Many market participants do not leverage chart patterns to their full extent. This is unfortunate, as many technical traders have made fortunes trading these patterns, and a good number of chart patterns have proven themselves time and again. Chart patterns are graphical tools that provide technical traders with a reliable way to make educated predictions about the future price fluctuations and trends. In fact, most chart patterns often give clear buy or sell signals when correctly interpreted.
In essence, Chart Patterns are formed due to mass psychology that drives the changes in price trends and exists on the price chart of security as recognizable price change patterns. Sometimes it is easy to spot these patterns, whereas on occasions these can be quite subtle and not obvious to the untrained eyes of a novice trader. Fortunately, these patterns can be easily inventoried by an average investor, with only a few brief lessons. However, it is important to note that not all chart patterns are equal and the results that they generate in trading can vastly vary.
The 13 Chart Patterns that have been found to work effectively and deliver consistent results in trading include the following –
- Head and Shoulders Pattern
- Inverse Head and Shoulders Pattern
- Double Top Pattern
- Double Bottom Pattern
- Cup and Handle Pattern
- Inverted Cup and Handle Pattern
- Rounding Top Pattern
- Rounding Bottom Pattern
- Wedge Pattern
- Triangle Pattern
- Pennant Pattern
- Flag Pattern
- Harmonic Patterns
Now that we have listed the most reliable chart patterns that are known to actually work in trading, let us briefly discuss the basic structure and application for each of these patterns in the following sections. Irrespective of whether you are a beginner to trading patterns or are an experienced pattern, I am sure you will find our discussion in the following sections quite useful. So, without further ado, let us dive deep into these patterns.
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Table of Contents
Head and Shoulders Pattern
The Head and Shoulders Pattern is a reversal chart pattern that is aptly-named for its structure containing three peaks, the middle of which is the highest in the same way that a head sits above the shoulders. According to a paper published by the University of California at Berkeley, experts consider this pattern to be one of the most popular and reliable chart patterns.
The Head and Shoulders Pattern is interpreted as a sign of upcoming bearish reversal. Hence, when this pattern appears on the price chart of an asset that has been in an uptrend for a considerable time, it is treated as an indication that the uptrend is about to end. That being said, as a trader, you must always validate this hypothesis using other trading techniques or signals from other technical indicators. In combination with signals from complementary technical analysis techniques, this pattern tends to provide very reliable trading signals.
Besides the head and two shoulders, an important component of this pattern is the neckline, which connects the outer edges of the left and right shoulders. In essence, the neckline of a Head and Shoulders Pattern indicates the line of support. Support in trading refers to the price level that a given security will rarely break through.
As per a study published by the University of Nebraska, the majority of technical traders use the neckline of the Head and Shoulders Pattern to determine the point of entry for sell or short-sell trades. According to this study, the specific point at which a trade is entered is the spot where the neckline intersects the price curve after the right shoulder.
Inverse Head and Shoulders Pattern
The Inverse Head and Shoulders Pattern resembles the standard Head and Shoulders Pattern, with the exception that it is flipped upside down. In the case of this pattern, instead of price increases, there are three price valleys forming this pattern that show a decline in the price of an asset. Contrary to the regular Head and Shoulders Pattern, an Inverse Head and Shoulders Pattern could be interpreted as a bullish reversal signal indicating that the price is about to start trending upwards.
The neckline in the case of an Inverse Head and Shoulders Pattern represents the resistance level. In technical analysis, resistance refers to the price level at which there is sizable selling interest for the asset being traded, and above which its price rarely goes. Hence, the Inverse Head and Shoulders Pattern indicates that the price of a given security is likely to trend upwards after spending some time near the resistance level and then breaking past it.
Double Top Pattern
The Double Top Pattern is another reliable chart pattern that is popular among investors. Similar to the Head and Shoulders Pattern, this is also a reversal chart pattern that is used to predict a bearish reversal in price trends. For this pattern to be valid, it is necessary that its appearance on the price chart is followed by a sustained bullish price trend. The trend reversal after the appearance of this pattern can be either intermediate or long-term.
To be considered a Double Top Chart Pattern, the price formation has to have peaked twice at a resistance level and failed to break through this resistance on both attempts. The trading strategy with the double top pattern leverages the tops, or the resistance levels, as the stop loss. Additionally, when the price breaks past the temporary support level that is formed after the first formation in the first peak in an unsuccessful attempt of downward reversal, it is treated as a confirmation signal of an emerging downtrend and a trigger for short-sell trade entries.
Even though the double top pattern is considered extremely reliable, the appearance of false chart patterns is not uncommon in financial markets. Furthermore, until the pattern construction is complete and the pattern breaks to the downside, it cannot be confirmed that the pattern that you are looking at is truly a double top pattern.
Hence, for sustainable trading, it is vital that you leverage a stop loss to minimize the risk of unbearable losses in trading this pattern. In other words, having a stop loss will give you the opportunity to cut losses before things get worse.
From the standpoint of exiting bearish trades taken based on this pattern, as a general rule, many market participants wait until the price reaches a target that is double the distance from the pullback value, or temporary support, to the extremes, or the tops. Then they will sell at the target price.
Double Bottom Pattern
The Double Bottom Pattern is similar to the Double Top Pattern, except in reverse. In essence, the double bottom pattern is the mirror image of the Double Top Pattern. Contrary to the Double Top Pattern, a Double Bottom Pattern is an early indicator for a potential bullish reversal in price trend. But, similar to its bearish counterpart, the trend reversal indicated by this pattern may also be over an intermediate or long time.
To be considered as a true Double Bottom Pattern, the pattern must have valleyed twice at a support price level and should have failed to break through it both times. The buy sign in a double bottom pattern is at the first break of the temporary resistance or pullback line (also referred to as the confirmation line).
When trading this pattern, you must remember that a brief retracement to the temporary resistance or pullback line is not uncommon after it is broken. Therefore, you must not panic or get alarmed when such a retracement happens. Additionally, your stop loss placement strategy in trading this pattern must account for these retracements. In fact, you can leverage these retracements or pullbacks as a method to trigger delayed trade entries, should you have missed to enter trades when the price first broke out.
Cup and Handle Pattern
The Cup and Handle pattern is named so for its distinctive shape that resembles a teacup with a handle. This pattern can appear after a prevalent uptrend or a downtrend. Depending on the trend that precedes it, the cup and handle pattern could act as a continuation pattern or as a reversal pattern. However, either way, it is a bullish pattern that breaks out into a bullish trend.
In this pattern, irrespective of the direction of the prevailing trend, the price of security transitions from bearish to bullish in the cup of the pattern. Hence, during the formation of the cup, the price first goes down briefly, flattens out for a few trading sessions, and then gives bullish traders a rejuvenated hope by starting an uptrend.
Thereafter, post a short-lived uptrend towards the resistance level, the price of the security begins to experience some pullback, and hence it starts to fall for a brief period again. This momentary retracement takes the shape of a handle, thereby completing the Cup and Handle Formation on the price chart.
After this pullback, which leads to the development of the handle, the price breaks out of the handle and roars higher, continuing the upward trend triggered at the later half of the cup formation.
Before moving to the next chart pattern that you must add to your trading arsenal, I would also like to briefly share one key finding of a study conducted by Harvard University on this pattern. According to this study, the Cup and Handle Pattern will typically take 30-50 candles or trading sessions to fully form on any selected time frame, be it days, weeks, or months. Integrating this finding as a guideline for your pattern trading strategy can provide significant value by helping you filter out some false patterns. Hence, I would strongly recommend that you leverage this finding in identifying a Cup and Handle Pattern on the price chart of the security that you are trading.
Finally, listed below are a few pointers that will allow you to understand the market psychology that leads to the development of the cup and handle pattern, and thus trade it with confidence.
- The left side of the Cup represents a period of uncertainty where the market participants, unsure about the future direction of the security, reduce their trading activity. This results in the downward sloping curve, forming the first half of the cup.
- The right side of the Cup corresponds to a period of low trading volume but rejuvenated optimism in the future performance of the asset. This leads to the development of the right side of the cup, which is an upward sloping trend.
- Once prices approach previous highs, the asset receives selling pressure from participants who bought at or near the old high. They sell because they fear that the price will trend downwards, similar to what happened during the formation of the cup portion of the pattern. This results in the formation of the Handle.
