How Beginner Traders Should Analyze Chart Patterns
Chart patterns are a key element in technical analysis. It is typically a starting point for many analysts given that a chart can provide a lot of information in a short period. Stocks develop patterns over time that help predict price movements and increase the odds for a successful trade.
They also help traders define their risk while providing clear price targets.
There are two general types of patterns in technical analysis: reversal and continuation. A reversal patterns signals that a prior trend will halt and reverse beginning a new trend whereas a continuation pattern indicates that the prior trend will continue in the current direction.
Flags and pennants are among the most basic continuation patterns and consist of a pole and a flag (rectangular shape) or pennant (triangle shape). Although closely related, they differ in their shape during the pattern’s consolidation period. The pole is formed by a sharp price movement followed by a consolidation period where the flag or pennant is formed.
The pattern is complete when there is a breakout in the same direction of the of the initial sharp price increase or decrease. Below is an example of both:
Triangle patterns, which as it sounds, form the shape of a triangle. It is a pattern that consists of two trendlines – either flat, ascending or descending – with the price of the stock moving between the two trendlines. The three types of triangles include the symmetrical triangle, the descending triangle, and the ascending triangle.
A symmetrical triangle, sometimes called a wedge is a continuation pattern formed by the convergence of a descending resistance line and an ascending support line made by a series of higher lows and lower highs that meet to form an apex.
An ascending triangle is a bullish continuation pattern formed by a flat trendline being a point on resistance and an ascending trendline acting as support made by a series of higher lows into the resistance level. Conversely, a descending triangle is a bearish continuation pattern that is formed by a descending trendline made by a series of lower highs into a support area. Examples of the three are as follows:
Double tops and double bottoms are reversal patterns that illustrate a security’s attempt to continue an existing trend and often resemble what looks like a “W” for a double bottom or an “M” for a double top.
In the case of a double top, strong selling drives the price lower from a previous resistance point indicating buyers are losing interest and price can be expected to move lower. Conversely, a double bottom shows strong buying at a previous support area igniting a move higher. Confirmation of the reversal occurs once neckline is broken as shown:
Head and shoulders is another reversal pattern that marks the top (head and shoulders top) or bottom (inverse head and shoulders) of a move and signals a change in direction of the current trend. It resembles a person’s head and shoulders consisting of a head being the high or low and a shoulder on either side being a lower high or a higher low.
The neckline is an area of resistance or support where price has held and bounces off forming the pattern