What are chart patterns? Part 2

What are chart patterns? Part 2

What are chart patterns? Part 2
Image by @KEN_G

Chart patterns are found on all charts that are showing a liquid market, that is basically most of the financial markets you’ll look to trade; forex, commodities, stocks, and more.

You’ll see them when a market goes into a consolidation period. They’re used to decide whether a market is likely to continue in the same direction or reverse.

How many types of chart patterns are there?

There are lots of different chart patterns and analysts are always looking for more, but here are a list of the most popular and the ones you should start with:

  • Head and shoulders
  • Double top
  • Double bottom
  • Rounding bottom
  • Cup and handle
  • Wedges
  • Pennant or flags
  • Ascending triangle
  • Descending triangle
  • Symmetrical triangle
  • Triple top
  • Harmonic

There is another type of chart pattern that we will cover in our next lesson, candlesticks. Chart patterns will use lots of candlesticks to create its pattern.

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What Chart Pattern Group do These Fall Into?

As we mentioned in our previous lesson, chart patterns fall into three groups; continuation, reversal and bilateral patterns. Below is a simple table showing you which chart pattern falls into which group.

Chart Pattern Name

Chart Pattern Group

Head and shoulders

Reversal

Double top

Reversal

Double bottom

Reversal

Rounding bottom

Reversal

Cup and handle

Reversal

Wedges

Reversal or Continuation (Bilateral)

Pennant or flags

Continuation

Ascending triangle

Continuation

Descending triangle

Continuation

Symmetrical triangle

Reversal or Continuation (Bilateral)

Triple top

Reversal

Triple bottom

Reversal

Harmonic

Reversal

Candlesticks

Reversal or Continuation (Bilateral)

Reversal patterns you will find at the bottom or top of a trend and the expectation is that they will reverse and go the opposite direction. 

Continuation patterns are found in a trending market and will give you a trade signal that the market is likely to continue in that direction.

Bilateral chart patterns can be used as either a continuation or a reversal pattern, therefore for these you need to make sure you wait for the signal and not try to preempt it.

What are the most commonly used chart patterns?

The most common chart patterns are head and shoulders, inverse head and shoulders, double tops and double bottom patterns. They’re also the easiest to recognise, making them some of the most popular to trade.

You will also see some continuation patterns like wedges, pennants and flags but sometimes when trading these, they can be tricky to execute correctly.

Even if you decide not to use chart patterns in your trading strategy, we recommend that you do learn about them and understand the logic behind them. Lots of traders do use them and therefore it’s worth you understanding why they are using them.

Head and Shoulder Pattern

Here we’ll look at two types of head and shoulders pattern, the inverse and the normal head and shoulders pattern. You’ll find the inverse head and shoulders at the bottom of a trend and the traditional head and shoulders at the top of a trend.

Head and Shoulders Top: 

As mentioned you will find these at the top of an uptrend. It’s shaped like a head and shoulders whereby there are three swings with the middle swing being higher than the left and the right swing. The middle swing is therefore the head.

  • The market is trending higher, confirmed by creating higher highs and higher lows
  • The market pulls back as normal but then fails to break the high of the previous high and we call this the right shoulder
  • You now have three swings, a higher one in the middle and two lower ones
  • You can find the swing lows between the head and connect those with a line, this is called the ‘neckline’
  • If you extend that line out and the market breaks below it after creating the right shoulder, this confirms the pattern. This is also the the signal that the market is about to move lower
  • You can then predict the Minimum Price Objective (MPO) using the neckline. Take the vertical distance from the top of the head to the neckline, then project this down from the break of the neckline after the right shoulder
  • Sometimes you’ll see that after the break of the neckline, the price bounces back to test that neckline again, this is the return move and can also be used as a place to sell. The problem with waiting to sell on the return move is that if the market is moving fast, then it might not do the return move and therefore you might end up missing the trade altogether
  • One strategy is to take a half position when the market breaks the neckline and if there is a return move, then take another half position when it tests the break line. Normally the return move gets you a better price and better risk to reward ratio. If you sell on the break, you tend to get in a bit late
Candlestick reversal pattern
Screenshot from TradingView

An inverse head and shoulders is exactly the same, except that it forms at the bottom of a down trend. The criteria is the same as a head and shoulder, it just happens in the opposite direction. With these chart patterns, you’re looking to buy the market and project a higher MPO.

