Patterns on a stock chart can be used to predict when a rising or sliding trend will begin or stop. A pricing pattern is a well-defined arrangement of price fluctuations that can be deduced from a set of trend lines and/or curves.
What are Stock Chart Patterns?
Price histories in any unit of time tend to form patterns, which are depicted graphically as chart patterns. Stock chart patterns can be broken down into two broad classes: continuation patterns and reversal patterns.
A reversal pattern happens when a price formation indicates a reversal in the trend's direction, while a continuation pattern occurs when the trend resumes its previous path after a halt. Traders utilise a wide variety of patterns. They help you establish your pricing range and target prices.
Types of Stock Chart Patterns
There are two types of stock chart patterns, namely continuation patterns and reversal patterns.
Continuation Patterns
A continuation pattern is a price formation that indicates the continuation of a trend after a brief pause. In the context of an ongoing trend, a continuation pattern might be understood as a temporary lull.
There is no way to know if a price trend will continue or reverse while a pattern is emerging. Therefore, it is crucial to pay close attention to the price pattern's continuation zone and the trend lines used to draw it. It is standard practise among technical analysts to assume the persistence of a trend until evidence to the contrary emerges.
Common continuation patterns include, pennants, flags, wedges, and triangles.
- Pennants
Two trend lines that move in opposite directions form a pennant, a type of continuation pattern. A defining feature of pennants is the presence of opposing trend lines, one pointing downwards and the other upwards. The volume tends to dip as the pennant takes shape, only to spike as the price finally breaks out.
Indicating an upward price movement, a bullish pennant forms with the flagpole on the left. When prices form a bearish pennant, it usually means a downward trend is underway. Declining volume and the appearance of a flagpole on the pennant's right side are indicative of a bearish pattern.
- Flags
Two upward, downward, or horizontally sloping trend lines are used to create a flag, which is another continuation pattern. A bullish flag indicates a pause in a downward trending market, whereas a bearish flag indicates a pause during an upward trending market. In most cases, falling volume coincides with the creation of a flag, only to recover once price breaks out of the pattern.
- Wedges
Wedges are continuation patterns that resemble pennants in that they are made up of two converging trend lines, but which differ in that the lines in a wedge always point in the same direction.
When the wedge is slanted downward, it indicates a pause in an upward trend, and when it is slanted upward, it indicates a pause in a downward trend. Wedge patterns, like pennants and flags, are characterised by lower volume during pattern development and higher volume upon a price breakout above or below the pattern's channel.
A wedge's tilted appearance is a result of the fact that unlike triangles and pennants, wedges only reflect upward and downward price changes.
- Triangles
Since triangles appear on charts more often than other patterns, they are widely used in technical analysis. Ascending triangles, descending triangles, and symmetrical triangles are the three most typical triangles. These graphical patterns might persist for a few weeks to months.
- Ascending Triangle
A continuation pattern with a defined entry, profit objective, and stop loss level, an ascending triangle indicates the presence of a trend. It's possible to enter the market at the point when the resistance line and the breakout line meet. One bullish chart pattern is the rising triangle.
- Descending Triangle
The inverse of an ascending triangle, a descending triangle indicates falling demand, and a breaking trend line indicates impending trouble.
- Symmetrical Triangles
In a symmetrical triangle, the convergence of two trend lines indicates neither an up nor a down trend, but rather the imminent possibility of a breakout. When a triangle forms, the height of the left vertical side is directly proportional to the size of the breakouts and breakdowns.
Reversal Patterns
A reversal pattern is a price formation that indicates an end to the current trend. These patterns indicate times when buyers and sellers have lost momentum. When fresh momentum comes from the opposite side, either bulls or bears, the current trend will pause, then shift.
A bullish rise, for instance, can temporarily stall out, indicating equal pressure from bulls and bears, before finally succumbing to the latter. Because of this, the trend is now declining.
