What are Chart Patterns？

Trading pattern research is a field of technical analysis that studies the patterns formed by prices on charts over time, also known as trading chart patterns. These patterns form on different markets and asset classes when a trend pauses and enters a consolidation phase.

Chart patterns are a way for you to decide whether the price will continue in the same direction as the basic trend after the consolidation phase ends, or whether the trend will reverse. Additionally, you can predict potential targets for the next move based on the pattern.

These chart patterns can be identified over many different time ranges, from one-minute charts, to one-hour and four-hour charts, to daily, weekly, and even monthly charts. In addition, these chart patterns cover almost all asset categories, individual stock charts, stock indices, commodity markets, bond markets, and forex chart patterns.

Some common chart patterns include head and shoulders tops and bottoms, ascending and descending triangles, double tops and double bottoms, etc.

Why are Chart Patterns Important？

Chart patterns are very important for technical analysts and technical traders because they provide a clear framework by which to make buying or selling decisions for any particular market. With their help, users can make better predictions about future market behavior and speculate on possible price trends.

For example, if an ascending or descending triangle pattern is identified, traders might predict a significant rise or fall in stock prices. This information can help traders determine when to buy or sell stocks, enabling them to make decisions in advance and increase investment returns.

However, it is not wise to rely solely on chart patterns for decision-making. Although chart patterns can provide useful information, accurate predictions can only be made by combining them with other technical analysis tools and market information. In addition, chart patterns cannot guarantee 100% accuracy, so potential losses should be limited by setting stop-loss points and risk management strategies.

Types of Chart Patterns

Chart patterns fall broadly into three categories: continuation patterns, reversal patterns and bilateral patterns.

• A continuation signals that an ongoing trend will continue

• Reversal chart patterns indicate that a trend may be about to change direction

• Bilateral chart patterns let traders know that the price could move either way – meaning the market is highly volatile

The most important thing to remember when using chart patterns as part of your technical analysis, is that they are not a guarantee that a market will move in that predicted direction – they are merely an indication of what might happen to an assets price.

1. Head & Shoulder Pattern

The Head and Shoulders Top Pattern is a chart pattern that is considered a reversal formation and is often seen at the top of an upward trend. It consists of three parts:

1. The 'Left Shoulder': This is formed when the price reaches a new high and subsequently declines to a certain level.

2. The 'Head': This is formed when the price rises from the level of the left shoulder to a higher peak, and then declines back to the same level as the left shoulder.

3. The 'Right Shoulder': This is formed when the price rises again, but only to the level of the first peak (left shoulder), and then declines again to the level of the left shoulder.

Together, these form a pattern that resembles a head with two shoulders. The line connecting the bottom points after each peak is referred to as the 'neckline'. The pattern is confirmed when the price falls below the neckline after forming the right shoulder. The theory is that after this point, the price is expected to fall typically by the same distance as from the head's high to the neckline.

2. Head & Shoulder Reversal

The Head and Shoulders Top Reversal, often abbreviated as H&S Top, is a chart pattern that signals a potential reversal of an upward trend. The pattern consists of three peaks, with the middle peak (the “head”) being the highest and the two outside peaks (the “shoulders”) being nearly equal in height and lesser than the head. Here's how it unfolds:

1. The “Left Shoulder” is created when the price rises to a new high and then declines to a certain level.

2. The “Head” is formed when the price ascends from the left shoulder's low, creating a higher peak, and then retreats back down to the same low hit after the formation of the left shoulder.

3. The “Right Shoulder” develops when the price surges again but only to the level of the left shoulder, and later pulls back to the low like in previous two cases.

The lows reached after each peak can be connected to form a support level, or what's commonly known as the “Neckline”. The complete formation is validated when the price breaks below this neckline after forming the right shoulder, indicating that the price is likely to decline further. The estimated decline is typically at least the same vertical distance from the neckline to the top of the head.

3. Double Top

A Double Top is a reversal chart pattern, typically formed after an extended upward trend, suggesting that the asset may experience a downfall.

The pattern consists of two consecutive peaks that are roughly at the same price level, separated by a moderate trough, creating a shape similar to the letter 'M'.

1. The “First Top” happens when bulls push the price up to a new high, reflecting a strong uptrend.

2. The “Trough” is formed when the price retraces from the first top, indicating some degree of selling pressure or a reduction in buying pressure.

3. The “Second Top” occurs when the price rises back to the similar level as the first top. However, it fails to push further, suggesting that the buying pressure is exhausted.

The pattern is confirmed when the price falls below the support level, which is the lowest point reached between the two tops. This signals that the bears have taken control of the market and a sell off is likely to happen.

4. Double Bottom

A Double Bottom is a reversal chart pattern typically formed after a sustained downtrend, signaling that the asset's price may begin to rise.

