Lesson 8 – Chart Patterns

Now that you have a grasp of Trend lines and Support & Resistance, the next phase of your learning focuses on the regularity of market behaviour.

You may recall one of the principles of Technical Analysis from the first lesson in this chapter: Market Action is Repetitive. From more than a century studying price activity, it is very clear that human psychology and interaction with the markets results in similar price reactions.

Using your new found knowledge of Trends, Support & Resistance, we can now start to identify common Chart Patterns that reflect changing buyer or seller behaviour.

In this lesson you will learn about Chart Patterns. In particular, we will discuss Triangles, Rectangles, Double Tops and Double Bottoms, and the Head & Shoulders pattern. We will show you how to identify these patterns forming, and what the expected movement is based on historical performance.

The premise of Chart Patterns is that with the natural occurrence of price activity, certain reactions by the markets will form recognizable patterns, which repeat themselves over time.

By recognizing chart patterns, we can establish a strategy to capitalize on the expected price movement. Of course, nothing is infallible and we do find that even the perfect chart pattern can fail. But the high frequency at which these patterns form and move as expected offers great potential for the trader and investor.

Identifying and reacting to chart patterns is a learned skill. The experienced trader will identify patterns easier than the beginner. Hence, Chart Patterns must be practiced. The skill of identifying a forming Chart Pattern comes with practice and from regular chart analysis.

One aspect of Chart Patterns that is a little more evident today is that with so many people identifying the same patterns, due to the computer and internet, that the pattern actually becomes self-fulfilling. While we cannot discount this completely, even if it were true, this can still lead to profitable trading. If there is a high probability that something will occur, why pass up the opportunity?

Chart Patterns will fall into one of 2 categories:

1. Reversal, or

• Continuation.

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Reversal patterns are those that change trend direction.

Some patterns actually can form either a Reversal or Continuation. In these scenarios, multiple signs of confirmation are best used. The key difference in identifying a Reversal or a Continuation is that Reversal patterns are typically larger in size, while Continuation patterns are typically smaller or over a shorter time-frame.

Let’s now start exploring some of the key

Chart Patterns that will help you in your trading.

The first patterns we are going to explore are the Double Top and Double Bottom patterns. These are Trend Reversal patterns that will typically be found at the end of trends.

Taking what we have learnt about trends and S&R, a Double Top

pattern will form when two consecutive peaks or High points meet the same level of resistance. Instead of the trend continuing to form higher highs, Buyer demand will stall at the previous high

point, forming resistance and the potential for a Double Top.

The pattern has not yet completely formed, however. For the pattern to be completed, it must retrace back through the previous low point. We call this the neckline. Once the price activity has

broken through the neckline, the pattern is complete and a Trend Reversal is in play. A few key points to this pattern:

• The distance between the peaks should not be wide or too close together. There is no specific time-frame. For end of day analysis, it would not exceed 2 months between peaks, or be less than a couple of weeks.
• The proceeding trend is upwards

• The expected distance for the stock to trend downwards following confirmation of the pattern, is equal to the distance between the resistance/peak to the neckline.

• Volume in the pattern is likely to be strong on the first peak, but weaker on the 2nd peak and we expect increasing volume on the downwards break of the neckline.

The Double Top is a very common pattern and quite regularly found at the tops of trends. It is not very common at the top of steep upwards

trends as buyer activity will usually exhaust itself very quickly. However, 45 to 60 degree trends can form these patterns regularly.

Next, the Double Bottom pattern. Nice and simply, this is the opposite to the Double Top

Reversal pattern that is typically

found at the bottom of a

downwards trend. Two

consecutive low points or Price

Troughs form at the same level

creating a Support base for

buyers. With a small peak in-

between creating the neckline,Time

the pattern forms once the price breaks above this point.

The key points to this pattern are:

• The preceding trend is downwards

• Distance between the peaks should not be too wide or too close, not exceeding 2-months or less than 2 weeks

• Expected distance on breakout is the difference between the support level and the neckline

• Volume will increase into the first

trough but be weaker on the second trough. Expect increasing volume on the upwards break of the neckline.

Again, the Double Bottom is a common pattern found at the end of a downwards trend. It signifies a firm buyer base that is significantly strong enough to reverse market sentiment.

In this example, we can see two troughs forming at a support level. Although the rally to the neckline is not as clean as we would prefer, it does signify a clear neckline. Once the share price breaks that neckline, it rallies to an equivalent level to meet our target range.

You might remember that the more points a stock price meets resistance or support, the stronger the resistance or support becomes. This is true for Double Tops and Double Bottoms. Therefore, these patterns can form at previous resistance and support levels, and it gives further weighting to the breakout of the neckline.

The next pattern family we will discuss is the Triangle.

There are numerous Triangle variants, which are classified as Continuation patterns. The key triangle patterns are:

• Ascending Triangle

• Descending Triangle

• Symmetrical Triangle

Ascending Triangles form in the middle of an upwards trend. The stock price begins to meet with some resistance, forming multiple short-term highs at the same price. This suggests buyer demand is weakening or that there is sufficient selling pressure to halt the upwards movement of the trend.

Time

However, the low points are increasing at the same time. So we get this convergence as the short-term movements get tighter and tighter.

The end result is that the price breaks to the upside as the selling pressure weakens and buyer demand over powers.

The key points to the Ascending Triangle are:

• Prior trend is upwards, and will result in a continuation of that upwards trend

• Must have at least 3 points of resistance

• That the Low points are rising

• Will not exceed 4 weeks in time-frame for end of day analysis

• Entry is once the price breaks through the resistance — closes above.

