One of the major assumptions of Technical Analysis is that history repeats itself. When looking at price charts, this is illustrated as specific chart patterns that form again and again due to predictable behavior of buyers and sellers in the market.
By definition, Chart Patterns are repeating price action structures that form due to notable changes in buying and selling.
When the economy is good and institutional buying is strong, chart patterns form bullish formations. During bad economic conditions when institutional selling is strong, chart patterns form bearish formations.
In this post, we will give a basic walkthrough on how new traders can approach chart patterns and break down the concepts to its most rudimentary level.
Price Action and Chart Patterns
Technical traders analyze price charts to interpret price action. Price Action in stock trading is defined as the movement and behavior of a stock price over a period of time. This means that chart patterns are a result of price action movements. They are the embedded footprint of trading activity left behind by the buying and selling taking place over a period of time.
Simply put, think of price action in three scenarios:
Prices go up when there is more buying than selling
Prices go down when there is more selling than buying
Prices move sideways when there is equal distribution in buying and selling
These three price action movements are the building blocks of the major chart patterns we know. This is why profitable traders are more keen on analyzing price action above anything else. There is no lag when it comes to analyzing the behavior and movement of price. What you see is what you get.
Major Chart Pattern Groups
Chart patterns can be classified to three major groups:
1. Continuation:
Continuation patterns are simply brief rests or pauses within a general trend. After the pause, the trend resumes.
Bullish: Higher high and higher low patterns driven by strong institutional buying.
Bearish: Lower high and lower low patterns driven by strong institutional selling.
2. Reversal:
Reversal patterns are distinct price action formations wherein a notable exchange between buyers and sellers take place. Once the pattern is complete, the trend shifts to a new direction.
Bullish: Price action pattern wherein the trend shifts from Downtrend to Uptrend.
Bearish: Price action pattern wherein the trend shifts from Uptrend to Downtrend.
3. Consolidation:
Neutral: Sideways price action movement wherein the price moves in between clear horizontal support and resistance levels.
Basic Types of Chart Patterns
Here are some classic Chart Pattern formations that every trader needs to know.
Note that we will only illustrate major Continuation and Reversal chart patterns in this section. Consolidation patterns is a topic which will be discussed in a different post.
1. Continuation Chart Patterns
a. Pennant
Bullish:
A Bullish Pennant is a continuation pattern forming within a general uptrend. It is characterized by a brief consolidation with lowering volatility that is followed by a surge in price.
Bearish:
A Bearish Pennant is a continuation pattern forming within a general downtrend. It is characterized by a brief consolidation with lowering volatility that is followed by a breakdown in price.
b. Wedge
Bullish:
A Bullish Wedge or Falling Wedge is a continuation pattern forming within a general uptrend. It usually appears in stocks with sharp trend movements. The price briefly shifts in the counter direction with decreasing volatility and a dry up in volume. After which, price spikes alongside volume and the uptrend continues.
Bearish:
A Bearish Wedge or Rising Wedge is a continuation pattern forming within a general downtrend. It usually appears in stocks with sharp trend movements. The price briefly shifts in the counter direction with decreasing volatility and a dry up in volume. After which, price breaks down and the downtrend continues.
c. Flag
Bullish:
A Bull Flag is a brief rectangle formation that interrupt the direction of an ongoing uptrend. The pattern is completed by a breakout with a spike up in volume and the uptrend continues.
Bearish:
A Bear Flag is a brief rectangle formation that interrupt the direction of an ongoing downtrend. The pattern is completed by a breakdown and the downtrend continues.
2. REVERSAL Chart Patterns
a. Bullish Reversals
Cup and Handle
A Cup and Handle pattern is a bullish formation defined by a “U” shaped basing formation (rounding bottom) which is followed by a brief pullback with lowering volatility. A breakout usually happens after the completion of the pattern.
Inverted Head and Shoulders
An Inverted Head and Shoulders pattern appears as a three-base formation along a neckline resistance. This reversal pattern points to a bearish-to-bullish transition.
Bullish Divergence
A Bullish Divergence is illustrated in the chart as a phase when a technical indicator (usually the RSI oscillator) begins to form a trend that contradicts the current price downtrend.
RSI is making HIGHER lows while the price action of the stock is establishing LOWER lows. This signifies weakening selling pressure that might transition to an uptrend rally.
Double Bottom
A Double Bottom formation is a reversal pattern usually forming in a multi year support level. After a stock bounces from a major downtrend, the price will likely retest the support area to validate the strength of the buying pressure. As more buyers come in, another bounce is triggered and eventually propels the stock price to break its initial resistance.
b. Bearish Reversals
Head and Shoulders
A Head and Shoulders pattern appears as three-peak formation along a neckline support . This reversal pattern points to a bullish-to-bearish transition.
Bearish Divergence
A Bearish Divergence is illustrated in the chart as a phase when a technical indicator (usually the RSI oscillator) begins to form a trend that contradicts the current price uptrend.
RSI is making LOWER highs while the stock price is completing HIGHER highs. The divergence here shows that the price action has weakening buying pressure and might soon transition to a downtrend.
Double Top
A Double Top formation is a reversal pattern usually forming in a multi year resistance level. After a stock is rejected from reaching a major resistance, a brief pullback happens and a retest of the resistance happens. Due to massive amount of selling, the price is rejected once again and proceeds to break down. When selling is sustained, the trend shifts to a downtrend.
In Summary
Chart patterns repeat based on prevailing conditions in buying and selling. Traders who can identify these chart patterns are able to align their plan to the market and land consistent profits.
It is important to know that these patterns form because of repeating buying and selling behaviors of institutional and retailer market participants. When you know the psychology behind price movements, you can navigate the market clearly and execute the trade plan with confidence and accuracy.
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