The pattern involves two consecutive low points that are roughly equal in price, separated by a moderate peak, creating a shape that resembles the letter 'W'.

1. The “First Bottom” occurs when bears push the price down to a new low, reflecting a strong downtrend.

2. The “Peak” is formed when the price retraces from the first bottom, indicating some degree of buying pressure or a decrease in selling pressure.

3. The “Second Bottom” happens when the price falls back down to a level similar to the first bottom. However, it fails to push further downward, suggesting that the selling pressure has subsided.

The pattern is confirmed when the price rises above the resistance level, which is the highest point reached between the two bottoms. This signals that the bulls have taken control of the market and a rally is likely to happen.

5. Triple Top

A Triple Top is a reversal chart pattern typically observed after a notable upward trend, indicating that the price of the asset is likely to decline. The pattern consists of three distinct peaks, all reached at approximately the same price level, separated by two intervening troughs. This creates a shape that is similar to three mountain peaks in a row.

1. The three “Tops” occur when bulls push the price up to a similar high level, each time followed by a pullback. The price level of these highs acts as a strong resistance level.

2. The “Troughs” are the lows reached after each peak. They act as a support level that the price has consistently bounced off.

3. The first and second tops are an indication that the buyers are having difficulty pushing the price higher which is a sign of weakening upward momentum. The third top is a confirmation of this weakness and is a signal that a reversal may be imminent.

The pattern is confirmed when the price falls below the support level which is the low points of the intervening troughs. This breakout downwards is a signal that the sellers are now in control and the price is likely to continue to fall.

6. Triple Bottom

A Triple Bottom is a reversal chart pattern usually recognized after a significant downtrend, indicating that the price of the asset is likely to rise. The pattern consists of three distinct troughs, all occurring at roughly the same price level, separated by two intervening peaks. This forms a shape that resembles three valleys in a row.

1. The three “Bottoms” occur when bears push the price down to a similar low level, each time followed by a rebound. The price level of these lows acts as a strong support level.

2. The “Peaks” are the highs reached after each bottom. They act as a resistance level that the price struggles to move beyond.

3. The first and second bottoms suggest that the sellers are having trouble pushing the price lower, which is a sign of weakening downward momentum. The third bottom confirms this weakness and signals that a reversal might be imminent.

The pattern is confirmed when the price rises above the resistance level, which equates to the high points of the intervening peaks. This breakout upwards is a signal that buyers are now dominating and the price is likely to continue to rise.

7. Rounding Bottom

A Round Bottom is a reversal chart pattern often seen after a sustained downtrend, suggesting a possible upward trend reversal. This pattern is characterized by a gradual and persistent decline in price, followed by a steady rise, forming a shape resembling a bowl or a 'U'.

1. The “Decline Phase”: This is the initial part of the pattern where sellers are in control, pushing the price lower and lower. This period sees a gradual slowdown in downward momentum over time.

2. The “Bottom Phase”: This phase occurs at the lowest point of the pattern, representing a period of consolidation where buying and selling pressures equalize. The price may move sideways during this phase, indicating that sellers are losing control and buyers are starting to show interest.

3. The “Advance Phase”: This is the final part of the pattern. During this phase, buyers take control, pushing the price higher and higher. Much like the decline phase, this phase sees a gradual increase in upward momentum over time.

Confirmation of the pattern happens when the price breaks above the resistance level established just before the decline phase. The signal suggests that the trend has reversed and that the price is likely to continue rising.

8. Ascending Wedge

An Ascending Wedge is a bearish chart pattern used in technical analysis. It is defined by a rising price channel that contracts as prices rise and trading range narrows.

1. The “Upper Resistance Line” is formed by connecting at least two price peaks, with each peak being higher than the last. This indicates that buyers are able to push the price higher, but at a slowing rate.

2. The “Lower Support Line” is also created by connecting at least two price lows, with each low being higher than the previous one. This signals that sellers are only able to push the price down to increasingly higher levels.

3. The pattern progresses as the price continues to make higher highs and higher lows. As the price vacillates between the upper resistance line and the lower support line, it will eventually reach a point where it breaks out of the channel.

The pattern is confirmed when the price breaks below the lower support line, signifying a reversal from the prior uptrend to a new downtrend. The expectation is that price will continue to decline, usually at least the same distance as the height of the back of the wedge.

9. Descending Wedge

A Descending Wedge is generally considered a bullish chart pattern observed in technical analysis. It is identified by a falling price channel that contracts as prices lower and trading range narrows.

1. The “Upper Resistance Line” is formed by connecting at least two price highs, with each high being lower than the last. This signifies that sellers are able to push the price lower, but at a decelerating rate.

2. The “Lower Support Line” is also marked out by connecting at least two price lows, with each low being lower than the previous one. This implies that buyers are only able to push the price up to progressively lower levels.

