Common Chart Patterns
When we talk about chart patterns, we are referencing structures in price formation that will give traders clues about the future value of an asset. Some patterns suggest that trends will continue while others signal potential reversals. The identification of chart patterns is arguably the way most trade signals are generated and once the most common formations are familiar, they become incredibly easy to spot in real-time. It could be argued that the process of finding these formations is more an art than a science because exact criteria for these patterns does not exist. Some patterns are better (more clear) than others but there is no shortage of tradable formations for traders watching a diverse range of markets.
Technical analysis relies heavily on the idea that history tends to repeat itself, and this is expressed clearly in the following pattern examples: Head and Shoulders, Double/Triple Tops and Bottoms, Triangles, Flags, and Pennants. There are many other chart patterns that traders use but these are the most common.
The Head and Shoulders pattern is one of the most recognizable and reliable structures used by traders. This is a reversal pattern, signaling an end to the trend that had prevailed previously. The Head and Shoulders Top is formed when a low high is followed by a higher high, which is then followed by a low high which is approximately equal to the first. A support line is then drawn below these highs. This level is called the “neckline” and when this level is violated, a trade is triggered, with the expectation that upward momentum has run its course. A Head and Shoulders Bottom is the inverse of this scenario and signals the end of a downtrend. Below is an example of the topping formation:
In this example, a short trade would be triggered once the Neckline support is broken. The bottoming formation would show an exact inversion of all these scenarios. Below is an example:
Another formation that is also very reliable is the occurrence of Double or Triple Tops and Bottoms. This is also a reversal pattern, as it contains levels of support or resistance that have been tested multiple times without being broken. These formations (as is generally true for all chart patterns) are considered to be more reliable and valid on longer-term charts. That is to say, A Triple Top formation on a Daily chart is usually considered to give a higher probability signal than the same structure on an Hourly chart.
Put simply, a Triple Top is an area of resistance that has been tested three times without a violation. A Double Top is an area that has been tested twice. A Triple Bottom is an area of support that has been tested three times without being violated. A Double Bottom is a support area that has been tested twice. The more an area has been tested, the more reliable that level is thought to be. So, as an example, a Triple Top is a better sell signal than a Double Top. Below is an example of a Triple Bottom:
And here is a potential Sell signal created by a Double Top:
In this case, a Sell trade could be placed close to the 1.0745 area with a stop-loss above that level of resistance. The argument supporting this is that, historically, price has had significant difficulty overcoming this level of market supply and traders will expect that to continue to be the case going forward. If that level is later violated, the bias will change, so a protective stop-loss must be used.
The next chart formation is the Triangle pattern. There are three types of Triangles: symmetrical, ascending and descending. These three look different and give traders different signals. As always, these patterns can occur on any time frame. However, longer-term charts are almost always seen as being more valid and reliable, giving higher probability trade setups.
First, the symmetrical triangle:
This pattern is unlike many of the others in that it is a completely neutral signal until one of the trendlines break. Support and Resistance lines converge in a relatively equidistant fashion, showing traders that energy and tension is building, to the point that a violent response will be expected once market participants make a firm directional decision.
Next is the ascending triangle, where we see a flat resistance line and an ascending support line. The bias in this formation is to the upside, but traders must wait for confirmation of the pattern, which is the break of the resistance line. Here is an example:
When looking at a descending triangle, we see the lower support trendline that is flat and an upper resistance line that is descending. Traders see this as negative for the asset involved but confirmation is needed, which is signaled by a break of the flat support line. Here is an example, where traders would expect continued downside:
The last of the major chart patterns that we will look at here are the Flag and Pennant patterns. These are examples of trend continuation patterns which show prices sharply moving in one direction, followed by a period of sideways consolidation. When this occurs, traders expect another sharp price movement, in the same direction and of a relatively equal distance.
Pennants and Flags are relatively similar in appearance. The main difference is that after the initial impulsive price movement, Pennants will show a structure that resembles a symmetrical triangle, whereas Flags will show prices trapped in a channel. Below is an example of a Buy signal created by a Pennant formation:
We can see the differences here, in the Flag pattern below (buy signal):
The main similarity in both of these patterns is that prices are expected to continue in the direction of the impulsive move (either up or down) after the period of sideways consolidation breaks out of its symmetrical triangle or sideways channel. The distance of the expected move is roughly equal to that is the initial impulse move.