Chart Pattern Formations
Intermediate Technical Analysis Series
Call to action
One of the basic premises in technical analysis is that history repeats itself. The theory behind chart patterns is based upon this assumption. A chart pattern is a distinct formation made by price movement that gives an indication of future direction.
It is through recognising these chart patterns that we can get an indication of how high the probability of a price moving in a specific direction is. In short, we look for chart patterns to identify trading opportunities.
There is a popular saying in technical analysis, ‘the trend is your friend’. A trend is merely an indication of an imbalance in the supply and demand which is shown through changes in acceptable levels of the price. These price changes can often develop into recognisable chart patterns that act as signals for deriving potential future movements in price.
Most importantly though, chart patterns in technical analysis can help to determine whether it is the bulls that are winning the battle, or it is the bears.
Technical pattern analysis is an art form, it is not a science, and subsequently it is very difficult to automate. For this reason, the view of a chart may differ from trader to trader. The main issue with pattern recognition is that traders can often be so desperate to see a pattern that they fool themselves into believing one is there, when it is not. Unless the pattern is clear and obvious, then caution should prevail. Seeing something that is not there could result in a trading position being taken on false information. This could lead to losses.
Chart pattern analysis can be used to make short-term or long-term forecasts. Analysis can be done intraday, daily, weekly or monthly and the patterns can be as short as a matter of minutes or as long as a number of years.
Below we cover some of the more popular chart patterns. There are two main categories of charting patterns: Reversal patterns and continuation patterns.
- The Reversal pattern suggests that the current trend is coming to an end and that the pattern is a signal for the beginning of a new trend.
- The Continuation pattern signals that the existing trend will remain in place after a period of consolidation and the completion of the pattern.
Reversal Patterns: Bottoms and Tops
Before delving into the detail of a variety of tops and bottoms, let’s keep things simple. Whether you are looking at a Head & Shoulders top, a Double Top, a Triple Top or a Rounding Top, the implied downside target will be the same. More conservative targets can be derived through different methods, but the essential premise remains the same. It will still be measured from the pattern peak to the neckline and projected downwards.
There is little to be gained from getting bogged down with the name of the pattern. As long as the basic principles of pattern formation are there, a top is a top and similarly a bottom is a bottom. The basics of technical analysis can be formed in Dow Theory, which states that uptrends are defined as a series of higher lows and higher highs. Downtrends are defined as a series of lower highs and lower lows.
For a top pattern formation, a high in the price with a subsequent reaction low; followed by renewed upside which fails at or just below the previous high (breaking the sequence of higher highs), if the price falls back below the previous reaction low (breaking the sequence of higher lows), a top pattern will be complete.
Ultimately, the number of times that the highs and lows are tested before the pattern completes is of minor detail (although it can add to the conviction on the break). The most important fact to be concerned with is that a reversal pattern has completed and there is a change of trend underway.
A bottom is formed when the price in a downtrend begins to replace the lower lows with higher (or equal lows) followed by a higher highs.
Trading the Pullback
Very often on the completion of a pattern breakout, there will also be a pullback. The pullback uses the principle that in a bullish reversal breakout, old resistance becomes new support. Subsequently, in a bullish breakout, an unwinding pullback correction gives a second chance to buy around the breakout support.
The principal works in reverse too. In a bearish reversal breakdown, old support becomes new resistance. A pullback rally would therefore give the bears a second opportunity to sell.
Fig 1. Illustrating the concept of a pullback
Head & Shoulders
This is one of the most recognisable and popular chart patterns in technical analysis. A head & shoulders is a reversal pattern that signals that the price is likely to retrace against the previous trend.
There are two versions of the head & shoulders chart pattern. The Head & Shoulders Top is a bearish pattern that is formed as an upward movement in price comes to an end. It signals that a trend reversal is underway and a new downward direction in price is forming. A Head & Shoulders Bottom (also known as an “inverse head and shoulders”) is a bearish pattern and is used to signal a reversal of a bull run into a new downtrend. The pattern completes on a closing breach of the “neckline”.
Technical analysis theory suggests that a target can be derived from the completed head and shoulders pattern. For the top patterns, measuring the move from the tip of the head to the neckline and then projecting this measurement downwards gives us an implied downside target.
Fig 2. A Head & Shoulders top on USD/CAD daily chart
Double Tops and Double Bottoms
Technical traders will watch trends. Subsequently, trendlines can act as a form of support and resistance. Therefore if a trend is identified, then it can be used for trading signals.
Having identified an uptrend, a correction back towards the support of the uptrend can be used as a chance to buy. The opposite is seen in a downtrend, where a rally towards the trendline resistance can be an opportunity to sell.
The more often a trendline is used as the basis of support or resistance, the stronger the conviction of the trade. Breaking a trendline will reduce the conviction of market direction and that of the trade. In this way, trendlines can be used for the basis of stop-losses too.
In the charted example of Gold, breaches in trendlines will often come with significant reversals. Once the trendline is broken, there can often be a sharp move as traders see an important level (either support in an uptrend, or resistance in a downtrend) having been removed. Subsequently, on long positions, having a stop-losses under the uptrends is a useful insurance against big trading losses.
Triple Tops and Triple Bottoms
It is important to be able to understand and identify trends so that you can trade with them, rather than against them. The most important saying in technical analysis is “the trend is your friend”. These illustrate how important trend analysis is for technical traders.