Chart Patterns I: Introduction to Reversal Patterns and Continuation Patterns
There are two major ways to trade the financial markets: swing trading and trend following. Swing traders use technical analysis to look for short-term price movement
and capture gains in a relative short-term period. They look for the price patterns that hint for a reversal, in order that they can pick the tops and bottoms of the trend. Trend followers pay attention to the general direction of the price movement and enter trades by following the current direction. They would look for continuation patterns on the price charts to predict the future direction of the trend, or exit the trade until the reversal patterns appear.
and capture gains in a relative short-term period. They look for the price patterns that hint for a reversal, in order that they can pick the tops and bottoms of the trend. Trend followers pay attention to the general direction of the price movement and enter trades by following the current direction. They would look for continuation patterns on the price charts to predict the future direction of the trend, or exit the trade until the reversal patterns appear.
The following articles discussed the rules for identifying reversal patterns and continuation patterns, and introduced some well-known reversal and continuation patterns. The reversal patterns include: Head and Shoulders, Double Tops and Bottoms, Triple Tops and Bottoms and Saucers. The continuation patterns include Triangles (Ascending, Descending, Symmetrical and Broadening), Flags and Pennants, Wedges and Rectangles.
The patterns exhibit the psychology and momentum of the market. No matter which type of traders you are, it is always helpful to be aware of the patterns. Using the patterns is not a stand-alone method of trading the market, in fact, it is better to be used with a mix of trend lines and technical indicators. Beginners might first find it difficult to identify the patterns; they can familiarise the patterns by looking at the historical charts and try to identify the patterns.
Chart Patterns II: Rules for identifying Reversal Patterns
The following are the three basic tenets about identifying reversal patterns. While they may seem obvious and even simplistic, they are important for successfully using these patterns.
A Trend Must Exist - A trend must exist before a reversal of the trend. There can be no reversal if a trend does not exist in the first place. A reversal pattern that follows a large trend will have much more movement to retrace, and so the strength of the move after the reversal pattern will likely be stronger.
Trend Lines - The first precise signal that the trend is ending is often the failure of a trend line, that might also come along with oscillators that show overbought or oversold before a reversal pattern occurs. Note that the intraday break of the trend line is not significant until a daily candle closes through the line. The chart below shows a trend line that is broken on an intraday basis before the price recovers. The first strong signal that a reversal may be coming appears when the price closes below the green support line. The price subsequently rallies to form a double top, but it does not hold these gains.
Time Frame - Like relative highs/lows and trend lines, reversal patterns gain greater significance if they occur over a longer time frame. A head and shoulders pattern that takes months to develop will of course signal a reversal of a much larger trend than a head and shoulders that takes place intraday.
Chart Patterns III: Head and Shoulders
Head and Shoulders Pattern
The Head and Shoulders pattern is one of the most famous reversal patterns and one that gives a clear signal and entry point. The head and shoulders in an uptrend consists of three relative highs: the first and last peaks are of nearly equal size and are the shoulders of the formation. The middle peak is greater than the other two and forms the head of the pattern. The relative lows in between the head and shoulders form a neckline at the base of the pattern. Once the pattern is completed, the neckline becomes a key support level; the market can bounce off it and reverse, or it can break through it and gather momentum.
Reverse Head and Shoulders
The reverse head and shoulders is the same formation in a downtrending market. The head and shoulders point lower in this case and signal a reversal of the market higher once the price crosses the neckline and closes on a daily chart.
Chart Patterns IV: Double Tops and Bottoms
The double top formation is a straightforward pattern that is easy to recognize on a chart. One of the features of a market in an uptrend is a series of increasing highs and relatively higher lows. If the market on one of its high points fails to break above the previous high, but instead stalls at the same price, this is an indication that the trend is weakening and may reverse. A double top is therefore a simple horizontal line that connects two relative highs at the same price.
The relative low between the two highpoints of the double top creates a miniature version of the neckline in the head and shoulders pattern, and provides traders with a potential entry point to sell. Traders should sell once they receive reasonable confirmation that the neckline has been broken; a good indication of this is when a candle closes beneath the neckline. In the case of the double top, traders can then place an entry order a few points beneath the low of the first candle that closes beneath the neckline.
The double bottom pattern is the inversion of the double top. In a down-trend, the price tested twice the low level but failed to break through, forming a double bottom pattern. Traders can look for opportunities to buy above the neckline once the pattern is confirmed.
Chart Patterns V: Triple Tops and Bottoms
A triple top is the same charting pattern as the double top with an extra relative high that touches the same resistance level. A triple top creates a strong resistance level and a neckline connecting the two relative lows in the middle of the pattern. A trader should enter a short position when the daily candle closes below the neckline of the triple top.
The entry point should be set a few points beneath the low of the candle that first closed below the neckline.
The triple bottom is similarly an extension of the double bottom. It simply contains an additional relative low on the chart that touches the same price as the two that preceded it. The triple bottom is a solid support level and can be a basis for entering a long position if it holds for a third time – particularly if there are additional indicators confirming a reversal at the triple bottom. Alternatively, a more conservative trader could also wait until the price closes above the neckline and buy when the following candle surpasses the high for the first candle. This is essentially the same logic utilized in trading the triple top, whereby traders place short orders to sell an asset at a few points beneath the low of the first candle that closes beneath neckline.
Chart Patterns XII: Rectangles
The rectangle formation is often a very simple one to recognize. It is essentially a market that is trading in a range between two horizontal lines. The rectangle formation represents consolidation of the move that preceded it, creating a foundation for a continuation of a further move in the same direction.
The chart below showed the consolidation period of EUR/USD from May 2004 to October 2004. EUR/USD had been going on an up-trend since the beginning of 2002. In February 2004, EUR/USD started a retracement and followed by the consolidation period in the chart, forming a rectangle. EUR/USD traded between 1.1970 and 1.2460 for five months. The price eventually broke above 1.2460 in mid-October and continued the up-trend, reaching EUR/USD historical high at 1.3660 at the end of year 2004. The rectangular consolidation period created a foundation for the continuation of a further move in the up-trend.
The rectangle formation can be used in either an up trend or a down trend, and although it normally signals continuation of a market move in the direction of the original trend, the important signal is upon the breakout from the rectangle. Reversals are possible in a rectangle pattern if the breakout occurs back towards the origin of the trend that preceded the pattern.