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Common Chart Patterns

Common Chart Patterns

A chart pattern is a distinct trading formation appearing repeatedly and which can be used to predict future price movements of a given stock. The formations appear on price charts and create unique, recognizable shapes. Analysts study these formations when trying to predict the future course of prices. The patterns reveal the collective psychological relationships within the market at a given time. There are two major types of chart patterns:

Reversal Patterns

A reversal pattern indicates that an earlier trend is likely to reverse once it is complete. The term ‘reversal’ actually refers to the trend of the stock prior to the development of the pattern. In fact, for a pattern to have some predictive value, the pattern must be preceded by a clear, distinguishable trend. Caution is necessary when trying to identify patterns for the purpose of price prediction. Perhaps the most useful and widely recognized reversal pattern is the head and shoulders pattern.

Head and Shoulders

As the name suggests, the head and shoulders pattern has 3 distinctive parts. It appears in form of a peak (left shoulder), followed by a higher peak (head), and then a lower head (right shoulder). When the lowest points of the two troughs are connected, they form what analysts call a “neckline.” This type of pattern is preceded by an uptrend.

The head doubles up as the second peak and the highest point in the pattern. Neither the left shoulder nor the right one exceeds the head. In an attempt to profit from a security that exhibits a head-and-shoulders pattern, technicians set a price target equal to:

$$ \text{Price target} = \text{Neckline} – (\text{Head} – \text{Neckline}) $$

Investors should anticipate the price target and close the investment at that point. Eying even higher returns beyond the price target almost always results in lesser returns.

Inverse Head and Shoulder

In addition, there are head and shoulders patterns preceded by downtrends called inverse head and shoulders which can be analyzed the same way as the reversal ones.

Other reversal patterns include double and triple top and bottom patterns.

Double Tops and Bottoms

Both double tops and bottoms are formed when a trend reverses twice at approximately the same price level. The volume is lower on the second attempt to break the neckline than the first attempt, signaling diminishing demand (supply. Price targets are calculated as in head and shoulder.

Triple Tops and Bottoms

Those patterns rarely occur but are more significant than double tops and bottoms.

Continuation Patterns

Unlike reversal patterns, continuation patterns suggest a pause in a trend. Some of the most well-known patterns under this category are triangles. Market veterans further subdivide these into symmetrical triangles, ascending triangles, and descending triangles. A triangle forms as the range between the high and low prices narrows. As a result, all the 3 types form after the convergence of two trend lines.

Continuation patterns

On an ascending triangle, two or more equal highs form a horizontal line representing overhead supply. This line serves as a price ceiling, effectively preventing further movement of price. Another two or more troughs form an ascending line that converges on the upper horizontal line. Although the price remains below the upper ceiling, the higher lows are a sign of increased buying pressure, hence the “bullish” formation.

The descending triangle forms during a downtrend. Remember that there are two or more equal lows that form a horizontal line at the bottom, representing overhead demand. This line serves as a price floor, effectively preventing further decline in price. Another two or more declining peaks form a descending line that converges on the horizontal line. Although the price remains above this level, the lower highs signal increased selling pressure, hence the “bearish” formation.

Lastly, the symmetrical triangles containing at least two higher lows and two lower highs form during a trend. Connecting these points yields convergence.

Other continuation patterns include rectangles, flags, and pennants.

Rectangle Pattern

A rectangle is a continuation pattern formed by two parallel trend­lines, whereby one line connects the high prices, and the other connects the lows. The horizontal resistance line that forms the top of the rectangle shows an end to the rally as the investors are repeatedly selling shares at a specific price level. The horizontal support line that forms the bottom of the rectangle signals reversal in decline as the investors are repeatedly making large purchases at the same price level.

Flags and Pennants

A flag is comprised of parallel trendlines. In an uptrend, the flag’s trendlines are downward sloping. In a flag formation, it is assumed that the trend will continue in the same direction.

A pennant is similar to a triangle. However, the pennant is a short-term formation, whereas a triangle is a long-term formation. In a pennant formation, it is assumed that the trend will continue in the same direction.

Question 

Which of the following is most likely a reversal pattern?

  1. A rectangle
  2. An ascending triangle.
  3. A triple top.

Solution

The correct answer is C.

A reversal pattern indicates that an earlier trend is likely to reverse once it is complete. A triple top is a reversal pattern.

A and B are incorrect. Continuation patterns suggest a pause in a trend. Both rectangles and triangles are continuation patterns.

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