3. As the pattern evolves, the price continually makes lower lows and lower highs. As the price oscillates between the upper resistance line and the lower support line, it will ultimately approach a point where it breaks out of the channel.

The pattern is confirmed when the price breaks above the upper resistance line, indicating a reversal from the preceding downtrend to a new uptrend. The anticipation is that price will continue to increase, generally at minimum the same vertical distance as the height of the back of the wedge.

10. Triangle Flag or Pennant

A Triangle Flag or Pennant is a short-term, continuation chart pattern in technical analysis that is typically seen after a strong vertical price move. It suggests that the previous direction of the price trend will resume after a brief pause.

1. The “Flagpole”: This is the initial steep or vertical price movement, either upwards or downwards.

2. The “Flag or Pennant”: This is a smaller, short-term triangular consolidation period immediately following the flagpole. It is formed as the price fluctuates within a small range, creating lower highs and higher lows. The top and bottom of this consolidation period can be connected to form two converging trendlines, creating a symmetrical triangle pattern.

3. The “Breakout”: The pattern is confirmed when price breaks out of the triangle in the same direction as the initial movement, continuing the previous trend.

The price target for the breakout from the pattern is typically of a similar price distance as the initial flagpole. Also, volume tends to decrease during the formation of the flag or pennant and increase during the breakout.

11. Ascending Triangle

An Ascending Triangle is a bullish chart pattern used in technical analysis that often forms during an uptrend as a continuation pattern. It is characterized by a rising lower trendline and a flat upper trendline.

1. “Upper Resistance Line”: This horizontal line is formed by connecting at least two price highs, each roughly at the same level. This shows that the buyers are not able to push the price beyond this resistance level.

2. “Rising Lower Trendline”: This ascending line is created by connecting at least two price lows, with each low being higher than the last. This indicates that buyers are gradually able to push the price higher, reflecting growing bullish sentiment.

3. The formation progresses as the price fluctuates between the rising lower trendline and the horizontal upper resistance line, until it eventually breaks out through the upper resistance.

12. Descending Triangle

A Descending Triangle is a bearish chart pattern used in technical analysis that often forms during a downtrend as a continuation pattern. It is characterized by a declining upper trendline and a flat lower trendline.

1. “Lower Support Line”: This horizontal line is formed by connecting at least two price lows, each roughly at the same level. This indicates that sellers are not able to push the price beyond this support level.

2. “Declining Upper Trendline”: This descending line is created by connecting at least two price highs, with each high being lower than the last. This signifies that sellers are gradually pushing the price lower, reflecting growing bearish sentiment.

3. As the pattern evolves, the price oscillates between the declining upper trendline and the horizontal lower support line, until it eventually breaks out through the lower support.

The pattern is confirmed when the price breaks below the lower support level, indicating that the sellers have assumed control and the price is likely to continue to decline. The expected price downswing after the breakout is usually the same as the vertical distance from the horizontal support line to the highest point of the triangle.

What are the Benefits of the Chart Patterns？

Chart patterns are useful in technical analysis for predicting future trends in stock prices. Here are some benefits:

1. Predict Future Outcomes: The most significant benefit of chart patterns is their predictive power. Once traders identify a pattern, they can predict with a decent level of certainty what is likely to happen next in the market.

2. Easy to Use: After gaining some experience, traders can easily spot trading patterns. Once the pattern is recognized, it becomes easy to make trading decisions.

3. Help to Determine Entry and Exit Points: Chart patterns can clearly indicate the positions for both the stop loss and the take profit. This feature can greatly optimize trade timing.

4. Provide Risk Assessment: They can also tell traders when a trend might be reversing, which can be a signal to exit a position. By recognizing these patterns, traders can reduce risk and avoid potential losses.

5. Frequent Appearance: Chart patterns form quite regularly, giving traders frequent opportunities to capitalize on potential trading opportunities.

6. Universal Applicability: They can be used in various financial markets, including stocks, currencies, commodities, etc.

7. Ease Decision-Making: By using chart patterns, traders can make more informed decisions as they have a better understanding of the market's sentiment and can predict what might happen based on historical precedents.

8. Provides tangible targets: Certain patterns give a predicted price target which can be helpful in setting profit targets.

1. What are the Limitations of the Chart Patterns？

While chart patterns offer several advantages, they also have their limitations. Here are a few:

1. No Guarantee: Chart patterns are not foolproof. They don't guarantee that the anticipated movement will actually occur. They merely suggest potential market outcomes, which may or may not come true.

2. Subjectivity: Recognition of chart patterns often involves a degree of subjectivity. What one trader interprets as a specific pattern, another might view differently.

