15. How to analyse Chart patterns
Chart patterns help us identify critical market conditions like a breakout or if the price is going to continue in a particular direction or if it is going to take a reverse turn etc. These are nothing but formations in your charts used for technical analysis. So, chart patterns are nothing but another set of technical indicators to help you in your technical analysis.
Some of the commonly seen chart patterns are as mentioned below:
- Head and Shoulders
- Double Top and Double Bottom
We will look at each of these patterns in more detail.
Head and Shoulders
A top peak and then two adjacent peaks on either side forms a Head and Shoulder pattern. This pattern is formed during an uptrend.
Shoulders are also peaks but they are lower than the head. A trend line drawn by connecting the two lows in this pattern is called the neckline. When this type of a pattern is formed price is expected to go down. Thus this pattern indicates a trend reversal. Also, price is expected to go down by the distance between the neckline and the head. It should be clear from the image above. So, where do you place your entry and stop loss in this case. Yes, entry order is placed below the neckline or the trendline and stop loss is placed above it.
When this pattern forms during a downtrend it is known as Inverse Head and Shoulders.
Inverse head and shoulders also signals a trend reversal and the price is expected to go high. Thus, it is just an upside down version of the Head and Shoulders Pattern. An entry order to take a long position will be placed above the neck line and stop loss will be below the neckline. Target price is calculated by finding the distance between the head and the neckline.
A wedge can indicate a continuation or reversal. Let’s see its behaviour. Wedges are of two types a rising wedge and a falling wedge.
A rising wedge looks like this:
It looks like a slope and price remains between the support and resistance levels. A rising wedge can be formed during both uptrend and downtrend. If the rising wedge pattern is formed after an uptrend, it signals a trend reversal and price is expected to go down. The magnitude of price movement after the breakout is expected to be same as that of the height of the wedge at the start
(as marked in the diagram). Whereas a rising wedge formed after a downtrend indicates continuation of the trend and prices are expected to move down. So whenever you see a rising wedge pattern, keep in mind that it signals a downtrend.
A falling wedge looks like this:
Just like rising wedge, a falling wedge may either indicate a reversal or a continuation. A falling wedge when formed following an uptrend signals a continuation of the trend and prices are expected to move up. And a falling wedge formed after a downtrend indicates a reversal and prices are expected to move up. Hence, a falling wedge pattern signals an uptrend.
A Rectangle chart pattern is formed when price bounces between parallel support and resistance levels.
A rectangle actually signals an indecision between buyers and sellers. A rectangle formed during a downtrend is called a bearish rectangle. It looks like as if prices are caught up in a rectangular box and hence the name. A bearish rectangle signals a downtrend and hence prices are expected to go further down. How much down? Down by the size of the rectangle. Thus you could be profitable by placing your entry below the support line.
A rectangle formed during an uptrend is called the Bullish rectangle. You would have definitely guessed by now. A Bullish rectangle signals that the uptrend would continue and price would go up.
Double Top and double Bottom
Double top and double bottom patterns formed during uptrend and downtrend respectively signal a reversal.
In case of a strong move up you can see two peaks getting formed and this pattern is called the Double Top. Double top is strong sign of a reversal and prices might move down by approximately the same height as that of the double top pattern. Since you are expecting a reversal in the uptrend, you would place your entry order just below the neckline.
When there is an extended downtrend and two bottoms are getting formed as shown in the chart above, it is called Double Bottom pattern. This also signals a trend reversal and prices are expected to go high. You would place your entry order just above the neckline as you expect price to go up.
Similar to Rectangles chart pattern, Pennants also signal continuation or in other words uptrend or downtrend is going to continue.
A Bearish pennant is formed after a very steep downtrend or fall in price. Prices consolidate for a while and then price starts falling further down. Since the price is expected to go down, you could place your entry order to take a short position just below the pennant as shown in the chart above.
Similarly a Bullish pennant is formed following a steep uptrend. Prices consolidate and then start moving further up by almost the height of the initial movement.
When the prices converge together to a point and the pattern looks like a triangle, it is called the Triangle Pattern.
Following variations of the triangle pattern can be seen on the chart used for Forex traders:
In a symmetrical triangle pattern you will see a slope formed by the highs and lows of the candlestick which converge to a single point. What actually is happening here? You would have guessed it. Neither the buyers nor the sellers are able to make an impact on the currency price.
This means that a breakout is on the way but we don’t know in which direction. Price can move in either direction. How do you deal with this scenario? You should expect price moving up or low and place your orders one below and one above the pattern.
When there is a resistance level and slope formed by the higher lows, the formation is called Ascending Triangle. Even in this case price can move in either direction and as a trader you should be prepared to handle both situations. Whether the price moves up or down it moves by the same height as that of the triangle.
Descending triangle is just the opposite of ascending triangle and is formed by the support line and the slope formed by lower highs.
This is not all. There are lots of other formations you would see on your charts. But the once we just spoke about are a few basic ones and good to know stuffs so that you can prepare yourself for critical market conditions.