i. Chart patterns are repeatedly found to be formed and they make it predictable to trade too.
ii. Two types - reversal chart patterns and continuation chart patterns.
iii. Chart patterns are mostly formed due to the mass market psychology.
What are chart patterns?
Price moves a lot and sometimes, this price movement might seem random, but, sometimes we see patterns in these price movements. This is what chart patterns are.
In trading, price charts are full of candlesticks. Hence, chart patterns can be defined as an arrangement of these candlesticks.
It should be noted that chart patterns are different from candlestick patterns.
Candlestick patterns are made up of a couple of candlesticks only but chart patterns consist of a larger number of candlesticks.
Repeatable and predictable
The basic essence of a pattern is that it should be observed more than once and that it should be predictable, i.e. it should provide some information.
If a pattern has been formed only once and has never been seen again, then it is just a random thing and is insignificant.
For a pattern to have some value, it must provide some information or some insight as to what can happen next.
If a pattern does not have any meaning then it is a waste of time to even consider such patterns.
How are chart patterns formed?
Price charts are the most important tools for traders and chart patterns just add more value to it for traders. Chart patterns are a part of technical analysis and have been widely used by traders for a long time.
It is often said that price movements are random and they have no inherent meaning to them, but this is wrong.
Prices of financial assets move on the basis of demand and supply forces in action at that time.
If a candlestick closes above its opening price then demand is higher, while if it closes below its open then it means that supply is higher.
Chart patterns are a phenomenon that is based on demand and supply too.
There are innumerable traders from around the globe looking to capitalize on price movements and each of them takes some actions to fulfill their goal.
The actions that traders take or their behavior in the market leaves behind certain patterns and chart patterns are one such pattern.
Chart patterns could be of different types, so read ahead to learn about these patterns in detail.
Types of chart patterns
Now that you know what chart patterns are basically and what are the reasons for their formation, let’s explore the various chart patterns that have been observed by traders.
Chart patterns can be of two types depending on the information it provides regarding the potential movement of price.
I. Reversal chart patterns
Reversal chart patterns as the name suggests, allow traders to identify potential price reversals.
We know that price can either trend up, down, or move sideways. If the price is declining then a reversal chart pattern will give an indication that the trend has reversed and that the price will move in an uptrend.
In the same way, if the price is moving in an uptrend and if a reversal chart pattern forms, then it indicates that a potential downtrend.
These chart patterns allow traders to spot a change in trend and take action to enter the potential trend from its beginning.
Let’s explore the most common reversal chart patterns and how you can look to trade them.
1. Double tops and double bottoms
Let us consider the currency pair GBPUSD and is moving in an uptrend.
The price reaches a level from where it corrects and moves away from. The highest level from which price corrected can be labeled as a swing high.
After correcting, it again moves up and reaches the previous swing high. In this case, the lowest level till the price corrects and moved up from can be labeled as a swing low.
A double top will be formed when the price gets rejected from the swing high and it is pushed down.
As the name suggests, the price made two tops i.e. it moved and reversed from the same level, twice.
Double bottoms are just the same, but it is formed when the price is in a downtrend.
Price already moving in a downtrend, gets rejected from a certain price level, corrects a little bit, again moves down to that price level, and gets rejected again.
These double tops and double bottoms indicate that there is a presence of a large number of strong market participants i.e. buyers or sellers accordingly, at those levels.
These market participants are protecting the level by either putting buying pressure in a double bottom or by putting selling pressure in a double top.
How to trade double tops and double bottoms?
In double tops, the price makes a swing high, then a swing low, and then gets rejected from the previous swing high. Traders can look to enter a short trade once the price breaks the swing low to the downside.
In double bottoms, the price makes a swing low, corrects to a swing high, and then gets rejected from the previous swing low. Traders can take long trades once the price breaks the swing high to the upside.
Traders can look to keep their stop loss at the swing high in case of double tops or may keep it midway between the swing high and the entry price level.
In the case of double bottom, stop loss can be placed at the swing low or midway between the swing low and entry point.
As to the targets, we would suggest a minimum 1:2 RRR but traders can always set the take profit levels accordingly.
2. Triple tops and triple bottoms
Just the way in double tops and bottoms, the price gets rejected once from the swing high and swing low respectively, in triple tops or bottoms, the price gets rejected twice from the swing high and swing low.
Let’s consider the currency pair EURUSD and it is in an uptrend. The price moves to a particular level and it corrects from there, this level can be called a swing high.
The price, after correction, moves towards the swing high but gets rejected again and again corrects from that price level.
After a small correction, the price again moves towards that swing high and again gets rejected. This is the triple top chart pattern.
The same is the case with triple bottoms, the difference being that the price was in a downtrend and it got rejected twice from a swing low.
In these chart patterns, the price moves in a range where it doesn’t create any new highs in triple tops and no new lows created in a triple bottom.
