Chart patterns are a vital part of technical analysis, but they take some practice to be utilized correctly. Here are five chart patterns that traders must be familiar with in order to assist you in understanding them.
What is a chart pattern?
A chart pattern is a shape within a price chart that indicates what prices may do in the future based on their past behavior. Chart patterns are the foundation of technical analysis and necessitate that traders know precisely what they are observing and what they are searching for.
chart patterns are used to highlight different trends in a huge variety of markets. Often, chart patterns are used in candlestick trading, which makes it slightly easier to see the previous opens and closes of the market.
Some patterns are more suitable for a volatile market, whereas others are less so. Some patterns work best in a bullish market, while others work best in a negative market.
However, it is crucial to know the ‘optimal’ chart pattern for your specific market, since selecting the incorrect one or not knowing which one to use could cause you to miss out on a profitable chance.
Support and resistance
Before diving into the complexities of various chart patterns, it is essential to briefly discuss support and resistance levels.
Support is the level at which the price of an asset stops declining and begins to rise again.
Resistance is when the price stops increasing and begins to decline again.
Support and resistance zones emerge due to the equilibrium between buyers and sellers, or demand and supply. When there are more buyers than sellers in a market (or when demand exceeds supply), prices have a tendency to increase.
When there are more sellers than buyers (supply exceeds demand), prices typically decline.
As an example, the price of an asset may be increasing because demand exceeds supply.
However, the price will ultimately hit the limit of what consumers are prepared to pay, at which point demand will decline. Buyers may decide to close their positions at this time.
This generates resistance, and the price continues to decline toward a level of support as supply begins to exceed the demand and more and more purchasers close their positions.
Once the price of an asset falls sufficiently, buyers may re-enter the market since the price is now more acceptable, producing a level of support where supply and demand begin to equalize.
If the increased buying activity persists, it will push the price back up to a level of resistance as demand begins to outpace supply. Once a price surpasses a level of resistance, it may transform into a level of support.
Types of Chart patterns
Generally speaking,
there are three types of chart patterns:
- Continuation patterns
- Reversal patterns
- Bilateral patterns.
* A continuation pattern indicates that an ongoing trend will continue.
* A reversal pattern indicates that a trend may be about to reverse direction.
* Bilateral chart patterns inform traders that the price could move in either direction, indicating that the market is extremely volatile.
The most essential thing to keep in mind when using chart patterns as part of your technical analysis is that they are not a guarantee that a market will move in the projected direction; rather, they are only an indication of what could happen to the price of an asset.
Examples of chart patterns
Here are examples of chart patterns.
- Cup and handle
- Wedges
- Pennant or flags
- Ascending triangle
- Descending triangle
- Symmetrical triangle
Cup and handle
The cup and handle pattern is a bullish continuation pattern that is used to show a period of bearish market sentiment before the overall trend finally continues in a bullish motion. The cup appears similar to a rounding bottom chart pattern, and the handle is similar to a wedge pattern – which is explained in the next section.
Following the rounding bottom, the price of an asset will likely enter a temporary retracement, which is known as the “handle” because this retracement is confined to two parallel lines on the chart pattern. The asset will eventually reverse out of the handle and continue with the overall bullish trend.
Wedges
Wedges form as an asset’s price movements tighten between two sloping trend lines. There are two types of wedge: rising and falling.
A rising wedge is represented by a trend line caught between two upwardly slanted lines of support and resistance. In this case, the line of support is steeper than the resistance line. This pattern generally signals that an asset’s price will eventually decline more permanently – which is demonstrated when it breaks through the support level.
A falling wedge occurs between two downwardly sloping levels. In this case, the line of resistance is steeper than the support. A falling wedge is usually indicative that an asset’s price will rise and break through the level of resistance, as shown in the example below.
Both rising and falling wedges are reversal patterns, with rising wedges representing a bearish market and falling wedges being more typical of a bullish market.
Pennant or flags
Pennant patterns, or flags, are created after an asset experience a period of upward movement, followed by a consolidation. Generally, there will be a significant increase during the early stages of the trend, before it enters a series of smaller upward and downward movements.
Pennants can be either bullish or bearish, and they can represent a continuation or a reversal. The above chart is an example of a bullish continuation. In this respect, pennants can be a form of the bilateral pattern because they show either continuations or reversals.
While a pennant may seem similar to a wedge pattern or a triangle pattern – explained in the next sections – it is important to note that wedges are narrower than pennants or triangles. Also, wedges differ from pennants because a wedge is always ascending or descending, while a pennant is always horizontal.
Ascending triangle
The ascending triangle is a bullish continuation pattern that signifies the continuation of an uptrend. Ascending triangles can be drawn onto charts by placing a horizontal line along the swing highs – the resistance – and then drawing an ascending trend line along the swing lows – the support.
Ascending triangles often have two or more identical peak highs which allow for the horizontal line to be drawn. The trend line signifies the overall uptrend of the pattern, while the horizontal line indicates the historic level of resistance for that particular asset.
Descending triangle
In contrast, a descending triangle signifies a bearish continuation of a downtrend.
Descending triangles generally shift lower and break through the support because they are indicative of a market dominated by sellers, meaning that successively lower peaks are likely to be prevalent and unlikely to reverse.
Descending triangles can be identified by a horizontal line of support and a downward-sloping line of resistance. Eventually, the trend will break through the support, and the downtrend will continue.
Symmetrical triangle
The symmetrical triangle pattern can be either bullish or bearish, depending on the market. In either case, it is normally a continuation pattern, which means the market will usually continue in the same direction as the overall trend once the pattern has formed.
Symmetrical triangles form when the price converges with a series of lower peaks and higher troughs. In the example below, the overall trend is bearish, but the symmetrical triangle shows us that there has been a brief period of upward reversals.
However, if there is no clear trend before the triangle pattern forms, the market could break out in either direction. This makes symmetrical triangles a bilateral pattern – meaning they are best used in volatile markets where there is no clear indication of which way an asset’s price might move. An example of a bilaterally symmetrical triangle can be seen below.
Conclusion
All of the patterns explained in this article are useful technical indicators that can help you understand how or why an asset’s price moved in a certain way – and which way it might move in the future. This is because chart patterns are capable of highlighting areas of support and resistance, which can help a trader decide whether they should open a long or short position; or whether they should close out their open positions in the event of a possible trend reversal.
