Chart Patterns are formations that can help us spot conditions where the market is ready to break out. They can also indicate whether the price of some stock will continue in its current direction or reverse.
The most important chart patterns are:
- Head and Shoulders and Inverse Head and Shoulders
- Double Top and Double Bottom
- Rising and Falling Wedges
- Bullish and Bearish Rectangles
- Bearish and Bullish Pennants
- Triangles (Symmetrical, Ascending, and Descending)
Head and Shoulders and Inverse Head and Shoulders
The head and shoulders chart pattern is a reversal pattern and most often seen in uptrends. It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs.
In this example, we can easily see the head and shoulders pattern. The head is the second peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head. You can see that once the price goes below the neckline it makes a move that is at least the size of the distance between the head and the neckline.
Inverse head and shoulders is basically a head and shoulders formation, except this time it’s upside down. A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
In the example above we can see that the price moved up nicely after it broke the neckline.
Double Top and Double Bottom
A double top chart pattern is a reversal pattern that is formed after there is an extended move up. The “tops” are peaks that are formed when the price hits a certain level that can’t be broken.
In the example above you can see that two peaks or “tops” were formed after a strong move up. You can notice how the second top was not able to break the high of the first top. This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
Looking at the chart below you can see that the price breaks the neckline and makes a nice move down.
Traders should have in mind that double tops are a trend reversal formation so you’ll want to look for these after there is a strong uptrend. It is also important to mention that the drop is approximately the same height as the double top formation.
The double bottom is also a trend reversal formation but these formations occur after extended downtrends when two valleys or “bottoms” have been formed.
In the chart above you can see that after the previous downtrend, the price formed two valleys because it wasn’t able to go below a certain level. The second bottom wasn’t able to significantly break the first bottom which is also important in stock trading. This is a sign that the selling pressure is about finished, and that a reversal is about to occur.
So what's happened?
In the chart above we can see that the price of some stock broke the neckline and made a nice move up.
Rising and Falling Wedges
Wedges patterns usually signal a pause in the current trend. A rising wedge is formed when price consolidates between upward sloping support and resistance lines. If the rising wedge forms after an uptrend, it’s usually a bearish reversal pattern. On the other hand, if it forms during a downtrend, it could signal a continuation of the down move.
In the chart below we can see a rising wedge at the end of an uptrend.
In the chart below we can see a rising wedge at the end of a downtrend. In this case, the price broke to the downside and the downtrend continued.
So keep in mind that - a rising wedge formed after an uptrend usually leads to a REVERSAL (downtrend) while a rising wedge formed during a downtrend typically results in a CONTINUATION (downtrend).
Just like the rising wedge, the falling wedge can either be a reversal or a continuation signal. As a reversal signal, it is formed at a bottom of a downtrend, indicating that an uptrend would come next. As a continuation signal, it is formed during an uptrend, implying that the upward price action would resume. Unlike the rising wedge, the falling wedge is a bullish chart pattern.
In the example below, the falling wedge serves as a reversal signal. After a downtrend, the price made lower highs and lower lows. Upon breaking above the top of the wedge, the price of this stock made a nice move upwards that’s approximately equal to the height of the formation.
On the other side, when the falling wedge forms during an uptrend, it usually signals that the trend will resume later on.
Bullish and Bearish Rectangles
A rectangle is a chart pattern formed when the price is bounded by parallel support and resistance levels. A rectangle exhibits a period of consolidation or indecision between buyers and sellers, the price will “test” the support and resistance levels several times before eventually breaking out. A bearish rectangle is formed when the price consolidates for a while during a downtrend. In this example, the price broke the bottom of the rectangle chart pattern and continued to move down.
On the other side, a bullish rectangle is formed when the price consolidates for a while during uptrend. In this case, the price will move up after breaking above the top of the rectangle pattern.
Bearish and Bullish Pennants
Similar to rectangles, pennants are continuation chart patterns formed after strong moves. After a big upward or downward move, buyers or sellers usually pause to catch their breath before taking the pair further in the same direction. A bearish pennant is formed during a steep, almost vertical, downtrend. In the chart below we can see how the price breaks below the bottom of the pennant and continues to move down.
On the other side, a bullish pennant is formed during a steep, almost vertical, uptrend. In the example below, the price made another strong move upwards after the breakout.
It is important to say that the size of the breakout move is around the size of the earlier price move.
Triangles (Symmetrical, Ascending, and Descending)
There are three types of triangle chart formations: symmetrical, descending and ascending. A symmetrical triangle is a chart formation where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle.
In this case, traders or investors can place entry orders above the slope of the lower highs. The ascending triangle is a type of triangle chart pattern that occurs when there are a resistance level and a slope of higher lows. On the other side, descending triangles are the exact opposite of ascending triangles.
The resistance level is too strong, and there is simply not enough buying power to push it through - the buyers lost the battle and the price has dropped.
The support level is too strong, and there is simply not enough selling power to push it through - the sellers lost the battle and the price has advanced.