A chart pattern is a
distinct formation on a stock chart that creates a trading signal, or a sign of
future price movements. Chartists use these patterns to identify current trends
and trend reversals and to trigger buy and sell signals.
In the first section
of this tutorial, we talked about the three assumptions of technical analysis,
the third of which was that in technical analysis, history repeats itself. The
theory behind chart patters is based on this
assumption. The idea is that certain patterns are seen many times, and that
these patterns signal a certain high probability move in a stock. Based on the
historic trend of a chart pattern setting up a certain price movement,
chartists look for these patterns to identify trading opportunities.
is a reversal chart pattern that when
formed, signals that the security is likely to move against the previous trend.
As you can see in Figure 1, there are two versions of the head and shoulders
chart pattern. Head and shoulders top (shown on the left) is a chart pattern
that is formed at the high of an upward movement and signals that the upward
trend is about to end. Head and shoulders bottom, also known as inverse head and
shoulders (shown on the right) is the lesser known of the two,
but is used to signal a reversal in a downtrend.
While there are general ideas and components to every chart pattern, there is
no chart pattern that will tell you with 100% certainty where a security is
headed. This creates some leeway and debate as to what a good pattern looks
like, and is a major reason why charting is often seen as more of an art than a
science. (For more insight, see Is finance an art or a science?)
There are two types of patterns within this area of technical analysis, reversaland continuation.
A reversal pattern signals that a prior trend will reverse upon completion of
the pattern. A continuation pattern, on the other hand, signals that a trend
will continue once the pattern is complete. These patterns can be found over
charts of any timeframe. In this section, we will review some of the more
popular chart patterns. (To learn more, check out Continuation
Patterns - Part 1, Part 2, Part 3 and Part 4.)
Head and Shoulders
This is one of the most popular and reliable chart
patterns in technical analysis.Head and shoulders
Figure 1: Head and
shoulders top is shown on the left. Head and shoulders bottom, or inverse
head and shoulders, is on the right.
Both of these head and shoulders patterns are
similar in that there are four main parts: two shoulders, a head and a neckline. Also,
each individual head and shoulder is comprised of a high and a low. For
example, in the head and shoulders top image shown on the left side in Figure
1, the left shoulder is made up of a high followed by a low. In this pattern,
the neckline is a level of support or resistance. Remember that an upward trend
is a period of successive rising highs and rising lows. The head and shoulders
chart pattern, therefore, illustrates a weakening in a trend by showing the
deterioration in the successive movements of the highs and lows. (To learn
more, see Price Patterns -
Cup and Handle
A cup and handle chart
is a bullish continuation pattern in which the upward trend has paused but will
continue in an upward direction once the pattern is confirmed.
As you can see in Figure 2, this price pattern forms what looks like a cup,
which is preceded by an upward trend. The handle follows the cup formation and
is formed by a generally downward/sideways movement in the security's price.
Once the price movement pushes above the resistance lines formed in the handle,
the upward trend can continue. There is a wide ranging time frame for this type
of pattern, with the span ranging from several months to more than a year.
Double Tops and Bottoms
This chart pattern is another well-known pattern that
signals a trend reversal - it is considered to be one of the most reliable and
is commonly used. These patterns are formed after a sustained trend and signal
to chartists that the trend is about to reverse. The pattern is created when a
price movement tests support or resistance levels twice and is unable to break
through. This pattern is often used to signal intermediate and long-term trend
Figure 3: A double
top pattern is shown on the left, while a double bottom pattern is shown on
In the case of the double top pattern
in Figure 3, the price movement has twice tried to move above a certain price
level. After two unsuccessful attempts at pushing the price higher, the trend
reverses and the price heads lower. In the case of a double bottom (shown
on the right), the price movement has tried to go lower twice, but has found
support each time. After the second bounce off of the support, the security
enters a new trend and heads upward. (For more in-depth reading, see The Memory Of Price and Price Patterns -
Triangles are some of the most
well-known chart patterns used in technical analysis. The three types of
triangles, which vary in construct and implication, are the symmetrical
triangle, ascending and descending
triangle. These chart patterns are considered to last anywhere from
a couple of weeks to several months.
