Technical Analysis: Chart Patterns

Traders believe that the underlying theory behind chart patterns is that various shapes, or patterns, repeatedly show up on charts, and highlight various trends that can present trading opportunities.

The most common chart patterns are:

• Symmetrical Triangles
• Ascending Triangles
• Descending Triangles
• Double Top
• Double Bottom
• Head and Shoulders
• Reverse Head and Shoulders

Symmetrical Triangles

A neutral continuation pattern signalling a breakout on either side. Symmetrical triangles are usually a continuation pattern, which means that prices will usually continue in a direction after the pattern is established. Symmetrical triangles have a distinctive pattern with the following signs:

• Upper trend line downwards sloping
• Lower trend line upward sloping
• Both trend lines converge together
• Breakout to upside or downside being confirmation of the trend in that direction

The slope of the price’s highs and the slope of the price’s lows converge on a point through a series of higher lows and lower highs. This type of price activity is called consolidation.

Traders who use symmetrical triangles are often looking for a breakout when the pattern reaches a stage where the price moves decisively in one direction or the other. Much like in the Bollinger “squeeze”, a breakout often occurs after a consolidation. Traders will wait for the price to either move above the top trend line or below the bottom trend line.

Ascending Triangles

A bullish continuation pattern with the following traits:

• Horizontal / flat upper trend line
• Lower trend line sloping upwards
• Both trend lines converging together
• Breakout to the upside through the upper resistance

Ascending triangles are experienced in instances where there is a resistance level coupled with a slope of higher lows as seen below:

As with a symmetrical triangle pattern, the price breaking the resistance level might signal a decisive breakout to the upside, which traders look out for.

The reverse occurs when the resistance level proves too strong for an upward breakthrough and the price move reverses downwards.

Descending Triangle

The descending triangle is a bearish continuation pattern and is the opposite of an ascending triangle. They have the following traits:

• Upper trend line downwards sloping
• Lower trend line horizontal/flat
• Both trend lines converge together
• Breakout to the downside through lower support

Unlike ascending triangles where traders are waiting for an uptrend breakthrough, traders watching a descending triangle are expecting a bearish market and waiting to see if or when the price makes a breakout to the downside.

Alternatively, the support level might prove too strong for a downward break. If that happens, the price will eventually bounce off the support level and generally begin in an upward movement.

Double Top

A double top is a bearish reversal pattern that is formed after there is an extended move up.

The “tops” are peaks that form when the price hits a resistance level that it seemingly is unable to break, forming the shape of an “M”.

We can see in the diagram above that, having bounced off the support level slightly, the price then returns to re-test the support. If the price is unable to break through the support level for a second time and bounces off it, a double top chart pattern has formed.

From the same diagram, we can see that the 2nd “top” is unable to break the high of the 1st. Traders often interpret this as a strong sign that a reversal is going to occur as this movement implies that the buying pressure is lessening.

When using double tops as a form of analysis, traders will often look to go short below the level which is referred to as the “neckline”, which is a level of minor support drawn at the trough between the two tops.

When the price level falls below the neckline, a downward trend is usually expected.

Double Bottom

A double bottom is the opposite of a double top. It is a bullish trend reversal formation, meaning that unlike double tops, traders are now looking for the price to reverse upwards after a downtrend.

Head and Shoulders

Head and shoulders is another reversal pattern consisting of two main types: Heads and Shoulders, and Inverse Heads and Shoulders.Head and shoulders is a bearish pattern formation that indicates a reversal in an uptrend

The Head and Shoulders formation is formed by a peak, known as the “Head”, flanked by two smaller peaks, known as the “Shoulders” on both sides.

There is also what is known as the Neck Line, which is drawn by connecting the lowest points of the two troughs on each side of the Head. The Neckline functions as a level of support, and is always a straight line, although it can be horizontal or sloping.

Just like in the case of the double bottom and top formations, traders using Heads and Shoulders will look for a drop below the neckline, which implies that there is an impending downward trend.

Inverse Head and Shoulders

The Inverse Head and Shoulders is a bullish pattern formation signalling a reverse in a downtrend. It is the opposite of the Head and Shoulders formation.

With the Inverse Heads and Shoulders, traders are looking to buy when the price moves above the Neckline, which in this case, functions as a level of resistance. A break through the Neckline in the Inverse Heads and Shoulders signals a coming uptrend.

Japanese Candlesticks

Said to have been invented in the 1700s in Japan, Japanese candlesticks, or a candlestick chart, is an information-dense technical analysis tool that shows information about the day’s high and low, and opening and closing prices all on the same chart.

How to read a candlestick chart

There are three parts to a candlestick: the real body, upper shadow, and lower shadow.

The real body represents the price range between the day’s open and close; while the shadows (which are sometimes called wicks) represent the range between the day’s high and low.

If the price for a day closes higher than its open, the real body is usually coloured green. If the price closes lower than its open, the real body will be coloured red. On some charts, white and black are used (instead of green and red) to denote a positive or negative close on a day.

