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While trending, the market usually creates chart patterns. Those chart patterns can provide indications of whether the trend will continue or reverse.
A chart pattern or formation is simply a configuration of the price action. Many of these configurations can be bounded by trend lines.
Understanding Chart Patterns
Chart patterns are visual representations of market psychology and the battle between buyers and sellers. Recognizing these patterns can give traders an edge in predicting future price movements.
A double top is a bearish reversal pattern that forms after an uptrend. It consists of two peaks at approximately the same price level, separated by a moderate trough.
[Image: Double top pattern showing two peaks and neckline break]
Image: Double top pattern example
A double bottom is a bullish reversal pattern that forms after a downtrend. It consists of two troughs at approximately the same price level, separated by a moderate peak.
Triple top and triple bottom patterns are similar to double tops and bottoms but with three peaks or troughs instead of two. They are considered more reliable reversal patterns due to the additional test of the level.
A triple top forms when the price attempts to break through a resistance level three times and fails each time. This indicates strong selling pressure at that level and often leads to a reversal.
A triple bottom forms when the price attempts to break through a support level three times and bounces each time. This indicates strong buying pressure at that level and often leads to a reversal to the upside.
Pattern Confirmation
Both triple tops and triple bottoms require a break of the neckline to confirm the pattern. Without this confirmation, the pattern remains incomplete and may fail.
A rectangle pattern forms when the price consolidates between parallel support and resistance levels. The price oscillates within this range, creating a rectangular shape on the chart.
Rectangles can be continuation patterns (the price breaks out in the direction of the prior trend) or reversal patterns (the price breaks out in the opposite direction).
[Image: Rectangle pattern with support and resistance levels]
Image: Rectangle consolidation pattern
Triangle patterns are among the most common continuation patterns. They form when the price action contracts, creating converging trend lines. There are three main types of triangles:
An ascending triangle forms with a flat top (resistance) and a rising bottom (support). This is generally considered a bullish pattern, with the expectation of an upward breakout.
Ascending Triangle:
A descending triangle forms with a flat bottom (support) and a descending top (resistance). This is generally considered a bearish pattern, with the expectation of a downward breakout.
Descending Triangle:
A symmetrical triangle forms with both converging trend lines sloping toward each other. This pattern is neutral and can break in either direction, typically in the direction of the prior trend.
Triangle Breakouts
Triangles typically break out when the price reaches about 2/3 to 3/4 of the way to the apex (where the lines would meet). The target is usually the height of the pattern's widest point, projected from the breakout level.
Flags and pennants are short-term continuation patterns that represent brief consolidations before the prior trend resumes. They typically form after a strong directional move.
A flag looks like a small rectangle or parallelogram that slopes against the prior trend. It forms after a sharp price move (the flagpole) and represents a pause before continuation.
Forms after a strong upward move. The flag slopes slightly downward or moves sideways. A breakout above the flag signals continuation of the uptrend.
Forms after a strong downward move. The flag slopes slightly upward or moves sideways. A breakdown below the flag signals continuation of the downtrend.
A pennant is similar to a flag but forms a small symmetrical triangle instead of a rectangle. It also follows a strong directional move and represents a brief consolidation.
Flags and Pennants as Continuation Signals
The target for flags and pennants is typically the length of the flagpole (the initial sharp move) projected from the breakout point. These patterns usually complete quickly, within 1-3 weeks.
Wedge patterns are similar to triangles but have both trend lines sloping in the same direction. Wedges can be continuation or reversal patterns depending on the direction of the wedge and the prior trend.
A rising wedge has both support and resistance lines sloping upward, with the lines converging. This is typically a bearish pattern, often signaling a reversal or continuation of a downtrend.
A falling wedge has both support and resistance lines sloping downward, with the lines converging. This is typically a bullish pattern, often signaling a reversal or continuation of an uptrend.
⚠️ Wedge Direction vs. Price Direction
Counter-intuitively, rising wedges are bearish and falling wedges are bullish. This is because wedges represent a loss of momentum in the current direction, setting up for a reversal.
The head and shoulders pattern is one of the most reliable reversal patterns in technical analysis. It consists of three peaks: a higher peak (head) between two lower peaks (shoulders).
A head and shoulders top forms at the end of an uptrend and signals a reversal to a downtrend.
The pattern is confirmed when the price breaks below the neckline. The target is typically the distance from the head to the neckline, projected downward from the breakout point.
An inverse head and shoulders (or head and shoulders bottom) forms at the end of a downtrend and signals a reversal to an uptrend. It is the mirror image of the head and shoulders top.
Volume Confirmation
Volume typically increases on the formation of the left shoulder, decreases on the head, and increases again on the neckline break. This volume pattern adds reliability to the signal.
The cup and handle pattern is a bullish continuation pattern that resembles a teacup on the chart. It consists of a rounded bottom (the cup) followed by a small consolidation (the handle).
Forms during an uptrend. The cup is a rounded bottom showing a gradual selloff and recovery. The handle is a small downward drift or consolidation. A breakout above the handle signals continuation of the uptrend.
The inverted cup and handle is the bearish version, forming during a downtrend. It resembles an upside-down teacup and signals continuation of the downtrend.
[Image: Cup and handle pattern showing rounded bottom and small consolidation]
Image: Cup and handle pattern example
Chart patterns are powerful tools in a trader's arsenal. However, they should be used in conjunction with other forms of technical and fundamental analysis for best results.