The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward each other. This pattern is
neutral in that a breakout to the upside or downside is a confirmation of a
trend in that direction. In an ascending triangle, the upper trendline is flat, while the bottom trendline
is upward sloping. This is generally thought of as a bullish pattern in which
chartists look for an upside breakout. In a descending triangle, the lower trendline is flat and the upper trendline
is descending. This is generally seen as a bearish pattern where chartists look
for a downside breakout.
Flag and Pennant
These two short-term chart patterns are continuation
patterns that are formed when there is a sharp price movement followed by a
generally sideways price movement. This pattern is then completed upon another
sharp price movement in the same direction as the move that started the trend.
The patterns are generally thought to last from one to three weeks.
. The main difference
between these price movements can be seen in the middle section of the chart
pattern. In a pennant, the middle section is characterized by converging trendlines, much like what is seen in a symmetrical
triangle. The middle section on the flag pattern, on the other hand, shows a
channel pattern, with no convergence between the trendlines.
In both cases, the trend is expected to continue when the price moves above the
As you can see in Figure 5, there is little difference between a pennant and aflag
The wedge chart
pattern can be either a continuation or reversal pattern. It is similar to a
symmetrical triangle except that the wedge pattern slants in an upward or
downward direction, while the symmetrical triangle generally shows a sideways
movement. The other difference is that wedges tend to form over longer periods,
usually between three and six months.
. A breakaway gap forms at
the start of a trend, a runaway gap forms during the middle of a trend and an
exhaustion gap forms near the end of a trend. (For more insight, read Playing The Gap.)
The fact that wedges are classified as both continuation and reversal patterns
can make reading signals confusing. However, at the most basic level, a falling
wedge is bullish and a rising wedge is bearish. In Figure 6, we have a falling
wedge in which two trendlines are converging in a
downward direction. If the price was to rise above the upper trendline, it would form a continuation pattern, while a
move below the lower trendline would signal a
A gap in
a chart is an empty space between a trading period and the following trading
period. This occurs when there is a large difference in prices between two
sequential trading periods. For example, if the trading range in one period is
between $25 and $30 and the next trading period opens at $40, there will be a
large gap on the chart between these two periods. Gap price movements can be
found on bar charts and candlestick charts but will not be found on point and
figure or basic line charts. Gaps generally show that something of significance
has happened in the security, such as a better-than-expected earnings
There are three main types of gaps, breakaway, runaway (measuring)
Triple Tops and Bottoms
Triple tops and triple bottoms are
another type of reversal chart pattern in chart analysis. These are not as
prevalent in charts as head and shoulders and double tops and bottoms, but they
act in a similar fashion. These two chart patterns are formed when the price
movement tests a level of support or resistance three times and is unable to
break through; this signals a reversal of the prior trend.
Confusion can form with triple tops and bottoms during the formation of the
pattern because they can look similar to other chart patterns. After the first
two support/resistance tests are formed in the price movement, the pattern will
look like a double top or bottom, which could lead a chartist to enter a
reversal position too soon.
A rounding bottom, also referred to as a saucer bottom, is a
long-term reversal pattern that signals a shift from a downward trend to an
upward trend. This pattern is traditionally thought to last anywhere from
several months to several years.
A rounding bottom chart pattern looks similar to
a cup and handle pattern but without the handle. The long-term nature of this
pattern and the lack of a confirmation trigger, such as the handle in the cup
and handle, makes it a difficult pattern to trade.
We have finished our look at some of the more
popular chart patterns. You should now be able to recognize each chart pattern
as well the signal it can form for chartists. We will now move on to other
technical techniques and examine how they are used by technical traders to
gauge price movements.