3. Unpredictable Market Factors: Chart patterns cannot account for sudden changes in the market due to unpredictable events, such as natural disasters, major political events, or sudden changes in market sentiment.

4. Requires Experience: Identifying chart patterns requires experience and understanding. Novice traders may struggle with interpreting patterns correctly, which could lead to poor trading decisions.

5. Confirmation Bias: Traders can often fall into the trap of “confirmation bias,” where they see the patterns they want to see, even if they aren't really there. This can lead to misguided trading decisions.

6. Depend on Volume: Some patterns depend on volume to confirm their formation, and without sufficient volume, they may not play out as expected.

7. Timing Issues: It's often difficult to identify the precise moment when a pattern has completed and a breakout or breakdown is about to occur.

Despite these limitations, many traders find chart patterns beneficial because they potentially add structure and a degree of predictability to the trading environment. But they are just one tool among many in a trader's arsenal and should be used in concert with other techniques of analysis.

What are the Techniques for Trading Using the Chart Patterns？

Trading with chart patterns involves a number of steps and techniques. Heres a general idea of how you might do it:

1. Pattern Recognition: The first step in trading using chart patterns is to recognize the pattern. There are many patterns to be aware of, including head and shoulder tops and bottoms, double and triple tops and bottoms, ascending and descending triangles, etc.

2. Confirmation: Once you identify a pattern, you need to wait for it to be confirmed—usually by a certain movement in price or an increase in volume.

3. Determine Entry and Exit Points: Chart patterns can help you determine both the entry point, which is typically immediately after the pattern is confirmed, and the exit point, which may be identified by the pattern itself or other technical indicators.

4. Establish Stop-Loss Orders: Chart patterns can also indicate where to place stop-loss orders. For example, if trading a breakout from a resistance level, a trader may place a stop-loss order just below the broken resistance line.

5. Manage Risk: Just as with any trading strategy, it's crucial to manage risk when trading with chart patterns. This can be done by never risking more than a small percentage of your trading capital on a single trade.

6. Backtest: Backtesting involves using historical data to check how effectively a particular pattern has predicted price movements in the past.

7. Modify as Required: Depending on your backtest results and real-world outcomes, you might need to modify your trading plan. You might, for instance, decide to only trade certain patterns or only trade patterns that appear in certain market conditions.

8. Stick to the Plan: Over time, you're likely to find that some of your planned trades don't work out—even when theyre based on a reliable pattern. It's crucial to stick to your trading plan, though, as long-term success in trading usually results from a consistent strategy.

How to Trade with Patterns？

If you want to trade any of the patterns we've mentioned above, you'll usually aim to open a position that can profit from the subsequent breakout. In a bullish reversal or continuation pattern, you would buy in the market; in a bearish pattern, you would sell.

However, no pattern is infallible - all patterns can fail. Because of this, managing risk when you trade a pattern is even more important.

There are three steps to managing risk when trading: confirm the move, set a stop loss, and set your profit target.

Confirming a pattern

A simple way to validate any pattern is through inaction—just wait for one or two sessions, and observe whether the expected price action starts to emerge following the pattern. If it does, you initiate your trade, missing only a small portion of potential profit. If it doesn't, you've bypassed a possible loss.

For instance, let's say you've identified a bullish flag pattern and the market has surpassed its resistance line. Instead of trading immediately, you wait for a few candlesticks. If they're green, chances are high that an uptrend has commenced.

However, there are other methods to validate patterns. Using multiple methods can strengthen your risk management. For example, if the pattern involves breaking through either support or resistance, you can examine past price action or use indicators to verify its significance. Alternatively, you can employ momentum indicators to assess if a trend is about to begin.

Setting your stop loss

Even when you're confident that a trend is imminent, it's crucial to set a stop loss when entering your position. This mechanism automatically closes out your position if the market goes against you by a predetermined number of points, thereby preventing substantial losses.

A useful guideline is to position your stop loss at a point that effectively signals the pattern's failure. The exact location varies, depending on whether you're trading a bullish or bearish formation.

• For bearish patterns, you could place your stop slightly above the market's preceding high. If the market reaches new highs, a downtrend may not be on the horizon.

• For bullish patterns, the strategy is reversed. You could place your stop beneath the previous noteworthy low.

• Taking our bullish flag pattern as an example, you might position your stop loss near the patterns support line.

Choosing a profit target

The concluding step involves selecting a profit target for your position. This not only guides you in setting your take profit order but also allows you to determine your risk-reward ratio for the trade.

Frequently, traders use the initial height of the pattern to gauge the potential size of the ensuing trend. For instance, if our bullish flag pattern has 50 points between its support and resistance lines, we might place our take profit order 50 points above the resistance.

Assuming our stop loss is positioned 25 points below, this configuration presents us with a 1:2 risk-reward ratio for the trade.