Candlestick Formations

Based on specific patterns or formations found on the candlesticks, traders forecast price movements. Here are some of the basic formations that traders often use in conjunction with other indicators to confirm a signal.

Spinning Tops
A spinning top is one of the most commonly-seen candlestick patterns. It is characterised by a short real body with relatively long shadows, indicating that, while the price can fluctuate wildly during the day, the market still closes inconclusively

Spinning tops can be coloured green or red, indicating an upward or downward sentiment.

While spinning tops are often regarded as neutral and indicate equal strength between the bulls and bears, they can also signal a change in the trend.

If a spinning top forms at the top of a long uptrend, it might indicate a reversal of the trend, especially if the reversal is confirmed by the candle that follows it – which should show a significant price drop.

The reverse is also true. In a long downtrend, a spinning top might indicate a reversal to an uptrend, if confirmed by a positive candlestick.

Marubozu

Marubozu candlestick patterns differ from the spinning tops in the fact that the marubozu (Japanese for “closely cropped”) have a larger body with little or no shadows.

When a Marubozu appears on an up day, it means that the opening price is the lowest of the day, and the closing price is the highest. On a down day, the opening price is the highest, while the closing price is the lowest of the day.

The appearance of marubozu on a candlestick chart is considered to be a strong indicator of trader conviction. A green marubozu pattern demonstrates a bull market, while a red marubozu points to a bear market.

A marubozu can confirm the continuation of a trend or signal a reversal, depending on where it appears. While the appearance of a green marubozu on an uptrend confirms its continuation, a green marubozu on a downtrend signals an impending reversal.

On the other hand, a red marubozu on a downtrend means things will continue the same way; while its appearance on an uptrend might mean a reversal of a bull market.

Doji

Just like the spinning tops, Doji candlesticks are said to be “neutral” as they do not indicate a definitive upward or downward trend.

Doji candlesticks have extremely small bodies, with the possibility of long or no shadows.

There are four main types of Doji candlesticks: the long-legged doji, dragonfly doji, gravestone doji, or four prince doji.

Long-legged doji

With almost-equal opening and closing prices and high volatility in the day, a long-legged doji implies equilibrium between supply and demand and indecision between buyers and sellers. Its appearance in a strong trend can indicate a turning point in the price direction.

Dragonfly doji

Characterised by equilibrium at the day’s high and a long bottom shadow, the dragonfly doji suggests that sellers took control at some point in the day, but were bought back out by bulls before closing. The appearance of a dragonfly doji implies that the direction of the trend is nearing a major breakthrough, with the longer lower shadow implying the possible reversal of a bearish trend.

Gravestone doji

A gravestone Doji is essentially the opposite of the dragonfly Doji explained above. It forms when the opening and closing prices are equal and occur at the end of the day. The long upper shadow implies that the day’s buying pressure was countered by sellers and that a bullish uptrend is about to be reversed.

Four prince Doji

The four prince Doji is a candlestick formation where the day’s high, low, open and close prices are all equal. This is the most neutral of all the Doji candlestick formations and does not occur often. It is seen mostly in times where there is a very low volume of trading such as during after-hours, and is often disregarded by traders as being a result of bad data.

Although Doji Candlesticks are important, it is their combination with preceding patterns that traders look most at. For example, if a Doji candlestick appears after a series of candlesticks with long green bodies it is an indication that buying pressure is weakening. Conversely, if a Doji candlestick is seen after a series of red candlesticks this is an indication that selling pressure is weakened.

Hammer and Hanging man

The hammer and hanging man look very similar with short bodies and long lower tails, but have opposite meanings.

The hammer, which can be seen above on the left in green, is a bullish reversal pattern when it forms during a downtrend. When prices are falling, the hammer signals that the support level has been approached and prices may begin to rise again – especially with confirmation.

The hanging man, which can be seen above in red, is the opposite of the hammer. It is a bearish reversal pattern that often is seen to mark a top or strong resistance. During an uptrend, the formation of a hanging man is often taken by traders as an indication that selling pressure is larger than upward buying pressure.

Inverted Hammer & Shooting Star

The inverted hammer and shooting star are flipped versions of the hammer and hanging man formations.

The inverted hammer forms as a bullish indication of a possible reversal during a downtrend. Its shape suggests that the day opened on a high, faced downward pressure from sellers, but were countered by buyers successful in closing the session at a price near its opening.

The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when prices are rising. Its shape indicates that the price opened at a low, rallied, but pulled back to the bottom. The shooting star shows us that sellers countered the upward pressure of buyers and were able to keep the day’s close almost near its closing.

Conclusion

Now that you know the basics of both technical and fundamental analysis, it’s time to put your newly learnt skills to use.

Depending on your trading style, your objectives, your time frame, and other factors, it’s wise to use a combination of any of the above techniques mentioned.

Don’t put yourself in a box and stick to one style, there’s value in diversity. Both technical and fundamental analyses complement each other. Many investors use technical analysis and graphing to decide on strategic exit and entry points, but use fundamental analysis to decide which asset to trade on. There are limitless combinations and opportunities – good luck with your trading!