A Comprehensive Guidebook To Trading Chart Patterns

We always talk about how trading charts are crucial for decision making for traders and investors. Today several trading charts have emerged, each catering to multiple needs, which makes it difficult, especially for new investors, to understand which charts are better for them. To trade successfully, traders must build the skills to quickly identify the commonly formed and indicative chart patterns to take a position in the market.

In this article, we will discuss different chart patterns and how investors and traders can optimise their risk-reward situation following those.

Chart patterns are a critical component of technical trading. They are multifunctional and useful to

  • – Read market trend so you know if you may buy or sell
  • – Discover new entry and exit points and avoid being at the wrong side of the trend
  • – Find highly profitable trading opportunities

Price patterns can give crucial trading insights, but the key is to know how to read them and eliminate noise while forming a workable trading strategy. To help you navigate through the maze of trading chart patterns, we have compiled a list of commonly emerged patterns that you must take note of.

11 Important Charting Patterns You Can’t Ignore

Head and shoulder formation

It is a typical formation that combines one large peak in the middle and two smaller peaks on either side of it. Traders look at the pattern to guess bullish-to-bearish trend reversal.

The first and the third peaks are typically smaller than the second peak, and all three eventually fall back to the support line, also known as the neckline. Once the third peak falls back to the support line, traders assume it to break out into a bearish downtrend.

Double top and bottom patterns

Double top and bottom shapes appear before a trend reversal. During these phases, asset price rises or falls twice before crossing over to the other side of the trend line. In double top price rise and then fall back to the support line, then rise again before bearish downtrend takes over.

Double bottom is the opposite of the double top. In a double bottom, the graph indicates strong selling to cause the asset price to fall below the support line. After the initial fall, the price rises back up again to the support line and then drops for the second time. Finally, the price rises above the support line to break into a bullish trend reversal.

Rounding bottom pattern

Rounding bottom is one of the many stock chart patterns that denote continuation or a reversal. The most common rounding bottom pattern is a bullish reversal. It looks like a ‘U’ and forms at the end of an extended downtrend.

It is a long-term price movement that forms over several weeks or several months. The initial downward slope is indicative of excess supply or selling, which eventually converts into an uptrend when buyers enter the market at a low price. Once the formation of the rounded bottom is complete, prices breakout and continue on the uptrend.

The cup and handle

The cup and handle pattern is quite similar to the rounded bottom, except a short downtrend that looks like the handle of a cup that forms after the rounded bottom is complete. The short bearish phase indicates a brief moment of retracement resembling a handle of a cup. Hence, the name.

The cup and the handle is a bullish reversal pattern, barring the short bearish phase, after which the market continues to rise.

Wedges

Wedges are a chart pattern where two sloping trend lines converge at the end. It can be either rising or falling. In a rising wedge, the price line gets caught between support and resistance lines, both slanting upward. In this case, the support line has a steeper rise than the resistance line. When the rising wedge pattern appears, investors expect the asset price to fall and eventually break out below the support line.

Conversely, for a downward wedge, the price line lies between two downward sloping trendlines. The resistance is steeper than the support, indicating that the price of an asset is rising and will probably break through the resistance level.

The rising wedge belongs to the bearish market, and a falling wedge is typical of a bullish market.

Pennants and Flags

Pennants or flags are compact triangular patterns where two lines converge at a set point. It can form after a strong uptrend or downtrend movement, indicating that traders might have paused to consolidate before the trend continues. Wedges and pennant may look similar, but they are not the same. Wedges are narrower than pennants and are trend reversal signals. Wedges are usually upward or downward patterns, while pennant is always horizontal.

Some traders recognise flag pattern separately from pennants. In a flag pattern, both the support and resistance lines run parallelly before the breakout, often in the opposite direction of the existing trendline. Unlike pennant, flag shape indicates a trend reversal.

Triangle Shapes – Ascending And Descending

An ascending triangle denotes the continuation of a bullish trend. It can be drawn by placing a horizontal swing line across the resistance level and then placing an upward-moving swing line or support line at the bottom.

Conversely, a downward triangle forms when the resistance line slopes downwards towards the horizontal support line. Eventually, a descending triangle breaks through the support line, and traders might enter a short position.

Symmetrical triangle

The symmetrical triangle is a continuation of a trend pattern. It appears when the market goes through frequent fluctuations, creating a series of peaks and troughs to converge to a point. Unlike ascending or descending triangles, the symmetrical triangle is a horizontal pattern.

It best describes market volatility, where there is opposite price movement during an ongoing trend without clarity over trend reversal. The market can break into either direction after the symmetrical triangle pattern is formed.

Deciphering Chart Patterns

There are different schools of analysts and traders who will read different patterns differently. But trendlines are useful is studying price movement in the market. An upwardly inclined trendline indicates that there are more significant price fluctuations between highs and lows. Similarly, a downward sloping trendline appears when the price is moving between lower highs and lows.

There are also arguments pertaining to which data points to use in drawing the pattern. Pattern and position for the formation are also suggestive of market sentiment. A section of analysts suggests that the body of the candle bar, not the shadows, should be used for drawing the price line. Some charters also prefer to use only the closing price for drawing patterns since it is preferably the position investors want to maintain at the end of the trading day.

Three Most Important Chart Types

Like patterns, there are different types of chart types too recognised by technical analysts. The three most widely used chart types are,

Line charts: These are simple financial charts that are drawn between closing prices to show general price movement. However, these charts don’t give granular information like bar or candlestick chart patterns. Hence, they must be tallied with more revealing charts for confirmation.

Bar charts: Bar trading chart patterns are also called OCHL charts, meaning opening, closing, high and low. Unlike, line charts these are more detailed, giving more insight to traders and investors about asset price movement.

Candlestick charts: Candlestick charts are popular trading charts that look like bar charts but also clearly show day’s high and low. Each cylindrical body captures day’s opening and closing price, while upper and lower shadows respectively represent day’s high and low for the asset.

Candlestick charts have different chart patterns that need separate discussions.

Conclusion

Chart patterns are useful technical tools to understand why an asset price has behaved in a certain way. These are indicative of market support and resistance level, helping traders to open a long or short position.

Stock chart patterns are used to study market movement and manage risk-reward situations. Traders use charts to identify profitable entry into the market or plan an exit when there is a downtrend. Based on these, they set their stop-loss level.

So, which is the most profitable chart pattern? The ideal answer is there is none. Investors align their trading strategies along with the ongoing market trend to optimise profitability under a particular situation.