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Chart pattern analysis consists of a set of pre-defined patterns formed by moving market prices. Chart patterns are used by traders and analysts to identify potential entry and exit points in the markets.
A part of technical analysis, chart pattern analysis can help traders to predict the future direction of the markets and spot potential trend reversals based on historical price data. Common chart patterns include triangles, double tops and bottoms, head and shoulders, flags, pennants and wedges. Some traders look at price charts to complement their fundamental research on what to buy and when, while others make decisions based solely on what the charts are telling them.
In this article we take a look at five influential stock chart patterns that can be a powerful addition to your strategy, no matter which approach you take to trading the markets.
The double top is a simple yet effective chart pattern that most commonly indicates that an upward trend may be losing momentum. It occurs when a stock hits a price level but meets resistance and falls back down from it (see highlighted area in chart). When the price moves back up but fails to break the previous high, it forms the influential double top pattern. The double top pattern is considered complete when the price falls back and breaks the previous low, indicating further weakness. The target being the 'height' of the pattern projected down from where it breaks that low.
The double bottom is the opposite of a double top and applies to a falling market. In a double bottom, the falling price hits a low point and then bounces back up. The price turns lower again but doesn't break through that previous low. It's when the price rallies and pushes through the previous high that the double bottom is completed. The target can then be perceived as the height of that double bottom, projected from that breakout point (see second arrow in accompanying chart).
Like the classic cliché 'the trend is your friend', chart followers look to identify a trend in a particular stock and jump on board with the intention of riding that move further. But of course trends don't last forever and a trendline break can be another influential stock pattern. Trendlines are drawn underneath rising lows in an uptrend (indicating buying demand) and above falling highs in a downtrend (indicating selling pressure). A break in this level, as indicated by the blue circle in the accompanying chart, is an indication that a change of trend could be on the cards, often prompting traders and investors to adjust their positions accordingly.
The head and shoulders pattern is similar to a double top, but is made up of three highs (a peak, followed by a larger peak and then a small peak again, hence the name head and shoulders). Typically in a head and shoulders pattern, the second peak should be the largest, indicating the head, followed by a lower high in the third peak. The chartist will draw a smaller trendline under the recent lows, referred to as the 'neckline'. It is when this trendline is broken and price moves lower that the head and shoulders pattern is said to be complete, and the target is for a move lower still – equal to the height of the 'head' in the pattern. Head and shoulders are reversal patterns that are used to indicate a possible change in sentiment from a bullish to a bearish market or vice versa.
Not all patterns suggest that the stock you are following is about to reverse direction. Some can signal that the market is just pausing, before continuing its original direction. One of the most common continuation patterns is the triangle. It gets its name because the stock trades in a tighter and tighter pattern, carving out the shape of a triangle on the chart. The assumption behind these patterns is that when it breaks, it will continue the direction of the prior trend. So in an uptrend, the triangle is expected to break upwards, giving a signal to buy, and vice versa if the stock was in a downtrend before the pattern formed.
Symmetrical patterns consist of at least two lower highs and two higher lows. If a trendline is drawn connecting the highs, and a separate trendline is drawn connecting the lows, the lines should have matching gradients Like a triangle, these lines get tighter and tighter until they converge and then continue to move in the same direction as before.
Ascending triangles are generally considered bullish and an indication that a previous uptrend will continue. In an ascending triangle, the top part of the trendline is flat, while the bottom trendline slopes upwards.
Opposite to an ascending triangle, the descending triangle is a bearish formation and typically signals a continuation during a downtrend. Descending patterns can sometimes be found at the end of an uptrend and could signal a reversal in price.
See our chart pattern analysis video for more information on how to identify chart patterns.
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