Reversal chart pattern
Screenshot from TradingView

Double Top & Double Bottom Patterns

When you look for a double top pattern, first, you’ll need to identify an up-trend, such as when:

  • The price makes a high and pulls back lower
  • A rebound then sees another high, at or close to the most recent, highest high
  • The price then falls back lower again. If it breaks below the low between the two highs, a double top is completed
  • The target for the potential price move lower (MPO) is the vertical distance from the double top peaks down to the low between the two highs and is then projected lower from the low
Double top
Screenshot from TradingView

The double bottom pattern is the inverse of the double top. For example, if: 

  • The market is in a downtrend, then puts in two lows around the same price 
  • Then the market breaks above the high between the two lows, a double bottom is confirmed

You can see this in action in the image below.

Double bottom
Screenshot from TradingView

Triple Top & Triple Bottom Patterns

The triple top is effectively the same as the double top, but with three highs around the same level. The pattern is completed when price breaks below the lowest low between the three peaks.

Triple top
Screenshot from TradingView

The triple bottom is the opposite of the triple top and is similar to the double bottom, with three lows around the same level. The pattern is completed when price breaks above the highest high between the three lows.

Rounding Bottom Pattern

You can find a rounding bottom chart pattern at the end of a downtrend. It’s identified by a series of lows that form a ‘U’ shape, which you’ll see in our image. A rounding bottom is usually seen at the end of longer-term downtrends and signal a longer-term price reversal.

Rounding bottom
Screenshot from TradingView

Wedge Pattern

Rising wedge (as continuation pattern): A rising wedge happens when the market is moving higher, but the higher lows are moving up at a steeper angle than the higher highs. This forms a rising wedge pattern

The expectation here is that the market will then break below the lower up trend line, signalling a move lower. If the market was previously in a downtrend, you’d recognise this as a continuation pattern.

Rising wedge - continuation
Screenshot from TradingView

Rising wedge (as reversal pattern): The rising wedge pattern is the same, but occurs in an up-trend. It signals a likely move lower on the break of the pattern, which would then be a reversal of the up-trend.

Rising wedge - reversal
Screenshot from TradingView

Falling wedge (as continuation pattern): It’s no surprise that a falling wedge pattern is the opposite to the rising wedge pattern. You’d see it when the market is moving lower, with the lower highs moving down at a steeper angle than the lower lows. 

With a falling wedge pattern, you’d expect that the market would push above the steeper, downtrend line, signalling a move higher. If the market was previously in an up-trend, for example, this would be a continuation pattern.

Falling wedge (as reversal pattern): This is the same as the falling wedge pattern above, but occurs in a downtrend. The falling wedge signals a likely move higher on the break of the pattern, which would then be a reversal of the downtrend.

Falling wedge
Screenshot from TradingView

Pennant or Flag Patterns

Let’s move on to look at pennants and flags, which are continuation patterns. You’d usually find them on short-term charts. They occur when price accelerates higher or lower, almost vertically. It’s this accelerated move that makes up the ‘flagpole’.

At this stage, the price goes into a consolidation (sideways) phase, where very little of the previous accelerated move is lost.

It’s important for you to recognise that the shape of the consolidation pattern is described as a flag or a pennant if: 

  • It’s a rectangle contained by two parallel support and resistance lines — a flag pattern
  • If it’s shaped like a triangle — a pennant pattern

If price breaks from the pennant or flag pattern in the same direction as the original accelerated move, then the MPO is the height of the flagpole, projected higher or lower.

Flag
Screenshot from TradingView

Ascending & Descending Triangle Patterns

An ascending triangle is a pattern that you’d usually see occurring in an up-trend after the price goes into consolidation. The consolidation phase is characterised by: 

  • An ascending triangle pattern with rising lows, but highs around the same price — the expectation is for the consolidation to break resolve higher, above the highs
  • The MPO is then measured as the widest point of the ascending triangle (at its base), projected up from the highs of the triangle
Ascending triangle
Screenshot from TradingView

Descending Triangle: This pattern is basically the opposite of the ascending triangle. 

When price breaks below the bottom of the descending triangle support line, a continuation of the downtrend is signalled. The MPO is calculated in the same way as the ascending triangle.

Candlestick Pattern

Candlestick chart patterns are a very important subcategory that we’re going to look at from a technical perspective in our next lesson, but here’s some background behind their origins:

Candlestick chart patterns were developed in 18th century Japan by Munehisa Homma, an incredibly successful rice merchant and trader. The patterns are based on combinations of candlestick price charts that Homma identified. These allowed him to predict potential price changes. For the main part, candlesticks are reversal patterns (though some are continuation patterns).

Gravestone doji candle
Screenshot from TradingView

We’ve looked at the most popular chart patterns here and shown you how to identify them.

With these, you should now be able to decide on the likely direction of the market and have the ability to calculate price targets. In our next lesson, we’re going to guide you through the world of candlestick patterns in more detail.

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