Market top reversals, also known as distribution patterns, occur when an asset is sold off with greater fervour than it is bought. Market bottom reversals, on the other hand, are characterised by an increase in the volume of purchases relative to sales.
A reversal pattern is a price pattern in which the price moves in the opposite direction after a pause. Head and shoulders, double tops and bottoms, cups and handles, and gaps are all examples of typical reversal patterns.
- Head and Shoulders
Head and shoulders is a reversal pattern that shows up at market tops or bottoms as a series of three pushes: a first peak or trough, a second peak or trough that's much greater, and a third push that's quite similar to the first.
It's possible for an uptrend to reverse into a downtrend if it's stopped by a head and shoulders top formation. In contrast, a reversal to the upside is commonplace when a downtrend forms a head and shoulders bottom (or an inverse head and shoulders).
In the event of a head and shoulders bottom, volume may fall while the pattern forms, only to surge after the price makes a decisive break above (or below) the trend line.
- Double Tops and Bottoms
If the market makes two unsuccessful tries to break through a support or resistance level, this is a reversal pattern known as a double top or bottom.
A double top, sometimes known as a "M top" because of its common resemblance to the letter "M," is characterised by an initial attempt to break above a resistance level, followed by a second attempt that also fails.
A double bottom, which resembles the letter “W”, forms when price initially attempts to break through a support level but is met with resistance. It usually causes the trend to reverse.
While head and shoulders, double tops, and double bottoms are all examples of reversal patterns, triple tops and bottoms are much less common. They both behave the same way, though, and can serve as a significant trading indication for a trend reversal. When the price makes three unsuccessful attempts to break through a key support or resistance level, a pattern is created.
When there are two troughs of the same depth, this is known as a double bottom and it suggests that sellers are in a more vulnerable position than they were before.
- Cup and Handle
A bullish continuation pattern, the cup and handle indicates that the upward trend will resume after a brief halt. Instead of a "V" form with parallel highs on either side of the cup, the "cup" part of the design should be a "U" shape that resembles the rounding of a bowl.
The "handle" (a brief pullback resembling a flag or pennant chart pattern) forms on the right side of the cup. Assuming the handle forms, the stock might resume its upward trend and potentially break out to new highs.
- Gaps
Gaps signal a reversal in price. When a large price increase or decline causes a pause in trade activity, gaps result. A stock that closed at $5.00 may open the next day at $7.00 if it has strong results or other positive news.
There are three types of gaps that appear in a trend's price action: breakaway gaps, runaway gaps, and exhaustion gaps.
How to read stock chart patterns?
Traders should look for signals that indicate that a price trend is likely to change. The following steps should be taken to trade:
- Identify the prior trend direction
- Wait for the pattern to form
- Identify the reversal pattern
- Find the breakout point
When the price breaks out of the pattern, you should enter the trade. When investors anticipate or observe a trend reversal in progress, they exit holdings that are in sync with the new direction. Traders that anticipate a price increase can take advantage of a bullish reversal by opening long positions. Conversely, bearish reversals signal a chance to make money by selling the stock.
Pros and Cons of Chart Patterns
PROS
Provide quality trading signals
Good price action technique
Do not lag price action
Provides a good way to take advantage of trading opportunities
CONS
Can inspire subjectivity
Can take a long time to form
Only effective for the short term
Conclusion
Chart patterns are useful technical indicators that can help traders understand the past and future price behaviour of a securities. This is very useful for determining when to enter and leave a trade, as well as for establishing stop-loss levels.
When the price, takes a break, this might be seen as a period of consolidation that could either strengthen the current trend or cause it to reverse. These pricing trends can be seen easily with the help of trend lines. Flags, pennants, and double tops are a few that may make an appearance.
Price and volume work together to create these patterns, with volume dropping as the pattern forms and rising when price breaks out of the pattern. To foretell future price action, such as trend continuations and reversals, technical analysts study historical price patterns.
While being able to spot chart patterns might give you a leg up in the business world, you should study the specific guidelines and tactics of any pattern you plan to apply before diving in.
