The ChoosaBroker Trading Academy
11.3. An Introduction to Classical Chart Patterns
A chart pattern can be defined as a distinct formation on the price chart of an underlying asset that generates a trading signal. Chartists use these patterns to forecast future price direction. The theory behind chart patterns is based on the assumption of technical analysis that history tends to repeats itself.
There are two types of technical chart patterns – reversal pattern and continuation pattern. A reversal pattern signals that an ongoing trend will change its direction upon the successful completion of the pattern, while a continuation pattern signals that a trend will resume its original direction once the pattern is complete. Technical chart patterns are formed on price charts of any timeframe, be they hourly, daily, or weekly. In this lesson, we will discuss some of the more frequently appearing chart patterns.
Head and Shoulders Pattern
The head and shoulders is one of the most reliable trend reversal chart patterns. There are two variations of the formation. The head and shoulders top is a bearish reversal pattern that is formed after prices have run up, while the head and shoulders bottom signals that price is set to rise after a downtrend.
Both of these head and shoulders variants have similar chart features in that there are two “shoulders,” with a “head” in between, and a neckline that connects the price troughs. The patterns are confirmed when the neckline gets broken post the completion of the second shoulder.
01. Head and Shoulders Top
A head and shoulders top forms after a bull run, and its completion signals a reversal in trend. The pattern is made up of three consecutive price peaks, with the middle peak, called the “head,” surrounded by two lower peaks (shoulders). The swing lows following each peak are connected to form the “neckline.”
For the formation of a head and shoulders top, it is important to establish the existence of a previous uptrend. Without a prior trend in place to reverse from, there cannot be a pattern. During an uptrend, prices first rally to form a new high. After plotting this peak, prices decline to complete the left shoulder.
From the trough of the left shoulder, prices again advance to exceed the previous high. This marks the head of the pattern. The subsequent fall takes price to the support zone that is holding the uptrend intact. The right shoulder is the final attempt by the bulls to keep the momentum going, the failure to do which, results in a change in trend from up to down.
02. Head and Shoulders Bottom
The head and shoulders bottom is also often referred to as an Inverse Head and Shoulders. It forms after a down trend, and the completion of the pattern marks a reversal in trend. The pattern comprises of three successive price troughs, with the middle trough, called the “head,” being the deepest. The head is flanked by two higher price troughs that are termed as the left shoulder and the right shoulder. The price swing highs are connected to form a neckline resistance.
During a downtrend, prices decline to new lows that form the left shoulder. From there, a rebound ensues to a chart a reaction high. The subsequent dip exceeds the previous low to form the head of the pattern. After printing this bottom, the high of the following price advance forms the second neckline point. The bears make one final attempt to hammer prices to fresh lows, the failure to do which, results in the formation of the head and shoulders bottom.
In technical analysis, triangle patterns can be both trend reversal and trend continuation formations. They can be best described as horizontal trading ranges, where the forces of demand and supply are in equilibrium, until one side overpowers the other to move prices in their favour.
Triangle patterns can be classified in to three categories:
01. Symmetrical Triangle
- Structure: The symmetrical triangle is also described as a coil. The pattern is made up of at least two lower price highs and two higher price lows, which are then connected. The two connecting trendlines converge as they are projected in to the future to form the symmetrical triangle. The pattern can occur on any time frame, be it 5 minute, hourly, daily or weekly.
- Volume: As the symmetrical triangle forms and the trading range begin to contracts, volume should ideally start to decline.
- Breakout Criteria: Most legitimate breakouts occur somewhere between half and three-fourths through the pattern’s development. The pattern time-span is measured from the apex to the beginning of the lower trend line. A break before the half way point is generally false, while a break too near the apex may not lead to a significant price move.
- Breakout Direction: Attempting to forecast the direction of the breakout can be risky. Let price action unfold and provide confirmation.
- Breakout Volume: For a breakout to be considered valid, wait for the bar to end. Also, most successful breakouts are accompanied by a volume expansion, especially upside breakouts.
- Target Price: The extent of the move following the breakout is more often than not equal to the widest distance between the two trendlines that form the symmetrical triangle.
02. Ascending Triangle
- Structure: The ascending triangle is generally a bullish chart pattern that forms after prices pause post a strong up move. Due to its shape, the pattern is also referred to as a right-angled triangle. Two or more equal swing highs are connected by a horizontal line. We then join two or more rising swing lows. Both these trendlines converge to form an ascending triangle.
- Highs Can Be Unequal:
As has been stated above, at least two swing highs are required to form the upper end of the ascending triangle. However, the highs need not necessarily be exact, and can be within reasonable proximity of each other.
The lower ascending trendline should connect two successive price troughs. If a reaction low is formed in between, the pattern loses its validity.
- Volume: As the pattern evolves, trading volumes contracts. This is usually the lull before the storm. Once the breakout materializes, there should be an expansion in volume. While the volume confirmation is preferred, it is not mandatory.
- Resistance Turns Support: One of the basic tenets of technical analysis is that when resistance gets broken, it turns into support and vice versa. When the upper trendline of the ascending triangle is breached, it turns into support, from where prices reverse in case of a pullback.