- Finally, after the formation of the Handle, all major short term selling is concluded and the bullish pressure takes control over the market once again. Hence, the price takes off upwards after the handle
Inverted Cup and Handle Pattern
The Inverted Cup and Handle Pattern is the mirror image of the Regular Cup and Handle Pattern. Hence, structurally, by shape, it looks like a teacup with a handle that is placed upside down. Similar to the Cup and Handle Pattern, the Inverted Cup and Handle Pattern can also be preceded by an uptrend or a downtrend. However, irrespective of the direction of this preceding trend, this pattern always breaks to the downside resulting in a downtrend.
Hence, the inverted cup and handle pattern is regarded as a bearish chart pattern that, depending on the direction of the prevalent trend, can signal either a bearish reversal or a bearish continuation.
Market participants wait until the Handle of the Inverted Cup and Handle Pattern is fully formed before looking for a selling opportunity. This is because until the pattern’s handle is fully developed, you can never be sure that the chart pattern that you are looking at is an Inverted Cup and Handle Pattern.
Finally, with the Inverted Cup and Handle Pattern, the market psychology leading to the development of this pattern is similar to the Regular Cup and Handle Pattern discussed above, but in reverse. Additionally, just like its bullish counterpart, the Inverted Cup and Handle Pattern also forms over 30-50 trading sessions.
Rounding Top Pattern
According to the researchers at the University of Pittsburgh, the Rounding Top Pattern is relatively simple to identify on the price chart but does not appear as frequently as some other patterns described in this article. However, when it does appear, the signals generated by it are extremely reliable, when traded with the right trading strategy.
In essence, the Rounding Top is a reversal chart pattern that is also referred to as an inverse saucer pattern occasionally. The pattern appears after a strong uptrend and its appearance signals the possibility of an upcoming downward reversal in price trend. Accordingly, technical traders leverage this pattern’s appearance as a bearish signal to plan their trade entries and exits.
The telltale sign of the Rounding Top Pattern is a flattening top at the end of an extended uptrend, followed by a downward price curve towards the support price level. Separately, this pattern can develop over a wide diversity of time periods, including days, weeks, months, and even years.
All the above being said, unfortunately trading this pattern is usually deemed difficult by most pattern traders. It is primarily because this pattern can take incredibly long to fully develop and because it can be easily confused with other chart patterns, such as the Cup and Handle Pattern. Furthermore, the pattern also lacks a clear trade entry trigger, such as the telltale “handle” in the case of a Cup and Handle Pattern.
Rounding Bottom Pattern
The Rounding Bottom Pattern is also referred to as the saucer pattern. In essence, it is the mirror image of the Rounding Top Pattern and is used to anticipate a trend reversal from a downtrend to an uptrend. Similar to its bearish counterpart, this pattern can also be difficult to decipher because it can take a really long time for this pattern to fully develop.
According to many experts, the Rounding Bottom Pattern is best suited to trade the weekly timeframe charts of various financial instruments. In this pattern, the breakout and trend reversal occurs once the upwards curve reaches the same height as the beginning of the downwards curve on the opposite side of the saucer. Investors trading this chart pattern would then anticipate a continued trend upwards towards the next resistance level.
Wedge Pattern
The Wedge Pattern is a chart pattern that, depending on the location of its appearance on the price chart, can be considered either a continuous or a reversal chart pattern. It is much like a triangle in appearance but differs considerably from a Triangle Chart Pattern. The Wedge Pattern slants or favors a downward or an upward direction, on the other side of the peak.
Unlike several other chart patterns that are simpler to trade, the trading signals from a Wedge Pattern can be a bit more confusing for novice traders. This is primarily due to the fact that a Wedge Pattern could represent both – a potential continuation or a potential reversal. That being said, to the eyes of a trained pattern trader, such differences are not very difficult to spot. Based on the shape of the Wedge Pattern, expert traders can easily anticipate the direction in which the price is likely to break post the completion of the pattern.
There are two main types of Wedge Pattern –
- The Rising Wedge: It is a bearish reversal or a bearish continuation chart pattern that is characterized by two converging trendlines. In this pattern, the slope and the momentum of the upper trendline is less than that of the lower trendline.
