Trading 101: Chart Patterns, Part 1
Arguably the most well-known part of technical analysis is the study of chart patterns. Even those not familiar with TA have seen double tops, double bottoms, head and shoulders formations, to name the most famous ones. These patterns are relatively easy to spot and give the illusion that it’s easy to spot a reversal in prices. Although some of the chart patterns have a pretty good track record, it’s very important to know their limitations, their background, and to use them as all other trading tools: to judge probabilities rather than to find The Holy Grail of trading.
The Premise of Chart Patterns
Visualization is one of the key elements of technical analysis. This method uses the unique ability of our brain to spot patterns and build models by comparing a particular price chart to different historical price movements. On a basic level, traders use price formations because similar price movements tend to resolve similarly, mostly because crowds tend to react to similar situations in a similar way. Looking at charts as the “log” of crowd behavior helps us to understand why the price history can help us in gauging the state of the market, and spotting the current “mood” of the participants, and most importantly the balance between buyers and sellers.
On the flip side, your mind can play tricks with you as well; you might see patterns when there is none, or even worse, use what you see to confirm what you already decided unconsciously. Psychologists call this confirmation bias, and it’s one of the most notorious enemies of traders and investors alike.
So while visualization is a huge help for traders, especially experienced ones, always treat chart patterns with a grain of salt. They are not magical tools, but in the good hands they can boost your returns and help you in spotting great trading opportunities while protecting your capital.
The previously discussed support and resistance levels can be viewed as the most basic (and some of the most reliable) chart patterns. As a general rule, simplicity is very helpful in technical analysis—overcomplicating your charts will generally lead to confusion. Also, on a complicated chart, you will definitely find some confirmation, no matter that you want to buy or short the given asset.
The Types of Chart Patterns
There are several possible factors to group the vast number of chart formations, but we will use the most practical one, the role of the pattern in the trend. This way, you will be able to look at the formations as part of the ongoing price movements, not just isolated things. Context is always very important when dealing with chart patterns, as, for example, a “double top” looking pattern can have significantly different importance in a downtrend or at the end of a multi-year advance.
We will use the following groups:
- Consolidation patterns
- Continuation patterns
- Reversal patterns
These groups already have some overlap between them, as, for instance, some continuation patterns could be consolidation patterns as well, but in practice it’s more important to know the usual consequence of a formation than to have nice and tidy groups.
Consolidation patterns in the WTI Crude contract, 4-Hour Time-Frame
We already saw that the price of financial assets isn’t always moving up or down, it also drifts sideways for long periods. When you notice a neutral short-term trend in an ongoing long-term move, it’s called a consolidation pattern. Consolidation patterns are brief “stops” in the trend which don’t change the basic structure of the move.
As you can see on the chart above the trend remained intact and the break-outs from the patterns gave great opportunities to enter the move. Also, it’s easy to see that these patterns often correspond with the swings that we already discussed. The reason that we use this grouping is that some swings will qualify as consolidation patterns, but others might mean entirely different things for the trend.
Consolidation patterns usually emerge in strong trends and last only for a brief period of time (5-10 candles on the given time frame). The names of these patterns usually simply refer to something that is similar to the pattern, wedges, flags, triangles, pennants, and rectangles (trading ranges). We will look at these in detail later on when discussing continuation and reversal patterns.
As soon as the ongoing consolidation pattern starts to break the structure of the underlying trend, violates the trend-line for example, we talk about a correction that could form a continuation or a reversal pattern, depending on the outcome. We have to stress again that the shape of the pattern is no magical forecasting tool, rather a hint on the probability of the outcome, but with experience and disciplined trading, this edge can be turned into significant and stable returns.
First, we will look into formations that are primarily continuation-patterns.
Consolidation (red), and continuation and reversal patterns (black) in the S&P 500, 30-minute Time-Frame
Triangle patterns are probably the most common ones, and they can simply be described as compression patterns, periods where the price action in the asset is limited to smaller and smaller ranges as the time goes by. This corresponds with the decline in volatility, and with less and less short-term trading opportunity in the pattern. These factors usually lead to declining volumes (as short-term traders look for other assets) and, lately, algorithms compressing the price even more.
Triangles can be symmetrical, ascending, or descending, depending on the angle of the lines that make up the pattern. Although all triangles are primarily considered continuation patterns, their success rate varies from asset to asset. As a general rule, a move out of the triangle in the direction of the prevailing trend is considered a more reliable signal. Also, symmetrical triangles are less reliable in both declining and rising trends, while ascending triangles give better signals in uptrends while descending triangles in downtrends. If you notice an inverse triangle (or megaphone pattern,) where volatility is rising, be careful, as it is a usually bearish pattern that is not just hard to spot in real-time, but also very tricky to trade.
Rectangles or Trading Ranges
These patterns are also very common and appear on every time-frame and every stage of trends. They are bordered with short-or long-term horizontal support and resistance levels. In practice, short-term trading ranges (consolidation patterns) are reliable both in up and downtrends, but longer-term ranges are less useful in downtrends, despite being reliable in uptrends. We will go into details in our next article on pattern-based strategies.
Double Tops and Bottoms
Giant daily double top in the S&P 500 at the end of the 2003-2007 bull market
These very famous patterns are closely connected to swing-analysis, as they are based on swings that fail to hit new highs or lows in an ongoing trend. By definition, a double top pattern forms in an uptrend if two upswings “top-out” at, or almost at the same level. These two tops set up a horizontal resistance line, while the swing low of the first swing will be the level of the so-called “neckline”. This level is very important (as you might remember from our swing-trading lessons), as if the second swing penetrates that level, a “lower low” will form, confirming the weakness in the trend.
A very common misconception regarding double tops (and bottoms), is that if you have the two tops, you already have the pattern formed. In contrary, a double top is only confirmed if the price falls below the neckline, end closes below it (basically hits a lower low). Also, a double top without an uptrend or a double bottom without a downtrend doesn’t exist. In fact, these patterns are more reliable on longer timeframes (such as daily charts) because they represent more stable market dynamics.
All in all, while double tops and bottoms are actually very reliable patterns, the misuse of the definition often leads to counter-trend positions, as traders enter into consolidation patterns against the trend, without confirmed weakness and a valid formation.
Triple and Multiple Tops and Bottoms
Similarly to the double tops, these formations occur when the price of an asset fails to surpass a prior high or low, but with these patterns, this happens on multiple occasions. As a general rule, triple and multiple tops are way less reliable patterns, even if the “neckline-break” occurs. A lot of times these will prove to be rectangle continuation patterns with a failed break-out or break-down, making them rather suspicious trading tools. Also, in connection with this, remember that in uptrends resistance levels (and in downtrends support levels) should be treated weaker and weaker if they are tested multiple times, as the underlying trend is more and more likely to continue.
Head and Shoulders and Inverse H&S Patterns
Daily Inverse Head and Shoulders Reversal in Oil (USO ETF)
These patterns are very close to double tops and bottoms, but with a twist; between the two similar swing highs or lows (the shoulders) there is third slightly higher or lower swing that is called the head. Head and shoulders patterns are even more reliable than double tops, as they point to imminent weakness in the trend, as the price breaks the neckline (the first of the three swing lows) even before re-testing the first swing high.
With these patterns the same rules apply as with double tops and bottoms; they should be preceded with a distinct trend, and they are only confirmed when the neckline is broken.
Now that we got to know the most common chart patterns and the theory behind them, we will dive into trading strategies based on them, while learning some very important details that could make all the difference in real-life trading, so stay tuned.