Just like the double tops and double bottoms, the triple tops and triple bottoms too give an indication of the presence of strong market participants at those particular price levels.
If the price gets rejected twice from the level then the traders get a strong indication that the prevailing trend is getting weak and a change in trend is imminent.
How to trade triple tops and triple bottoms?
In triple tops, the price gets rejected twice from a swing high and it corrects twice. Traders can look to enter a short trade once the price breaks the recent swing low.
In triple bottoms, traders can take long trades once the price breaks the recent swing high i.e. the recent level till the price corrects.
Just like the double tops and double bottoms, the stop loss in triple tops and triple bottoms can be placed at swing high or swing low respectively.
Or traders can place their stop loss midway between the entry point and swing high in triple tops or swing low in the triple bottom.
Targets again are suggested to be placed with a 1:2 RRR but traders can always decide targets accordingly.
3. Head and shoulders and inverse head and shoulders
This is another reversal chart pattern that is often observed to be formed on price charts.
To help make it easier to spot a head and shoulders chart pattern try and picture mountain peaks.
Head and shoulders are not exactly like peaks of a mountain but once you identify a mountain peak-like structure on a hart, you will instantly identify it as a potential head and shoulders pattern.
The head and shoulders pattern is formed when the price is in an uptrend. The price moves in the upward direction but then corrects a little bit. It again moves up and goes higher than the previous high but it again corrects and moves down.
There is another push in the upward direction but this time the move is lower than the previous higher high and then it falls back again. If you visualize this then you easily understand why it is called head and shoulders.
The baseline at which the price corrects three times is known as the neckline.
An inverse head and shoulders are the same but it is formed when the price is moving in a downtrend.
The price is moving down but corrects and moves up a little. It again moves down creating a lower low but sees a correction again.
Another downward move is seen but this time a lower low isn’t formed and the price again corrects.
In both head and shoulders patterns, the first and third price moves are the shoulders and the second move is the head.
Head and shoulders clearly show the weakening of the underlying trend.
The first shoulder is in direction of the prevailing trend but it loses momentum. The second move, the head, tries to gain momentum and is successful in creating a new high or low accordingly, but it loses strength again.
The third move, the second shoulder, tries to move in direction of the trend again, but this time the weakening of the trend becomes completely evident.
How to trade head and shoulders and inverse head and shoulders?
In the head and shoulders pattern, traders look to enter a short trade once the price breaks the neckline to the downside.
While in the inverse head and shoulders pattern, traders take long trades when the price breaks the neckline to the upside.
The stop loss can be placed above the recent lower high while it can be placed below the recent higher low in case of the inverted head and shoulders pattern.
Targets are advised to be placed with a 1:2 RRR but it can be altered according to the trader’s preferences.
II. Continuation chart patterns
Continuation chart patterns are the second type of pattern that is observed.
Now, these chart patterns indicate one thing, that the trend is going to sustain and the price will move in the prevailing trend.
But there is a catch to these continuation chart patterns and we will discuss this after we explore the various types of continuation chart patterns that have been identified by traders.
1. Ascending triangle and descending triangle
Ascending triangle patterns are formed when the price is already in an uptrend.
In this pattern, the price is unable to create higher highs and there is a resistance from a horizontal level, while the price keeps forming higher lows.
This allows traders to understand that there is a tussle between buyers and sellers and the higher lows indicate that buying pressure is increasing.
In a descending triangle pattern, it is the same but opposite. It is formed during a downtrend.
In this pattern, the price is unable to form lower lows and the price gets support from this horizontal price level, but it keeps forming a lower high. These lower highs indicate that the selling pressure is taking over the buying pressure.
In the triangle patterns, there must be a horizontal price level that is acting as a support or resistance and the price must create higher lows or lower highs that seem like a sloping line in direction of the prevailing trend.
The triangle patterns involve price moving in a tighter and tighter range that shows a fight between buyers and sellers.
How to trade ascending triangles and descending triangles?
In an ascending triangle pattern, traders can take long trades once the price breaks the resistance to the upside.
In the descending triangle pattern, traders can take short trades once the price breaks the support to the downside.
Stop loss can be placed at the resistance or support respectively or traders can place their stop loss at the recent swing low or high that is formed in the triangle respectively.
Targets are advised to be placed with an RRR of 1:2 but it can be altered accordingly.
2. Bullish rectangle and bearish rectangle
Just as the names suggest, bullish rectangles are formed when the price is in an uptrend while bearish rectangles are formed during downtrends.
In these rectangles patterns, the price moves in the prevailing trend, then it consolidates and moves in a range for some time before breaking out and continuing the trend. The price will oscillate between horizontal support and resistance levels.
The rectangle chart patterns indicate that there is brief exhaustion in the trend and the price is in an accumulation phase.
During this phase, market participants of the prevailing trend look to buy or sell more of the financial asset and build their position. In this pattern, the price can be observed to be stuck in a box.
How to trade bullish rectangles and bearish rectangles?
