The Beginner’s Guide to Technical Analysis Part 5: Chart Patterns
To the uninitiated, a chart is just random noise. To a trader, it’s a precise portrait of the past. By isolating and analysing chart patterns, we can use this “noise” to plan high probability trades.
No matter what currency pair you’re observing, every pattern says something profound about the mood of the market. In a wider sense, every group of candlesticks gives us an insight into the bigger picture.
When read in the right way, chart patterns can be the key to unlocking where the market may be headed. With the right skills, these patterns can be identified, interpreted, and exploited.
Continuation vs. reversal patterns
On a basic level, a chart pattern can tell us one of two things. Either the trend looks set to resume (in which case you will want to plan your trade accordingly), or the trend looks set to reverse. In the latter case, you would want to plan a counter-trend trade.
It sounds simple enough, right? But it’s not always. Reading chart patterns isn’t a magic bullet technique. It requires an appreciation for ambiguity, uncertainty, and (perhaps more than anything else) the ability to tolerate being wrong once in a while.
But let’s not undersell it, either. Armed with a strong ability to read the charts, a trader can greatly enhance their entries and exits, not to mention stop-loss placement and risk management on the whole.
Which timeframes are patterns effective on?
Patterns are effective on every timeframe (with a caveat). On faster timeframes when we’re talking in terms of minutes, there is more noise to contend with. It’s easy to get jumpy when every medium sized intra-minute move looks like the start of a selloff.
Conversely, when the big moves do happen, it’s helpful to examine the faster timeframes to get some idea of the shorter-term momentum.
On the higher timeframes – daily, weekly, monthly – the chart patterns will be the most accurate. Traders in aggregate pay more attention to established trends, and look to filter out as much noise as possible.
This is where the majority of real market players will be formulating their ideas, so it pays to look at the same information they are.
By all means, if you suspect you’re seeing the start of something, then it makes sense to confirm on the low timeframes.
Beware, though. Their very nature means they are volatile. A huge move on the 5-minute chart is a blip on the daily radar, which some people will never notice or worry about.
When you base your perceptions on lower time-frame chart patterns – 4 hour and lower – you are much more vulnerable to noise. There is such a thing as too much information.
Double top and bottom
Double tops look like the letter M. Double bottoms look like the letter W. Simply put, if you see either M or W, it could indicate a reversal.
The psychology behind a double top is that market participants have attempted to breach a new high and failed, leading to a broad based sell-off. The reverse is true for double bottom.
Here is a double top followed by a double bottom on the daily chart of the EURJPY.
Triple top and bottom
This is what happens when price doesn’t break out after a double top or bottom, but falls back to the original point for the third time. This is an even stronger reversal pattern.
A triple top signifies a third failure for the bulls to reach new highs and will often result is a complete capitulation with the bears taking charge. Of course the opposite is true for a triple bottom.
Here is a triple bottom on the EURGBP which signalled a reversal of around 400 pips.
Cup and handle
A cup and handle is a bullish continuation pattern.
This patterns is a longer-term base followed by a breakout with a re-test of the breakout point (the handle) before the trend resumes.
This is a continuation pattern marked by a steep upward trend, and then a jagged decline that bounces between two upward sloping parallel lines.
Eventually, price is expected to touch the bottom line and fall slightly, then rebound and continue the trend before making it back to the top line.
A pennant is much like a flag, except that with a pennant, the first low creates a support line, meaning price converges like a funnel, rather than falling steadily.
Consider the chart directly above. We’re in an uptrend. Price is consolidating because some traders are exiting long positions to take profit, and some are betting on a reversal. Both of these factors are causing the trend to lose a slight amount of steam.
Of course not everybody is abandoning long positions. The trend is still alive. Plus, some of those traders who had been flat are now looking for a good price within the consolidation to go long, betting that this is in fact a continuation pattern.
What you’re witnessing is a skirmish within the greater war: the naysayers against the faithful. In essence, what causes this type of pattern is a relatively even split of people betting either way within a short space of time.
But consider the facts: the overall trend is still long and strong. Why would it reverse violently without a big catalyst? This is why we consider this a continuation pattern.
As stated above, the flag and pennant are both continuation patterns. It would be wise to stalk your entry when you see these patterns. Wait for confirmation that price has broken out in favour of the trend.
Ascending and descending triangle
An ascending triangle is a pennant with a clearly defined resistance line. It may look like a triple top with slightly higher lows each time.
If this follows an uptrend, you can consider it a period of consolidation with a favourable bullish breakout coming.
A descending triangle is the reverse of an ascending triangle with a clearly defined support line.
A symmetrical triangle looks a bit like a pennant that has broken out, and whose new high connects to the old high in such a way as to form two tessellating triangles of the same angle.
Don’t just shoot for the moon if this pattern appears, though. It’s contextual, and you should be looking at is as confirmation of an existing trend, rather than an arbitrary indication that the price is about to skyrocket upwards.
Head and shoulders
The simplest explanation is often the best. If it seems like you’re looking at a mountain on your charts, then you’ve probably already seen the top.
A head and shoulders is a reversal pattern marked by three triangles: a left shoulder, a head, and a right shoulder. If you draw a line under the head’s lows, you should find the point at which price is expected to drop off as it completes the right shoulder.
Inverse head and shoulder
This is the exact reverse of a head and shoulders – a pattern that indicates reversal of a bearish trend.
A descending wedge is quite similar to a flag, except that the price is not range-bound between two parallel lines. Instead, the lows get lower until an upside breakout occurs and the bullish trend resumes.
As you can see, not every wedge is going to conform to the stereotype, or break out in exactly the way you want it to. Once the lows get low enough, look for a quick shooting star up to the top trend line before you place a bullish trade.
The wedges are said to be hard to identify and trade accurately. A lot of times, charts are going to show you rising wedges that are just made of noise. The key is to know when it means something significant.
Look for a doji or a hammer (preferably both) around the support line before you take a rising wedge seriously. You will need something to confirm.
A broadening wedge comes in two varieties; ascending and descending.
An ascending broadening wedge is a bearish reversal pattern. In an ascending broadening wedge, the two lines are upwards sloping and move away from each other near the end.
A descending broadening wedge is a bullish reversal pattern. In a descending broadening wedge, the two downwards lines move away from each other near the end. Notice that the lines begin by seeming almost parallel, but do quickly deviate is the lows become lower.
Broadening top and bottom
“Broadening top and bottom” is a lower probability reversal pattern, but these can be useful to take note of. As you can see in the next section, a very similar chart setup can also indicate the exact opposite.
Right-angled descending and ascending broadening formations
Broadening tops and bottom are continuation patterns that occur during a trend.
These patterns can be quite useful in Forex as they indicate a failed attempt to reverse the trend. Stops have been taken out, and the way is clear for a continuation once support or resistance is broken.
There is a clear resistance line in this instance, unlike with the broadening top and bottom. New lows are being created within the pattern itself, but no new highs until the eventual breakout.
Make sure to differentiate properly between the above chart patterns.
No trading technique is 100%. These patterns will let you down at times, especially when it comes to unexpected news or announcements (or a bang moment).
The key is not to win all the time, but to lose less. By taking these techniques on board, you can vastly increase your win rate overall, by looking for smarter trading opportunities more often.
Remember, you are a risk manager first and a trader second. When you know the charts like the back of your hand, it’s much easier to exist comfortably in both of these roles.
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