Chart Patterns Every Trader Should Know About
5 must-know chart patterns for every trader
Introduction to chart patterns
Chart patterns tell a robust story of demand and supply in any stock, which is why some hugely successful traders use only chart patterns as the key inputs in their trading.
Unlike straightforward indicators, chart patterns take time and a lot of practice to master. The good news is that you don’t need to know too many of them. Even if you become proficient in identifying and trading 2-3 chart patterns, you can bring about a significant improvement in your trading results.
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When studied well, chart patterns can significantly improve the timing of entry and exit from stocks, but more importantly they provide logic to create a favorable risk reward structure.
Chart patterns can be continuation or reversal patterns based on where they are being formed in a cycle of a stock.
Here we discuss 5 other must-know chart patterns.
Head and Shoulders
Head and Shoulders is a reversal chart pattern that signals an end of a trend. It contains 3 back to back-to-back peaks that resemble the head and shoulders. The middle peak is higher than the ones on each side, as displayed in the image below. The line connecting the base of the pattern is called the neckline.
The ideal time to get into a reversal trade is when the price breaks the neckline on high volumes after forming the second shoulder.
Head and shoulders don’t only form during downside reversals but also during upside reversals, as shown in the image below. The upside reversal pattern is called an inverted head and shoulders and it signals the completion of the bottoming out process. Traders go long in inverted head and shoulders when the price pierces the neckline on the upside with high volumes.
Cup with Handle
A cup with handle is one of the most common continuation patterns and obviously resembles a cup with a handle on the chart.
The bullish pattern is formed during intermittent consolidation after a run-up in price. The cup in the pattern is a rounding bottom as seen in the image above.
The high of the cup generally gets formed below the stock’s previous high. The price retraces a little after the formation of the cup to form the handle and gradually inches back to reach the new high ground.
In cup with handle and all other bullish continuation patterns, the volumes on down days decline significantly as the pattern matures. The pattern gets completed when there is little remaining overhead supply and big buyers queue up to buy the stock as it hits a new high ground.
The buy point is when the price penetrates the high of the cup. Ideal stop loss is set at the low of the handle.
A flag is a small bullish continuation pattern that is formed after a stock experiences a large increase in price. Traders consider an 80-100% move in the previous 8 weeks as a precondition to label the successive pattern as flag.
Generally the stock experiences another bout of strong move once it breaks out of the flag pattern. Flags are rare, but one of the most rewarding chart patterns to trade.
Double Top and Double Bottom
Double tops and bottoms are reversal patterns that are formed at the end of the trend. The stock price sees volatile high-volume action during the formation of these patterns and marks the reversal of the trend as the price breaks the support/resistance line of the pattern.
The second top/bottom can be formed at higher/lower than the first top/bottom. The price retreats significantly after the formation of the second top/bottom.
As the name suggests, these chart patterns resemble triangles when the highs and lows of the patterns are connected with trendlines.
Triangles are continuation patterns and are formed amidst existing trends, providing an alternative point of entry if you miss the start of the trend.
When the prices are in an uptrend, an ascending triangle is formed with a resistance area on the upper part and a series of higher highs at the lower part. The trend continues when the price overshoots the resistance area on the upside and reaches a new high ground.
In down trending prices, descending triangles are formed with a support area on the lower part and a series of lower highs on the upper part. The trend continues as the price breaches the support level and reaches a new low ground.
Triangles can also be symmetrical, in which the price tightens on the right side of the pattern and the existing trend continues when the price pierces the upper or lower trendline depending upon the direction of the primary trend.
Using the chart patterns
Chart patterns are very subjective and can be often misunderstood and misread. They are also not the holy grail of successful trading.
However, they still make an essential part of a traders’ tool book because they occur frequently and provide great trading opportunities when understood and traded well. Stocks that are under continuous accumulation or distribution tend to form multiple patterns along the trend, offering several opportunities to trade.
To trade the chart patterns, you must master one chart pattern first and practice the pattern as much as possible. Once you become proficient in one, you can move on to the next.
While looking at the chart pattern, observe how the price and volume have behaved from the start to the maturity of the pattern. The volumes will be high when the pattern starts and drift afterward at the right side of the pattern. At the end of the pattern, the moves or the breakout/breakdowns come with higher than average volumes and continue further into the trend.
While in the pattern, the daily moves in the direction of the primary trend come at higher than average volumes, while the moves in the opposite direction are less severe and come with lower volumes.
These price volume characteristics are common across chart patterns, and you need to develop an eye for the best demand/supply equation. Proficient traders can spot it with just a casual glance on the chart.
The key is to analyze as many charts as possible of the previous winners and see how they behaved before each of their moves. Then, find those characteristics in present chart patterns to trade.
There are no shortcuts here. Only the perfect practice will make you sharp in trading chart patterns.
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