Table of Content How do Chart Patterns Work? Understanding Chart Patterns Why are Chart Patterns Important? What is Consolidation in trading? Types of Chart Pattern
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 been 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.
Trading the Pullback
When a pattern breakout completes, there will often 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 you 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 can provide you with an implied downside target.
In Fig 2. tracking USD/CAD, the March correction begins to retrace, but the support of the first higher low remains intact. A lower high then forms late March to then sell-off below the 1.2800 neckline. Numerous pullbacks find resistance around the neckline before the selling pressure pulls the market lower again. Note how the implied target was never achieved (this pattern was actually part of a bull market correction which was part of a longer-term rally – bull market corrections will often undershoot their downside implied targets before the uptrend re-asserts).
Fig 2: A Head & Shoulders top on USD/CAD daily chart
This Fig 3. chart captures a period in late August 2019, when the German DAX completed a near perfect head and shoulders base pattern. A pullback to the neckline breakout at 11,865 provided a near perfect opportunity for bulls before the market tracked a strong recovery to the target. (Note also how the neckline breakout once more became supportive in October.)
Fig 3. A Head & Shoulders Bottom on the DAX daily chart
Double Tops and Double Bottoms
Double Tops and Double Bottoms are arguably the most basic of reversal patterns. Formed after a sustained trend, the pattern is created when the price tests support (in a downtrend) or resistance (in an uptrend) twice but is unable to break through. The market then begins to reverse the trend, breaching the previous reaction high (for a bullish double bottom) or previous reaction low (for a bearish double top). In both instances, a trend breach and pattern completion are subsequently followed by a retracing move.
Fig 4. A double top on the USD/JPY daily chart
This chart shows how a target can be derived from the breakout. For double bottoms, measure from the limit of the troughs to the neckline and project higher. For double tops, measure from the two peaks to the neckline and then project downwards.
Once more, pullbacks to the neckline breakout are often seen. However, should this retreat continue, the pattern would be considered to be aborted if the market breaks below half the measured size of the pattern?
N.B. Imperfect pattern targets
Patterns are imperfect where the reaction from the neckline in the second move may not be quite as large as the first move, leaving a pattern that is not uniform in shape.
You can either derive a conservative target (from the smaller peak/trough) or measure the full implied target (higher conviction).
Triple Tops and Triple Bottoms
Triple tops and triple bottoms are extensions of the double top and bottom reversal pattern. Although they don’t occur as frequently as head & shoulders, double tops and double bottoms, they act in a similar fashion.
Both patterns are formed when the price tests a level of support or resistance three times, and is unable to break through. The breakout at the neckline signals a reversal of the prior trend.
N.B. A Triple Top or a Range Breakout?
The triple formation (top or bottom) is a reversal pattern and is also the opposite to a range breakout which is a continuation pattern (see later).
Rounding Tops and Bottoms
Another multiple top and bottom formation is the Rounding Top and Rounding Bottom. Once more this is a pattern that consists of neckline before the construction of a rounding element to the pattern, rather than an obviously defined series of peaks or troughs.
This is far more of a generic pattern and is often referred to as “rounding” due to the lack of clarity with the pattern. However, there is still a topping or bottoming process that plays out, and therefore needs to be covered.
The implied target of the rounding bottom pattern comes from the measurement from the key low up to the neckline resistance and then projected upwards. The rounding top is the opposite move which results in a move lower.
Fig 6: A rounding bottom on the Dollar/Yen daily chart
Continuation Patterns - Triangles, Flags, Wedges and Ranges
A Descending Triangle
A downside break from a descending triangle
A Consolidation Rectangle
An upside break from a consolidation range
Continuation patterns are market consolidations that ultimately breakout in the direction of the prevailing trend that was in place prior to the consolidation.
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