• Price targeting is the distance between the resistance and the low point at the start of the pattern.

• Pattern should not trade through to the apex. It should break through two thirds into the

The Descending Triangle is a Continuation pattern found during a Downwards trend.

The price begins to find support where there is sufficient buyer demand to halt the retracing stock price. However, selling pressure continues to form lower high points. Eventually, buyers can no longer hold the trend of the stock, and a downwards break of the support results in a continuation of the previous trend.

Key points to the Descending Triangle are:

• Prior trend is downwards, and will result in a continuation of the downtrend

• Must have at least 3 points of support

• High points are lower

• Will not exceed 4 weeks in time-frame (end of day analysis)

• Entry is once the price breaks through the support — closes below.

• Price targeting is the distance between the support and the high point at the start of the pattern

• The pattern should not trade through to the apex, it should break through two thirds into the pattern

• Volume will typically increase on the breakout.

In this chart, we can see a Descending Triangle forming midway through a trend. Support is at $ with decreasing high points. On breakout, the stock price continues to retrace.

Next, let’s look at the Symmetrical Triangle

Where the Ascending and Descending Triangles form clear support and resistance levels, the Symmetrical Triangle is a more predominant period of indecision. Here we have lower highs and higher lows, suggesting neither the buyers or sellers are clearly in control and that the stock price is looking for direction.

During this pattern, investors are unsure whether the trend should continue or come to an end. Volume levels will decrease and hence we have decreasing trend movements in the pattern. Either an upwards trend or a downwards trend could precede the pattern.

We like to see significant breakouts of the pattern for confirmation, and 90% of the time the breakout will be in the direction prior to the pattern forming. It is usually a smaller pattern, less than 4 weeks in time for end of day trading. Also, Volume should increase sharply on the breakout.

One final note, a very large Symmetrical Triangle can actually form a Reversal pattern and change trend direction. The more time for uncertainty to creep into investors’ minds, the likely a change in trend. In this scenario, we are referring to patterns that are at least 3-months in length.

Key points to the Symmetrical Triangle are:

• They are preceded by an upwards or downwards trend, but will continue the trend direction on breakout

• They are typically 4 weeks in length

• They have Higher lows and Lower highs and

• There is Low volume through the pattern, but a sharp increase in volume on breakout.

Moving on from the Triangle Family, the next pattern to discuss is the Rectangle.

We’ve actually seen this pattern before during our discussion of Trend. The Rectangle is a pattern that has equal highs and equal lows. We have referred to this as a Sideways Trading Range,

Consolidation, or it could also be called a Channel.

We need at least 2 points of resistance and 2 points of support to form the Rectangle. The preceding

trend could be upwards or down, and this can result in a breakout in either direction as well. Rule of

thumb is, the smaller the pattern, the more likely a continuation in the previous direction. The larger the pattern, the more likely a Trend Reversal will occur.

Most common is a large increase in volume on breakout. This can help identify whether a false breakout has occurred, or if there is a true potential for movement. Large patterns are commonly found at the top or bottoms of trends, whereas smaller patterns can be found within the trend.

Key points for the Rectangle pattern are:

• At least 2 points of support and 2 points of resistance

• Volume decreases in the pattern, but increases on breakout

• Smaller patterns can be continuation of the trend, whereas larger patterns could be trend reversals.

The final pattern we are going to investigate today is the Head & Shoulders Pattern.

The Head & Shoulders is a Trend Reversal pattern that has a high probability of completion. Basically, it is a change in trend, where we have a shift from buyers to sellers taking control. It is how this forms that offers a clear explanation of what is happening to the market sentiment.

There are 4 distinct sections to the pattern:

1. The left shoulder

• The head

• The right shoulder, and

• The neckline

The pattern is preceded by an upwards trend. The left shoulder is actually just a normal progression of the trend with a higher high point.

The head of the pattern forms a peak to the trend. Of course, we do not know this is a peak until we have a lower high point, which is the right shoulder of the pattern. For this reason, a Head & Shoulders pattern is not typically identified until the formation of the right shoulder.

The two troughs between the head and the two shoulders forms the Neckline or support. This neckline is our benchmark for when the pattern has confirmed. Following the right shoulder forming a lower high point, once the share price breaks through the neckline, we have a confirmation of the pattern.

Price targeting for this pattern is the distance between the peak at the head, and the neckline. We

Key points for the Head & Shoulders pattern are:

• That it is Preceded by an upwards trend, and is a trend reversal pattern

• Normal trend activity forms the first half of the pattern

• A lower high point forms the right shoulder

• Then we identify the Neckline based on the support levels of the two troughs between the head and two shoulders.

• An incline or decline to the Neckline can have influence on the breakout. A declining neckline having greater probability. An inclining neckline will typically have a smaller right shoulder and lower probability
• Volume is likely to increase on the breakout as a change of trend occurs.

In this example, we can see distinct Shoulders and a Head formation on this chart. If we draw the neckline in, once a clear break of the pattern has occurred, we can target an expected price movement.

In this lesson, you have learnt

about Chart Patterns including Double Tops & Double Bottoms, Ascending, Descending and Symmetrical Triangles, Rectangles, and the Head & Shoulders patterns. We have shown you how to identify these patterns

orming, and what the expected movement is based on historical performance.

In the next lesson, we will explore Technical Indicators and how they can be used to make trading decisions.