Most traders use a combination of technical indicators and chart patterns when looking for opportunities. While technical indicators analyze momentum with statistics, chart patterns assess a market’s psychology through its price action. The subjective nature of chart patterns makes them a bit more difficult for active traders to master.
Let’s take a look at the five most popular chart patterns, how you can use them and best practices to keep in mind.Technical indicators are quantitative statistics, while chart patterns are qualitative measures of market sentiment. Click To Tweet
What Are Chart Patterns?
Chart patterns are simply patterns in prices that appear on a chart. While these price movements may appear random at first glance, traders look for a series of patterns to assess market sentiment. These insights are combined with other forms of technical analysis, such as technical indicators or candlestick patterns, to make trading decisions.
At the core, most chart patterns are built using trend lines that connect a series of highs or lows. Trend lines are significant because the price tends to react to them as psychological barriers — especially if the price has reacted to them many times in the past or if there’s a lot of volume when the price approaches the trend lines.
Top 5 Chart Patterns
There are hundreds of different chart patterns out there, but a handful of them have survived the test of time. Since chart patterns are so subjective, there aren’t any “proven” patterns that work better than others, as is the case with less subjective analytical tools. Most traders identify a handful of chart patterns that work best for them.
#1. Price Channels
Price channels are built by creating two ascending, descending or horizontal parallel lines that connect a series of highs and lows. These are areas of support (lower) and resistance (higher) and prices tend to bounce between them. Most traders buy toward the bottom and sell toward the top, while breakouts or breakdowns can be significant moves.
In the example above, there’s a descending price channel that the price remains in over the course of two months — except for a false breakdown in late-May. Traders would have bought low and sold high throughout this period to realize small gains or maintained a bearish position until the breakout from the pattern in mid-July.
#2. Ascending & Descending Triangles
Ascending and descending triangles are created with one horizontal trend line connecting highs or lows and a second sloped trend line connecting rising highs or falling lows. The resulting right triangle leads up to a decision point where the price tends to breakout or breakdown from the horizontal line in the direction of the sloped line.
In the example above, there’s an ascending triangle followed by a breakout on high volume. Traders would have entered into a long position following the breakout from the upper trend line with a price target equal to the height of the triangle applied to the upper trend line. In this case, the high volume during the breakout provides a great confirmation.
#3. Head & Shoulders
The Head and Shoulders is a slightly more advanced chart pattern that’s characterized by a temporary high or low, followed by an even bigger move higher or lower, followed by a third move higher or lower that’s equal to the first move. The pattern resembles a head with two shoulders that’s either right-side up (bearish) or upside down (bullish).
In the example above, there’s a bearish head and shoulders pattern that predicts the subsequent sharp decline. Traders would have entered into a short position after the price broke down from the shoulder line (the horizontal trend line) with a price target equal to the distance between the shoulder line and head.
#4. Double Top & Bottom
Double tops and bottoms are exactly what they sound like — a series of two highs or lows that are roughly equal. A double bottom is considered to be a bullish signal, while a double-top is considered to be a bearish signal. There are also triple top and bottom patterns and single tops and bottoms, but double tops and bottoms are the most widely used.
In the example above, there’s a bearish double top pattern that predicts a decline. Traders would have entered into a bearish position after the price broke down from the prior reaction low in early-July. In this case, it’s worth noting that the bearish volume was light compared to the high bullish volume, suggesting that it was a weak pattern.
#5. Rising & Falling Wedges
Rising and falling wedges are similar to ascending and descending triangles, except both the upper and lower lines are sloped in the same direction (but are still converging). Unlike the ascending and descending triangle, rising and falling wedges are reversal patterns. A rising wedge is a bearish signal and a falling wedge is a bullish signal.
In the example above, there’s a bearish rising wedge pattern that predicts a short-term decline in price amid the longer-term uptrend. Traders would have entered a short position following the breakdown from the lower trend line and realized a modest profit before the uptrend resumed over the following days.
Best Practices to Keep in Mind
Chart patterns are helpful for assessing market psychology, but they are more subjective than technical indicators. In other words, there is no standard definition of “how parallel the shoulders need to be on a head and shoulders pattern” or “when the price might breakout from an ascending triangle.” It’s up to each individual trader to define their own shapes.
That said, there are some best practices to keep in mind:
- Always Seek Confirmation: Chart patterns provide hints into market sentiment, but they shouldn’t be the only basis for a trade — you should look for confirmations elsewhere.
- Look at the Volume: Volume plays an important role in analyzing chart patterns. If a breakout occurs on low volume, there’s a risk that it could be a head fake or false breakout.
- Set a Stop Loss: Chart patterns can be helpful for setting stop loss levels. For instance, a good stop loss for an ascending triangle breakout is the lower trend line.
- Try It Out First: Consider paper trading to get comfortable with chart patterns before committing actual capital to trading ideas that incorporate them.
The Bottom Line
Chart patterns provide traders with insights into market psychology, but they shouldn’t be the only tool in a trader’s tool belt. It’s important to understand technical indicators and other market dynamics to achieve the best results.
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