What Are The Classical Chart Patterns?
In technical analysis, transitions between rising and falling trends are often signaled by price patterns. By definition, a price pattern is a recognizable configuration of price movement that is identified using a series of trendlines and/or curves.
When a price pattern signals a change in trend direction, it is known as a reversal pattern; a continuation pattern occurs when the trend continues in its existing direction following a brief pause.
Technical analysts have long used price patterns to examine current movements and forecast future market movements.
Important Points To Keep In Mind:
- Patterns are the distinctive formations created by the movements of security prices on a chart and are the foundation of technical analysis.
- A pattern is identified by a line that connects common price points, such as closing prices or highs or lows, during a specific period of time.
- Technical analysts and chartists seek to identify patterns as a way to anticipate the future direction of a security’s price.
- These patterns can be as simple as trendlines and as complex as double head-and-shoulders formations.
- Chart patterns are not intended to be used by themselves as entry or exit signals. You need always to combine them with other forms of technical analysis to achieve good results.
Trendlines in Technical Analysis
Since price patterns are identified using a series of lines and/or curves, it is helpful to understand trendlines and know how to draw them. Trendlines help technical analysts spot areas of support and resistance on a price chart. Trendlines are straight lines drawn on a chart by connecting a series of descending peaks (highs) or ascending troughs (lows). Make sure to check trendlines guide to learn more.
A trendline that is angled up, or an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows.
Trendlines will vary in appearance depending on what part of the price bar is used to "connect the dots." While there are different schools of thought regarding which part of the price bar should be used, the body of the candle bar—and not the thin wicks above and below the candle body—often represents where the majority of price action has occurred and therefore may provide a more accurate point on which to draw the trendline, especially on intraday charts where "outliers" (data points that fall well outside the "normal" range) may exist.
On daily charts, chartists often use closing prices, rather than highs or lows, to draw trendlines since the closing prices represent the traders and investors willing to hold a position overnight or over a weekend or market holiday. Trendlines with three or more points are generally more valid than those based on only two points.
Important Points To Keep In Mind:
- Uptrends occur where prices are making higher highs and higher lows. Up trendlines connect at least two of the lows and show support levels below price.
- Downtrends occur where prices are making lower highs and lower lows. Down trendlines connect at least two of the highs and indicate resistance levels above the price.
- Consolidation, or a sideways market, occurs where price is oscillating between an upper and lower range, between two parallel and often horizontal trendlines.
Continuation Patterns
A price pattern that denotes a temporary interruption of an existing trend is known as a continuation pattern.
A continuation pattern can be thought of as a pause during a prevailing trend—a time during which the bulls catch their breath during an uptrend, or when the bears relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell if the trend will continue or reverse. As such, careful attention must be placed on the trendlines used to draw the price pattern and whether price breaks above or below the continuation zone. Technical analysts typically recommend assuming a trend will continue until it is confirmed that it has reversed.
In general, the longer the price pattern takes to develop, and the larger the price movement within the pattern, the more significant the move once price breaks above or below the area of continuation.
If price continues on its trend, the price pattern is known as a continuation pattern. Common continuation patterns include:
- Pennants: They are constructed using two converging trendlines.
- Flags: They are drawn with two parallel trendlines.
- Triangles: The three most common types of triangles are symmetrical triangles, ascending triangles, and descending triangles.
- Cup and Handles: The cup and handle is a bullish continuation pattern where an upward trend has paused, but will continue when the pattern is confirmed. The "cup" portion of the pattern should be a "U" shape that resembles the rounding of a bowl rather than a "V" shape with equal highs on both sides of the cup.
Reversal Patterns
A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These patterns signify periods where either the bulls or the bears have run out of steam. The established trend will pause and then head in a new direction as new energy emerges from the other side (bull or bear).
Reversals that occur at market tops are known as distribution patterns, where the trading instrument becomes more enthusiastically sold than bought. Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the trading instrument becomes more actively bought than sold.
As with continuation patterns, the longer the pattern takes to develop and the larger the price movement within the pattern, the larger the expected move once price breaks out.
When price reverses after a pause, the price pattern is known as a reversal pattern. The most common ones are as follows.
- Wedges: They are constructed with two converging trendlines, where both are angled either up or down.
- Head and Shoulders: They signal two smaller price movements surrounding one larger movement.
- Double Tops: They represent a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level.
- Double Bottoms: They show a short-term swing low, followed by another failed attempt to break below the same support level.
- Rounding Tops: A rounding top is a price pattern used in technical analysis. It is identified by daily price movements, in particular the tops, which when graphed, form a downward sloping curve.
- Rounding Bottoms: A rounding bottom is a chart pattern used in technical analysis and is identified by a series of price movements that graphically form the shape of a "U".
Most Reliable Chart Patterns
Based on our research at AlgoStorm.com, we found the following patterns to be more reliable than the others:
- Ascending & Descending Triangles.
- Bull & Bear Flags.
- Rounding Tops & Bottoms.
- Double Tops and Bottoms With Regular Divergences.
Note: Divergence is when the price of an asset is moving in the opposite direction of a technical indicator, such as an oscillator, or is moving contrary to other data. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction.