Ever thought about including chart patterns in your trading arsenals? Chart patterns are one of the most powerful weapons to use in your battle with the markets.
They can help you to decipher who is about to dominate the market —the bulls or the bears — thereby showing you the most likely direction the price may be headed.
If you learn how to accurately identify and analyze chart patterns, you can read market conditions and determine when to look for buying or selling opportunities, how to find high probability trade setups, when to get out of losing trades, and how to better manage your risks and rewards.
In this post, you will learn:
What are chart patterns?
Chart patterns are recognizable price structures created by price movements and transitions between rising and falling trends that can be identified with the help of trend lines, horizontal lines, and curves.
Chartists (technical analysts that rely majorly on naked charts) and other technical traders use the patterns to analyze the current price movements so as to predict future market movements.
To identify these patterns, chartists use lines to connect the common candlestick points or swing points, such as highs or lows, to see the kind of shape that emerges, which determines the name given to the pattern.
If the shape is triangular, the pattern is called a triangle, and if it is wedge-like, it is called a wedge.
The shape of the chart formation and the nature of the price movement preceding it help analysts to forecast what the price might likely do next.
So, they can create tradable opportunities for traders, who can recognize them. Some of the patterns signal a change in trend, while others indicate that the trend may continue in its current direction.
While you can identify chart patterns in any type of chart — candlestick chart, bar chart, and even line chart — the patterns are better appreciated on the candlestick chart.
Uses of chart patterns
Chart patterns are useful price action tools for analyzing the market since they help traders understand the dynamics of demand and supply, feel the mood and sentiment of the market, and estimate the potential reward in a potential trading opportunity. Generally, chart patterns offer the following benefits:
The different chart patterns and how to trade them
There are many chart patterns, and they are generally grouped into reversal chart patterns and continuation chart patterns, depending on whether the price is more likely to continue in the direction of the trend preceding the chart pattern formation or reverse. The reversal chart patterns include:
-Inverse Head and Shoulder
-Pennant or flags
However, patterns, such as the different triangles, wedges, and rounding bottom are sometimes classified as bilateral or neutral chart patterns because, depending on where the pattern occurs, it may bring about a trend reversal or trend continuation.
Now, let’s take a look at them one by one.
Head and shoulders
The head and shoulder pattern consists of three price swing highs and two intervening price swing lows.
The middle swing high is higher than the other two, and it is called the head. The first swing high is called the left shoulder because it lies to the left of the head, while the third swing high is called the right shoulder because it lies to the right of the head.
A line connecting the two swing lows is known as the neckline, and it serves as a support level. The pattern is completed when the price breaks below it.Often seen at the end of an uptrend or an extended pullback in a downtrend, the head and shoulder pattern is considered a bearish reversal chart pattern.
Most people take a short position when the price breaks below the support level, but some may enter a trade earlier when the right shoulder is formed if there is a bearish reversal candlestick pattern, such as the shooting star, bearish engulfing, and inside bar.
Whichever way you want to enter the market, you can estimate the profit target by measuring the height of the head from the neckline and projecting it downwards from the neckline.
The stop loss can be kept above the right shoulder for a breakout entry or above the head for entry at the right shoulder.
Take a look at the EURAUD chart below. With the bearish pin bar at the right shoulder, one can go short at that level and put a stop loss above the head.
For a neckline breakout entry, the stop loss can be above the right shoulder. The profit target is always estimated from the height of the head.
Inverse head and shoulders
This is the opposite of the head and shoulder pattern, so it consists of three swing lows and two swing highs.
The central swing low is lower than the other two and is called the head. Lying on the left side of the head, the first swing low is called the left shoulder, while the third swing low is called the right shoulder because it lies on the right of the head.
The line connecting the two intervening swing highs is called the neckline, which serves as a resistance level. When the price breaks above the neckline, the pattern is considered complete.
The inverse head and shoulder pattern is seen at the end of a downtrend or an extended pullback in an uptrend.
It has a bullish reversal implication. While most traders who trade the pattern go long on the breakout of the neckline, some traders may prefer to enter earlier during the formation of the right shoulder if there is a bullish reversal candlestick pattern, such as the hammer, inside bar, and bullish engulfing.
Whatever the method of entry, the price target is estimated by measuring the size of the head from the neckline and projecting it on the other side of the neckline.
The stop loss can be kept below the head for entry at the right shoulder or below the right shoulder for neckline breakout entry.
The EURUSD chart below shows an inverse head and shoulder pattern. Note the breakout entry and the positions of the stop loss and profit target.
The double top pattern is a reversal chart pattern seen at the end of an uptrend or a prolonged pullback in a downtrend. When completed, the pattern indicates that the price is likely to turn and head downwards.
As the name implies, the double top pattern consists of two swing highs and a swing low between them.
The two swing highs end at roughly the same level, which now becomes a resistance level. A line joining the swing low to the preceding swing low constitutes a neckline, which serves as a support level. The pattern is considered complete when the price breaks below the neckline.
Being a bearish reversal chart pattern, traders use it to look for downward trend reversal opportunities, and they enter short positions when the price breaks below the neckline.
The profit target is estimated by measuring the height of the pattern and projecting it downwards from the neckline.
For the stop loss, it can be in the middle of the pattern, which offers a better reward/risk ratio, or above the pattern, which offers poor reward/risk ratio but appears safer.
Take a look at the double top pattern in the EURAUD chart below. Note the position of the stop loss in the middle of the pattern, above a mini-swing up.
The double bottom pattern consists of two swing lows and a swing high in-between. With the two swing lows ending around the same level, that level becomes an established support level.
The line connecting the swing high with the preceding swing high is known as the neckline. When the price breaks above the neckline, the pattern is considered completed.
A double bottom pattern can be seen at the end of a downtrend or a prolonged pullback in an uptrend.
The pattern shows that the price is about to turn and start heading upward. So, when traders see it, they look for long positions when the price breaks above the neckline.
When trading the pattern, you can estimate the profit target by measuring the size of the pattern and projecting it upward from the neckline.
You can place your stop loss order in the middle of the pattern, which offers a 2:1 reward/risk ratio or below the pattern, which is a bit safer but offers poor reward/risk.
In the chart below, you can see a double bottom pattern. Take note of the profit target and the stop loss, which offers a 2:1 reward/risk ratio.
The triple top pattern consists of three swing highs that end roughly around the same level and two intervening swing lows.
As the swing highs end around the same level, that level is seen as a strong resistance level. The line connecting the two swing lows is called the neckline, and it forms the support level, the breakdown of which completes the pattern.
You can see this pattern at the end of an uptrend or a prolonged pullback in a downtrend, and it shows that the price is about to head downwards.
Most people who trade the pattern go short when the price breaks below the support level, but some traders attempt to go short when the price gets rejected at the top for the third time, especially if there is a bearish candlestick pattern.
To estimate the profit target, measure the height of the pattern and project it downwards from the neckline.
The stop loss order can be placed above the resistance level or in the middle of the pattern, depending on your entry point and risk tolerance.
The chart below shows a triple top pattern. You can see the position of the stop loss above the small upswing.
The triple bottom pattern consists of three swing lows and two intervening swing highs. The swing lows end around the same level, which now becomes a strong support level.
A line connecting the two swing highs is known as the neckline, which serves as a resistance level. When the price breaks above that resistance level, the pattern is said to be completed.
This pattern can be seen at the end of a downtrend or a prolonged pullback in an uptrend, and it has a bullish reversal implication.
For most traders using this pattern, the signal to go long occurs when the price breaks above the resistance level, but it may be possible to enter a long position earlier when the price gets rejected for the third time at the bottom level, especially if there’s a bullish reversal candlestick pattern there.
For the profit target, project the size of the pattern upwards from the neckline. The stop loss order can be placed below the support level or in the middle of the pattern, depending on your entry point and risk tolerance.
The EURAUD chart below shows a triple bottom pattern. Take note of the entry point, stop loss, and profit target
Also known as the saucer bottom, the rounding bottom pattern is a bullish pattern that could indicate the continuation of an uptrend if it is occurring during a pullback in an uptrend or a trend reversal if it is occurring at the end of a downtrend.
With a U-shaped formation, the pattern shows a gradual shift from an excess of supply (the initial declining slope) to an excess of demand (gradually ascending slope) as more buyers enter the market.
The pattern is completed when the price breaks above the point from where the decline started.
If you go long after the breakout, you may use double the size of the pattern as your profit target and set your stop loss order below the lowest point of the pattern, or you can use the size of the pattern as your profit target and set your stop loss somewhere at the middle of the pattern.
In the gold chart below, you can see a rounding bottom pattern that ended a downtrend. As the price broke out of the pattern’s high, it commenced an uptrend. Take note of the position of the stop loss and profit target.
Cup and handle
The cup and handle pattern can occur during a pullback in an uptrend. It is a bullish continuation pattern that shows when the bulls are taking a break in an uptrend.
The pattern looks like a rounded bottom pullback followed by a smaller drop in price that rose back again climbing past the point where the initial pullback started.
The smaller pullback after the rounded bottom pullback is known as the handle. When the price breaks above the beginning of the pullback, the pattern is considered complete and is an indication to enter a long position.
The stop loss can be kept below the low of the handle, while the profit target can be estimated from the depth of the cup.
In this gold chart below, you can see a cup and handle pattern occurring as a pullback in an uptrend. Take note of the position of the stop loss and the profit target.
A wedge is a price structure that forms when the price bars lie between two descending or ascending trend lines but with one trend line having a greater slope than the other. There are two types of wedges: the rising wedge and the falling wedge.
The rising wedge is formed when the price moves between two ascending trend lines with the lower trend line having a greater upward slope than the upper one.
A rising wedge has a bearish effect, which, depending on when it occurs, can be a bearish reversal effect or a bearish continuation effect.
When a rising wedge occurs in an uptrend, it will have a bearish reversal effect, and when the pattern occurs as a pullback in a downtrend, it has a bearish trend continuation effect.
In this AUDUSD chart below, you can see a rising wedge pattern ending an uptrend. Notice how the price dropped when it broke below the lower trend line. Take not of the stop loss and profit target.
Here, the rising wedge is a pullback in a downtrend. Notice the downswing that followed. Note the stop loss and profit target.
A falling wedge is formed when the price moves between to descending trend lines with the upper trend line having a greater slope than the lower one.
It can have a bullish reversal or continuation effect, depending on when it occurs. When a falling wedge occurs in a downtrend, it will have a bullish reversal effect, and when the pattern occurs in an uptrend, it has a bullish continuation effect.
The GBPAUD chart below shows a falling wedge as a pullback in an uptrend. Take note of the entry level, stop loss, and profit target.
Pennants and flags
These are continuation chart patterns that occur as price consolidations after a swift price movement. A pennant is a small triangular price consolidation after a swift move, while a flag is a small rectangular consolidation following a fast price movement.
Both patterns can be bullish or bearish, depending on the direction of the trend they occur in. When any of the patterns occurs in an uptrend, it is called a bullish pennant or bullish flag, as the case may be. In a downtrend, you can have a bearish pennant or bearish flag, as the case may be.
You can see a bear flag in the Brent Crude Oil chart below.
An ascending triangle occurs when the swing lows are rising, but the swing highs end at the same level.
It can be shown by placing a horizontal line across the swing highs and drawing a rising trend line across the swing lows. Thus, the pattern is formed against a horizontal resistance but has a rising support level.
When occurring in an uptrend, the pattern is considered a bullish continuation pattern. It means that the price is trying to overcome a resistance level.
However, the pattern can occur in any market situation, and the price can break out in any direction.
In this USDJPY chart below, you can see an ascending triangle in an emerging uptrend. Take note of the stop loss and profit target.
In a descending triangle, the swing highs are declining, while the swing lows end at the same level.
You can appreciate the triangular shape by placing a horizontal line along the swing lows to serves as the support level and drawing a descending trend line across the swing highs — a descending resistance level.
A descending triangle is considered a bearish continuation pattern, especially when there is already a downtrend before the pattern occurred.
The pattern implies the price is making efforts to break a support level. However, the price can break out in any direction, and the pattern, itself, can occur even in an uptrend.
The chart below shows a descending triangle. After all the delay, the price still hit the profit target.
This pattern occurs when the swing highs are descending, while the swing lows are ascending. You draw the pattern by placing a descending trend line along the swing highs and an ascending trend line across the swing lows. So, it has a descending resistance level and an ascending support level.
While the pattern is considered a continuation pattern, the price can break out from any side, irrespective of the direction of the trend before the pattern occurred. However, it is safer to look for a breakout in the direction of the pre-existing trend.
Here, we have a symmetrical triangle and the price broke above the upper trend line. Note the profit target and stop loss positions.
Choosing the chart patterns to trade
Obviously, you cannot trade all the chart patterns. You have to choose the ones to trade and learn them very well so that you can easily identify them on your chart.
While you can choose to trade either reversal or continuation patterns, it is better to pick individual patterns that have a high probability of success — irrespective of whether they are continuation or reversal patterns.
When you have chosen the patterns to focus on, try to learn everything you can about them so that you can easily identify them when they occur on your chart and trade them consistently.
It is better to master a few chart patterns than know a little about many. The more you trade a particular pattern, the more you learn how it works in different market conditions.
Drawbacks of chart patterns
Despite how well they can work, just like any technical analysis method, chart patterns have their shortcomings. Apart from the usual false signals, which is normal with every technical approach to trading, chart patterns have the following unique drawbacks: