Chart Pattern Formations
Technical Analysis Series for intermediate traders
One of the basic assumptions in technical analysis is that history repeats itself. The theory behind chart patterns is based on this idea.
Chart patterns are distinct formations made by price movements that can give an indication of future direction. By recognising chart patterns, we can get an indication of how high the probability is that a price we’re watching will move in a specific direction.
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 supply and demand, one which is shown through changes in acceptable levels of the price. These changes, however, can 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 determine whether it’s the bulls that are winning, or the bears.
Technical pattern analysis is more art than science, and that makes it very difficult to automate. For this reason, the view of a chart may differ from trader to trader. The main pitfall with pattern recognition is that you can be so desperate to find a pattern, you fool yourself into seeing one that isn’t there.
, caution should prevail. Seeing something that isn’t there could result in a trading position being taken on false information. This could lead to losses.
Top tip: Don’t see what isn’t there!
When learning about technical pattern recognition, one of the big mistakes to avoid is to believe that you see a pattern that is not there.
“If it doesn’t hit you between the eyes, then it is not a pattern”.
Chart pattern analysis can be used to make short-term or long-term forecasts. Analysis can be done intraday, daily, weekly or monthly. 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.
- A 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.
- A 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
What’s in a name?
“Is it a head and shoulders, or is it a double top?”
Essentially, it doesn’t matter. A top is just a top and a bottom is just a bottom.
Before delving into the detail of a variety of tops and bottoms, let’s keep things simple.
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
Whether you’re 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 premise doesn’t change. It will still be measured from the pattern peak to the neckline, and projected downwards.
The basics of technical analysis can be formed in Dow Theory, which defines uptrends as a series of higher lows and higher highs. Downtrends are defined as a series of lower highs and lower lows.
A top pattern formation
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 that a change of trend is underway.
A bottom is formed when the price in a downtrend begins to replace the lower lows with higher (or equal lows), followed by higher highs.