- The Falling Wedge: Contrary to the Rising Wedge, the Falling Wedge is a bullish reversal or a bullish continuation chart pattern that comprises two converging trendlines. In this pattern, unlike its bearish counterpart, the momentum and the slope of the upper trendline is greater than that of the lower trendline.
Hence, when trading this pattern, based on the characteristics, such as the slope and the momentum, of the upper and the lower trendline, the direction in which the price is likely to break can be easily anticipated by expert traders.
Triangle Pattern
The Triangle Chart Pattern is exactly what it sounds like. Somewhere along the line, the price curve will form a shape that resembles the shape of a triangle. According to a study performed by the New York University, the Triangle Pattern can be an effective tool in determining the future price performance of a security.
Triangle Patterns are particularly effective when used for identifying breakout trades. Breakout Trading, in essence, is identifying opportunities where the price change is expected to have a considerably higher momentum and trading such price moves to book sizable profits in a relatively small period. Triangles often, but not necessarily, lead to a continuation of the prevalent price trend.
In technical analysis, there are several different types of Triangle Patterns. The triangle types are set apart by price movement along the lines of support and resistance. Support refers to the lower trendline forming the triangle on the price chart of a security. Similarly, resistance refers to the upper trendline forming the triangle. Depending on the variation of the Triangle Pattern that appears on the price chart, some triangles will show a slope in the resistance line while others will show a slope in the support line. There are also triangles that show an identical change in both support and resistance lines.
In essence, there are three different types of Triangle Patterns –
- Descending Triangle: In this pattern, the price tends to lose resistance and begins to turn downwards while still maintaining its current levels of support. Post completion, this pattern often results in a bearish breakout.
- Ascending Triangle: Contrary to the Descending Triangle, in an Ascending Triangle, the pattern shows a stable resistance line and an upward sloping support line. Traders anticipate a bullish breakout once the construction of this pattern is complete.
- Symmetrical Triangle: The Symmetrical Triangle is defined as one in which support and resistance are changing at an almost identical rate. With this type of triangle is difficult to make a directional prediction of the breakout. Additionally, these triangles don’t occur as often as do the Ascending and the Descending Triangles.
To summarize, for the most part, Triangles are continuation patterns that usually indicate nothing more than a brief pause in the prevailing trend. Market participants can anticipate the price of the security to go back upwards or downwards, depending on the preceding direction of the price trend, once the construction of the triangle pattern is complete. Therefore, if the price was trending upwards prior to the period of sideways movement, the Triangle Pattern will likely result in a bullish breakout and vice-versa.
Pennant Pattern
The Pennant Pattern is a short term trend continuation pattern that frequently forms on the price chart of a security. This continuation pattern is formed when a sharp price trend is followed by a period of sideways movement and breaks in the direction of the prevalent trend.
The Pennant Pattern is relatively simple to identify and is composed of just two trendlines. In this pattern, the price creates a series of lower highs and higher lows and therefore does not move in either of the two directions – bullish or bearish. Hence, one of the trendlines forming this pattern slants downwards from the highest high to lower highs, whereas the other slants upwards from the lowest low to higher lows. When these two trendlines intersect (or nearly intersect), the construction of the Pennant Pattern is considered complete and the price breaks in the direction of the prevalent trend.
As discussed above, Pennants appear at regular intervals in a trending market when the trend takes a pause. Therefore, incorporating them into your overall trading strategy can prove very rewarding. Furthermore, on relative terms, the pattern is very reliable and accurate in the trading signals that it generates.
That being said, while the Pennant Pattern is typically seen as a pause in trend, they can also precede a trend reversal on some rare occasions. Hence, you must never forget to use proper risk management while trading these patterns and use thought through stop losses.
Finally, you must remember that the two trendlines forming the Pennants are not always symmetrical and can occasionally point upwards or have a downward slope. In trading this pattern, traders watch for the end of the pennant and, depending on the direction of the previous trend, wait for a price breakout past the upper or the lower trendline. Additionally, also note that experts use Pennants in conjunction with other forms of technical analysis for more accurate trade entries and exits, so you should consider combining this pattern with other tools to improve its reliability in trading.