- Breakout Target Price: The extent of the price move following the breakout is measured by calculating the widest distance between the two trendlines and then applying it to the resistance breakout.
03. Descending Triangle
- Structure: The descending triangle is a bearish continuation pattern that forms during a downtrend. Because of its shape, descending triangles are also referred to as a right-angle triangle. They are made up of a horizontal line, which connects two or more comparable lows at the bottom. Another trendline is drawn joining two or more declining price highs. Both these lines converge to form the descending triangle. The pattern can occur on any time frame, be it 5 minute, hourly, daily or weekly.
- Continuation of Trend:
In order to be counted as a continuation pattern, an established trend should be in place. The duration and momentum of the trend is not important.
The two reaction lows that form the lower horizontal line need not be exact price points. All that matters is that they should be in close vicinity to one another. It is important to remember that the two swing highs that create the upper descending trend line should appear successively. Any price peak in between will make the descending triangle invalid.
- Volume: As the pattern develops, volume should decline. This will reflect that less and less traders are interested in status quo, and a breakout is imminent. When the downside break happens, it’s not necessary that there be an expansion of volume. Prices can fall on their own weight.
- Support Turns Resistance: Following the break down, the lower horizontal trendline will act as resistance in case price mounts a bounce back.
- Target Price: The target price is achieved by measuring the widest distance between the two trendlines that make the pattern, and then subtracting it from the breakout level.
- Presence of Trend: To be considered as a valid continuation pattern, both flags and pennants should be predated by a sharp up or down trend on heavy volume. After an underlying asset puts in a strong move, prices often pause to gather momentum for the next leg of the trend.
- Structure: A flag looks like a small rectangular range that has a slope that’s against the prior trend. Since flags typically are too short in duration to have swing highs and swing lows, the price action is contained between two parallel trend lines. On the other hand, a pennant resembles a small symmetrical triangle consisting of two converging trendlines within which prices remain sandwiched. The slope can be neutral.
- Breakout: A bullish breakout is signalled by a price close above the higher of the two trendlines. In case of a bearish flag or pennant pattern, a break below the lower trendline (support) indicates the previous down trend has resumed.
- Volume Characteristics: Since flags and pennants are pauses within a trend, volume is considerably low when the pattern gets formed. However, the breakout should be accompanied by a substantial increase in volume to be considered legitimate.
- Target Price: In case of a break above or below a flag or pennant, the resulting price moves generally equals the distance of the move that preceded the pattern.
Double Tops and Double Bottoms
Double tops and double bottoms are frequently-occurring and reliable reversal patterns. A double top is a bearish reversal formation that signals a price rally is no longer sustainable, and that markets are primed for a change in direction. A double bottom is a bullish chart pattern that appears after a pronounced down trend and indicates that prices are more than likely to head higher.
01. Double Top
As the name suggests, the double top pattern is composed of two consecutive price peaks that are roughly of equal height, with a distinct trough in between. Just like any other major reversal pattern, it is imperative that a preceding trend be in place to reverse from. In the case of the double top, a significant uptrend of several bars is a necessary pre-requisite. The first peak of the pattern marks the highest point of the current trend. Once the first peak is plotted, a price pull-back takes place that typically lasts for 10% to 20% of the prior up move. Bulls intervene at this point to absorb the selling pressure and take prices higher. But they fail to break through the first peak, which represents a significant resistance zone. While exact peaks are desirable, there is some latitude. Usually, a peak within a 3% distance of the first peak is considered valid.
The subsequent drop from the second peak should be accompanied by an expansion in volume. This serves as an affirmation of the fact that the forces of demand are weakening, and a move lower is imminent. The double top pattern is confirmed when prices break down below the support level that exists at the lowest point between the two peaks. The distance from the support break to either of the price peaks should be deducted from the support break area to arrive at a price target for the breakout move. This would imply that bigger the double top formation, the larger is the likely decline.
02. Double Bottom
The double bottom pattern is made up of two successive price troughs that are roughly of equal depth, with a well-defined peak in between. As is the case with the double top formation, there must be an ongoing trend to reverse from. The double bottom requires that a significant downtrend of several bars be in place for the pattern to be deemed acceptable. The first trough represents the lowest point of the current trend, and is fairly normal in appearance. After the first trough has been printed, a minor price advance materializes that typically ranges from 10% to 20% of the last down move. Some bears see this as opportunity to load up on their shorts and enter to push prices lower. But this bearish volume quickly dries up and prices are unable to breach through the strong support zone created by the first trough. This should serve as a warning that a change in trend from down to up is in the offing. The double bottom pattern is finally confirmed once prices breakout above the highest point between the two troughs on greater than average volumes. The distance from the resistance break area to the low of the troughs can be added to the resistance break to estimate a price target for the ensuing up move. Traders should note that broken resistances often tend to turn to future support areas. There are times when following the completion of a double bottom pattern, prices temporarily retrace to near the resistance zone that marks the high between the two troughs. Such dips offer a second chance to traders who missed out on the original breakout to initiate fresh long positions.