that the price forms. It’s been found that certain patterns replicate over time and if you can identify them, you can predict the next move of the price.

They can be formed on any timeframe, from the one minute chart up to the monthly, and everything in between. Likewise, you’ll also find them on all types of assets. Where the price changes over time, you will likely be able to identify certain patterns.

If you have enough price data, you can see that the same patterns that occurred hundreds of years ago are still relevant today. That is because the price of a market is determined by traders’ emotions. And human emotions have not changed, humans still feel greed, anxiety, nervous, despair and more.

How do chart patterns work?

Chart patterns work because of two of the connected principles of technical analysis:

  1. Patterns repeat themselves
    • If you can identify a pattern that has shown to work, then you can trade in the expected direction and profit
    • While it’s not guaranteed, if you were to take the same trade 100 times, it would be profitable more often than not
    • This is why you must not give up on a chart pattern if one doesn’t work. The idea is that on average they will work therefore you must be prepared to lose as well as win
  1. History repeats itself
    • History does tend to repeat itself, maybe not exactly the same, but there are definitely similar patterns that can be recognised. This is because as mentioned earlier, market price is determined between the interaction of humans and their emotions, this is what drives the price
    • Key drivers of price include macroeconomic, fundamental and geopolitical events, which while do change over time, are also similar (a natural disaster is the same no matter when it happens, it directly affects the region and the people where it happens, and this will affect the price of certain markets in those regions)
    • History is repeated again because of human interaction. The emotions and behaviours of groups of individuals affect the price, no matter when in time you’re looking at a markets price

An example of human emotions not changing over time might be parenthood. Parents are excited, happy and proud of their children but when they see them in a risky situation, they will feel fear and nervousness. This hasn’t changed over time and it’s the same with the markets.

If an investor 200 years ago see’s their investment falling, they’re likely to feel nervous and might be inclined to sell their investment for fear it will go lower. That same emotion is true today, and one of the big reasons we see crashes in the market. Everyone is getting scared and selling up quickly.

You can spot these emotions in chart patterns and can use these to your advantage because they repeat themselves.

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Understanding chart patterns

Understanding how chart patterns work, you’ll need to know a few things: 

  • Signals: Patterns provide either bullish or bearish trade signals which you will need to understand. 
  • Why they work: Understanding why they work helps you have confidence in the strategy. If you don’t understand why it works then you can quickly start to question your trades, which leads you to doubting yourself
  • Targets: Chart patterns not only give you a direction and an entry but they can also provide you with a target, which help you gain the maximum profit

Why are chart patterns important?

  • Chart patterns provide a structure or framework for you to trade around, essentially giving you a strategy to follow and deciding when you should buy or sell
  • They’re great to use to back up your primary analysis techniques, lots of traders use them which also means that the patterns are more likely to work. The more people that trade them the more likely the market will go in that direction
  • They’re great ways to identify a trade set up. This includes finding the direction and entry and exit levels, this includes stop loss and take profit levels
  • You can use chart patterns on lots of markets including stock charts, index charts, forex charts and more. All you need is a relatively liquid market that isn’t influenced by any large participant from either the buy or sell side

What is pattern recognition?

Pattern recognition is as it sounds, it’s the process of identifying a chart pattern on a chart.

It’s a subjective task, which is why it can be difficult at first. You first need to understand each pattern and go back and identify past patterns to see how they work. With this experience, you will then find it easier to recognise patterns in real time. 

You can also use automated chart pattern recognition software, which as it sounds, will automatically recognise patterns for you. This is done based on data plugged into an algorithm. While these are good ways to identify patterns, we’d also recommend that you understand how to do this manually as well. It will help you decide which of the automated patterns you should take seriously and which might be less likely to succeed.

What is consolidation in trading?

You may well hear the term consolidation in trading, and it basically means that the market is going sideways. Neither the bulls or bears are in control and the market is waiting for a break out in either direction.

You find consolidation periods in between trending markets and they’re often gearing up for a move in either direction. It is often caught between key support and resistance levels. These are the levels we as traders are waiting to break to show us the direction the market intends to go.

Often you’ll find that chart patterns happen in these consolidation periods, that’s because the market was in a trend but now is looking to either reverse or continue in the same direction, but using chart patterns helps you trade both directions.

Consolidation phase
Screenshot from TradingView

 

What is range trading?

Range trading is trading within a consolidation period. When the market is going sideways, you can trade between the support and resistance levels that it’s stuck in. Here are a few things you should know about range trading:

  • You can trade between the support and resistance levels the price is stuck in before it decides which way it wants to break out
  • You need to identify the bottom and the top of the range using support and resistance levels
  • Sell at the top of the range, at resistance, and target the support level
  • Buy at the bottom of the range, at support, and target the resistance level
  • For a higher chance of success, you should identify the underlying trend and only trade in that direction. For example, if the underlying trend is up, then you should only be looking to buy at support and not looking to sell at resistance
Range trading
Screenshot from Trading View

What are the three main groups of chart patterns?

Chart patterns come in three main types; reveral, continuation, bilateral. 

Reversal chart patterns

Reversal patterns are some of the most popular patterns to trade because they’re relatively easy to identify. They’re found either at the top of an uptrend or the bottom of a downtrend.

If a market is trending higher and enters a consolidation period, you would:

  • Use pattern recognition to decide whether it was a reversal chart pattern. If there was a reversal pattern, you would be looking for the sell signal of that pattern
  • If you had bought this market and identified a reversal pattern, you would be looking to exit the trade if you see the chart patterns sell signal

The opposite would be relevant if the market were going down and you recognised a bullish reversal pattern.

Bearish reversal pattern
Screenshot from TradingView

Reversal patterns include double tops, double bottoms, head and shoulders, inverse head and shoulders, plus more. We look at these in more detail in the next lesson.

Reversal chart pattern
Screenshot from TradingView

Continuation Chart Patterns

A continuation pattern is when a market is in a trend and then enters a consolidation period, it is then the pattern that signals the market will continue in that direction.

  • As mentioned, the market needs to be in a trend and the fall into a consolidation period, you would recognise the continuation pattern and wait for a buy or sell signal in the same direction of the trend
  • Once you get the continuation buy or sell signal, you then need to decide your strategy, where will you exit the trade? We’ll look at possible targets for continuation patterns in our next lesson

Continuation patterns include rectangles, pennants, and flags. Again, we’ll look at these in more detail in the next lesson.

Continuation pattern
Screenshot from TradingView

Bilateral chart patterns

Bilateral chart patterns can go in either direction and can therefore either be a reversal or continuation pattern. This can be confusing but the simple fact about them is that they will give you a signal in either direction, so as long as you’re not biased to either direction, it’s just a case of waiting for the signal and trading in that direction.

Bilateral chart patterns include symmetrical triangles, rising and falling wedges, which again you will find more information about in our next lesson.

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