Tailing the right approach to deciphering what chart patterns signify can greatly affect your approach to trading in the fast moving world of trading. There are visual representations of how buyers and sellers tend to interact at critical price levels offered by chart patterns, useful to inform of general market sentiment. Once you learn these patterns, you know how the price will behave, when to enter, when to exit, and how to reduce the risk in your trading.
Today we will look at seven important chart patterns that every trader should know:
- How to recognize and understand the psychology of each pattern.
- Use these patterns to benefit on your trades.
- This is training on how to actualize these patterns.
So let’s get to the most powerful chart patterns and how to apply them in some real world trading situations.
Head and Shoulders Pattern
The head and shoulders pattern is the most reliable of all reversal patterns in technical analysis. It indicates a possible trend reversal and is effective in both bull and bear markets.
Anatomy of the Pattern
- Head: The topmost peak in the pattern.
- Shoulders: Two small peaks flanking the head.
- Neckline: A line drowned through the troughs connecting the two shoulders.
When the price falls below (or rises above, in the case of an inverse head and shoulders) the neckline, then the pattern is complete.
Why It Works
This formation is a battle between buyers and sellers, which results in buyers not pushing the price higher after the head. A neckline break confirms the sellers dominance.
Trading Strategy
- Now, we need to wait for the break of the neckline.
- To set your price target, measure the distance from the head to the neckline.
- Place a stop-loss a little above the second shoulder (or below in inverse cases).
Example
For example, suppose the stock price of XYZ has formed a head at $120, shoulders at $100, and a neckline at $90. So, the target would be at ADD $::=Price - $30 (if price breaks below $90).
Double Top and Double Bottom
These are reversal signals that a trend is shifting. A double top is a bearish reversal pattern, whereas a double bottom is a bullish reversal pattern.
Anatomy of the Pattern
- Double Top: Two tops of nearly equal height with a valley between them.
- Double Bottom: Two troughs roughly equal in depth, with a peak in between.
Why They Work
These patterns show an exhaustion of buyers (or sellers), leading to a loss of momentum, which suggests a reversal.
Trading Strategy
- For double tops, short when the price falls below the retracement level.
- In a double bottom, you would go long when the price exceeds the spike between the troughs.
- After that, place the stop-loss slightly higher than the second peak or slightly lower than the second trough.
Example
For example, in a double top if a stock price has highs at $150 and a low at $130, and below 130 it will target $110 (measured as $150 – $130 = $20 subtracted from $130).
Flags and Pennants
Flags and pennants are after strong price movement followed by a consolidation period. Advertisement Continue reading the main story They foreshadow that trend is likely to return.
Anatomy of the Pattern
- Flag: A small rectangular consolidation area that slopes against directional tendency.
- Pennant: A small symmetrical triangle that forms during the consolidation stage.
Why They Work
These are known to be temporary retracements in an overall strong movement, hence they allow traders to step back in and benefit with the market trend.
Trading Strategy
- Find the flagpole (strong price movement) that precedes the pattern.
- You should get in the trade when price breaks the consolidation phase.
- Target price = Height of the flagpole + Breakout point
Example
A stock price moves from $50 to $100 (flagpole) and then consolidates in a flag pattern. If it breaks out at $100, the target would be $150 (flag pole height of $50 added).
Triangles: Ascending and Descending
An ascending triangle is bullish, a descending triangle is bearish.
Anatomy of the Pattern
- Ascending Triangle: Horizontal resistance line with an uptrend of increasing supports.
- Descending Triangle: Horizontal support line with declining resistance level
Why They Work
Triangles mirror market psychology, where buyers or sellers slowly assert dominance.
Trading Strategy
- Ascending Triangle: Long on Break Above Resistance
- Descending triangle: short if the price breaks down from support.
- Rise in target price = height of the triangle added (or subtracted) to the breakout point.
Example
In the case of an ascending triangle with resistance at 100 and support from 90 to 95 coming up, a break over 100 could target 110 (triangle height of 10 added to 100).
Cup and Handle
The cup and handle forms a bullish continuation pattern which indicates a short pause before trend continuation. This is like a teacup, with a rounded bottom (cup) and a consolidation (handle).
Anatomy of the Pattern
- Cup: A rounded “U-shaped” bottom.
- Handle: A small area of consolidation sloping down.
Why It Works
This indicates the establishment of a consolidation pattern and a potential entry before the continuation of the trend due to a strong upward move.
Trading Strategy
- Go long on a breakout above the horizontal resistance of the handles
- Target price is equal to Depth of cup+Breakout point
Example
For example, if the cup depth is $30 and the breakout level is $100, then the target price would be $130.
Wedges (Rising and Falling)
They are converging trend lines and can indicate continuation, or reversal.
Anatomy of the Pattern
- Rising Wedge: An overall pattern of higher highs and higher lows with the price range tightening.
- Falling Wedge: Lower highs and lower lows, decreasing price range.
Why They Work
These patterns indicate a weakening of momentum, corroborated by volume analysis.
Trading Strategy
- Rising Wedge: When the price breaks behind the lower trend line, enter a short position.
- Falling Wedge: Long position when price breaks above upper trend line.
- Place stop-losses just above or below the wedge to reduce risk.
Example
For example, a stock would be forming an upward wedge if it moved from $100 to $150 but only consolidated to $145. A break beneath $140 would signal a bearsih move to $120.
Rectangles
Rectangles: Vertical formations alternating between horizontal support and resistance. They iterate indecision in the market.
Anatomy of the Pattern
- Three horizontal support and resistance zones that hold price.
Why They Work
Rectangles signify the balance zone between buyers and sellers, while breakouts indicate control.
Trading Strategy
- In the direction of the breakout, take a trade.
- The target price is equal to the height of the rectangle added (or subtracted) to the breakout level.
Example
A stock bounces between $50 (support) and $60 (resistance). But a breakout over $60 can target $70.
How to incorporate chart patterns into your trading strategy
- Use Confirmation Tools
- Volume should increase on breakouts.
- Indicators: Combine pair patterns with RSI, MACD, or Bollinger Bands for confirmation.
- Manage Risk
- Always place stop-loss orders relatively close to invalidation points.
- Don’t over-leverage, and follow a risk management plan.
- Practice Regularly
- Find past trends by looking at old charts
- Even test a pattern-based strategy with a demo account; no money and no risk to build up the strategy.
Conclusion
Learning chart patterns such as the head and shoulders, double tops and bottoms, flags and pennants, triangles, cup and handle, wedges, and rectangles can change your trading! Learn all the patterns to read the market and know where the price is going to lead you.
However, if you want to level up your skills, learn about other advanced tools that can help to support your chart analysis, such as Fibonacci retracements or pivot points. This takes practice, and eventually, you’ll get good at tuning to the market flow and making decisions based on data.