When a bullish rectangle pattern is identified, traders should take long positions once the price breaks the resistance to the upside.
In a bearish rectangle pattern, short positions are to be taken when the price breaks the support level to the downside.
In the case of a bullish rectangle, the stop loss is to be placed below the support level, while in a bearish rectangle, the stop loss is to be placed above the resistance level.
Targets are again advised to be placed with a 1:2 RRR. Traders can always alter the targets according to their trade plans.
3. Bullish pennants and bearish pennants
The pennant patterns are similar to the triangle patterns, the only difference being that with time the price movement becomes very narrow.
The pennant patterns are also known as flag patterns. These patterns are also of two types i.e. bullish and bearish.
Bullish pennants are formed during an uptrend, while bearish pennants are formed during downtrends.
The pennant pattern usually begins with a strong move indicating a strong prevailing trend. After this strong impulsive move, the price tends to consolidate for some time and it creates lower highs and higher lows.
The price moves narrower and a strong breakout is seen in the direction of the prevailing trend. In the bullish pennants, breakouts are in the upward direction, and in the bearish pennants, breakouts are in the downward direction.
Just like the other continuation patterns, this pattern too comprises of a move in the prevailing trend and then a brief consolidation.
In the pennant patterns, the formation of lower highs and higher lows shows accumulation by the market participants of the respective prevailing trend.
Once enough accumulation and build-up have taken place, the price explodes in the direction of the trend.
How to trade bullish pennants and bearish pennants?
Traders take long trades once the price breaks out of the structure on the upside in bullish pennants and short trades are taken once the price breaks the structure to the downside in bearish pennants.
With regards to stop losses, it can be placed below the recent swing low in bullish pennants and above the recent swing high in bearish pennants.
I'd suggest having a target of at least 1:2 RRR but you can alter it according to your preference.
4. Falling wedge and rising wedge
The wedge pattern is a commonly formed pattern and lots of traders have their strategies around this particular pattern.
A falling wedge is formed in an uptrend and rising wedges are formed during downtrends. The wedges are basically price phases in which there are an impulse and a correction.
In falling wedges, we see an upward price move and then there is a correction in price. This correction is in the opposite direction of the trend and is a minor move.
Traders can identify wedges by plotting trend lines above and below the correction move.
In rising wedges, the price is in a downtrend and it sees a correction in the upward direction. This can too be spotted by trend lines plotted above and below the correction move.
The wedges just indicate a brief consolidation in price before it resumes the trend. The trend lines that are plotted go on to converge and a break out takes place in the direction of the actual trend.
These patterns get their names from the nature of the pattern itself. It is called a falling wedge because the structure looks like a declining one while it is called a rising wedge as the structure looks like an upward-moving one.
How to trade falling wedge and rising wedge?
In falling wedges, traders look to take long trades once the price breaks the structure to the upside, while short trades are taken once the price breaks the structure to the downside in rising wedges.
Stop loss can be placed below the recent swing low in falling wedges and can be placed above the recent swing high in rising wedges.
Targets are suggested to be placed with a 1:2 RRR but can be altered according to the trade plan.
The right way to trade chart patterns
The reversal patterns always indicate reversals only as and when they play out. But it should be noted that these patterns will not play out and have the same effects.
Price may or may not move according to these patterns and there may not be any reversal in the trend. This is known as a reversal pattern failure and if traders can identify these failures then they could capitalize on these too.
I have discussed in detail the most commonly traded continuation chart patterns, there is a catch to it as I mentioned.
The continuation chart patterns too, may not always indicate a price trend continuation.
I have discussed strategies to trade these continuation patterns and it is mainly based on breakouts from the structure in direction of the prevailing trend.
But what happens if the breakout is not in direction of the trend but is in the opposite direction? Nothing to worry about, this is just a sign of a price trend reversal.
This can also be called a continuation pattern failure and if traders are able to identify it then they can capitalize on this move too.
What I intend to infer from all this is that these chart patterns are not holy grails and they will not play out according to the theory always.
There will be times when these patterns will fail and the price will move in the other direction. You should be ready for such moves and should have a plan to trade these instances too.
This will only happen if you backtest these patterns properly and note down the price movements that follow these patterns.
Having tested and practiced these chart patterns will increase your confidence in them and also allow you to avoid getting caught off guard in case the price does not move according to the patterns.
One more thing to be noted is that no matter how reliable the pattern is, risk management is the ultimate thing.
So, never fail to manage risk properly whenever you are trading these chart patterns.
What type of chart pattern trader are you?
Are you a reversal pattern trader or a continuation pattern trader?
Do you look for counter-trend moves or a move in direction of the prevailing trend?
Do let me know about your experiences with these patterns and how you look to incorporate them in trading.
Are there any other patterns that traders use to trade that I haven’t mentioned? Mention them in the comments section.
You can always ask questions or queries through the comments section and I would be more than happy to revert.