Flag Pattern
Much like the Pennant Pattern, the Flag Pattern is also interpreted as an indicator of trend continuation. Similar to trading the Pennants, even when trading the Flag Pattern, you would forecast that the price trend will continue its prevalent trajectory once the pattern formation is complete. The difference between the Flag Pattern and the Pennant Pattern is that in the case of the Flag Pattern, there is no convergence between the upper and lower trendlines. In essence, in a Flag Pattern, the two trendlines run parallel to each other.
In technical analysis, the Flag Pattern is considered to be the most frequently appearing continuation pattern. Just like the Pennant Pattern, the Flag Pattern can also be either bearish or bullish. Additionally, both Pennant and Flag patterns will typically last 1-3 weeks (when trading on a daily timeframe), which puts them among the shortest of chart patterns from the duration to form standpoint. Furthermore, similar to the Pennant Pattern, the profit potential or price target when trading the Flag Pattern also depends upon the length of the flagpole or the prevailing trend.
If you are looking to utilize the Flag Pattern in your trading strategy, make sure that the pattern appears after a steep price move. Flag Patterns are most effective at making predictions on the future price movement after sharp price trends. Some experts also encourage traders to invest in a stock or other financial instruments when the Flag Pattern succeeds in a 90 percent rise in the price of a security. This is called a high-and-tight Flag Pattern and is one of the clearest signals of a good time to make a move.
Harmonic Patterns
There are 6 basic types of Harmonic Chart Patterns in trading. In order to see these patterns, you must first plot the 4 most recent price turning points and the price point in the status quo. Harmonic Patterns have been designed to take advantage of recurring price ratios that occur in markets.
Repetitive patterns occur in markets as prices often move back and forth between one set of price ratios to the next. It is for this reason that price projections are practical and why chart patterns often, but not always, do an adequate job at predicting where the future prices will fall.
These geometric patterns can be utilized to help market participants visualize the harmonic relationship between the price and the time swings. Harmonic Chart Patterns are mostly considered reversal patterns because these shapes can help project swings between high and low prices, followed by the swings in the opposite direction.
Examples of the commonly used harmonic patterns include the Gartley Pattern, the Butterfly Pattern and the Bat Pattern. Before closing this category of chart patterns, let us briefly discuss these three examples in the following sections.
Gartley Pattern
As stated above, the Gartley Pattern is counted among the most commonly traded Harmonic Patterns. The 5 plotted points in various harmonic patterns, including the Gartley Pattern, are often labeled as X, A, B, C, and D. The pattern leverages specific geometric ratios between all the price moves leading to its complete formation and is considered extremely reliable in technical trading circles. In fact, patterns like the Gartley Pattern are broadly assumed to be more successful at predicting price movements than the basic chart patterns such as the Flag Pattern, the Head and Shoulders Pattern, or the Triangle Pattern among others.
Butterfly Pattern
The main difference between different Harmonic Patterns is the ratios between the price turning points. The Butterfly Pattern is slightly wider than the Gartley Pattern but is otherwise very similar to the Gartley Pattern from a visual perspective. The Butterfly Pattern is often found during the unfolding of intermediate-term price movements. The pattern indicates bearish and bullish markets in the same way that the Gartley Patterns do.
Bat Pattern
The Bat Pattern is another Harmonic Pattern that is very similar to the Gartley Pattern. The main difference is that the Bat Pattern uses a 0.5 ratio that gives it a bat-like appearance. Just like the Gartley Pattern and contrary to the Butterfly Pattern, the Bat Pattern usually forms during the early stages of longer price trends.
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Conclusion
Chart Patterns provide market participants with a dramatically more successful alternative to simply buying and selling securities based on pure instincts. It is often the case that an investor’s intuition is a little off-kilter from reality. Due to the nature of the financial markets, market participants are involved in a system that often gives counterintuitive results, thanks to influence from a variety of external forces.
Fortunately, most chart patterns are time-tested. They are the brainchildren of experts who noticed that there are patterns to the price swings that occur in the market. They have been able to separate the most effective chart signals from the rest. The 13 most effective trading chart signals were included in this article.
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