Introduction to chart patterns
Head-and-shoulder, flag, pennant, triangle… You’ve probably already read or heard about chart patterns at some point, perhaps without fully realizing what they are, what they truly mean, and how they can help you take your trading to the next level.
While market participants buy and sell financial assets for different reasons, chart patterns are really useful for synthesizing the competing forces of supply and demand for a single asset. They help put trading activity into perspective for a better understanding of what’s going on and what direction the given asset might follow.
Let’s discover what types of chart patterns you can find and how you can best exploit the information they provide to improve your results.
What is a chart pattern?
Chart patterns serve as a comprehensive visual record of all buying and selling transactions and offer a framework for analyzing the conflict between bulls and bears in a given market. Simply put, a price pattern is a recognizable structure of how prices move. Most of the time, supports, resistances, trendlines, and curves are used to find price patterns.
The ability to identify the victor of the conflict between the bulls and bears via the use of chart patterns when using technical analysis allows technical traders and investors to take appropriate trading positions according to the kind of chart patterns.
The 3 kinds of chart patterns
In order to characterize existing trends and prospective corrective or reversal price movements, chartism relies on chart patterns that can be different depending on market configurations. That’s why there are different types of chart patterns you can use, which we’ll explain now.
As the name implies, a continuation pattern is a pattern that materializes a situation where prices are about to continue moving in the main direction of a given asset after a pause. This break is often necessary after a strong movement in one direction, so bulls or bears can catch their breath.
In the event of a bullish continuation pattern, prices are about to rise after briefly falling. A bearish continuation pattern, on the other hand, means that prices are about to go down after a short rise.
Rectangles, channels, triangles, pennants, wedges, flags, as well as cup and handles are among the most commonly used continuation chart patterns.
A reversal chart pattern suggests a change in the price trend as a result of the bulls’ or bears’ exhaustion, as the current trend isn’t strong enough to keep moving in the initial direction. In the case of a bullish trend, prices will reverse to move downwards, while in the case of a bearish trend, prices will move upwards after the formation of a reversal pattern.
Usually, when reversal chart patterns occur at market tops, they are considered “distribution chart patterns”. When they form at market bottoms, they are referred to as “accumulation chart patterns”.
Head-and-shoulder, double tops/bottoms, triple tops/bottoms, V-tops, V-bottoms, and rounding tops/bottoms are among the most popular reversal chart patterns.
Indecision chart patterns usually appear on candlestick charts in the form of a single candle, depicting a situation where neither the bulls nor the bears are in control of the market, which indicates that both buying and selling pressures are steady.
Dojis and Spinning Tops are among the most well-known indecision candlesticks. While a Doji usually indicates that buying and selling pressures are in equilibrium, meaning that the candle doesn’t have a body, a Spinning Top has a very small body with relatively long shadows as buyers and sellers are battling for control without a clear outcome of which one will win.
How to detect these chart patterns and trade them
By using chart patterns, traders are able to better time their entry and exit in and out of positions, which improves their chances of success when trading regardless of the traded markets (Forex, stocks, bonds, commodities…) or the trading strategy used (scalping, day trading, swing trading…).
The first step in recognizing and trading chart patterns is to spot the main trend, as chart patterns always appear within a trend to confirm it or reverse it. So let’s first come back to the definition of a trend, which is a key concept in technical analysis.
An upward trend means that bulls are in control, pushing prices higher with higher highs and higher lows. On the other hand, a downward trend means that bears are in control, pushing prices lower with lower highs and lower lows. When prices move sideways and neither the bears nor the bulls are in charge, this is called a neutral trend.
Trendlines, supports, resistance, and channels are the best trading tools you can use to spot the main trend.
After that, you can recognize a potential chart pattern formation.
Then, you need to analyze the trading volume, as it plays a key part in the formation of chart patterns. Typically, it drops during the development of a pattern, while it spikes when prices break out of the pattern to resume the trend or reverse it.
It is also critical never to predict the formation or the exit of a chart pattern, as you should always wait until a pattern is completely formed and that prices have broken out before opening a trading position to take advantage of the strong price movement. To help you spot specific trading conditions where prices are more likely to exit a chart pattern, you can use technical indicators that can complete your analysis.
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