Using Chart patterns for profitable trades

Let’s Take a Look at a Few “Classic” Patterns

 Technical analysis is based on historical pricing patterns, so how far back do technical analysts look for patterns?

That all depends.
Some patterns can be traced back to a market's inception, some go back a number of years, some are seasonal and some chart patterns can even be seen happening by the minute or second. Because technical analysis focuses on historical prices, patterns can emerge in the pricing during any time period.
“Classic” refers to a group of patterns that typically have a longer-term horizon (greater than 12 days) and that have distinct price movements that form distinctive patterns.
In technical analysis, the names of classic patterns generally describe the shape of the formation such as the double-top, double-bottom, head-and-shoulders top, ascending triangle, etc.
But, as I stated at the beginning, there are really only two trends to technical analysis: continuations and reversals. If we can remember that trends tell us direction, then we've got the important parts down.

Ascending Triangle

You may also hear this called an ascending right triangle. It's a bullish indicator.
Technically speaking, what happens is that an ascending triangle is a rally to a new high, followed by a pullback to an intermediate support level, then a second rally to test the first peak, followed by a second decline to a level higher than the intermediate-term support level and, finally, a rally to fresh new highs on strong volume.

Descending Triangle

A descending triangle is a decline to a new low on news that's followed by a rally to an intermediate resistance level, then a second decline to test the recent low, followed by a second rally toward (but not through) intermediate resistance. Then, finally, there's a decline to new lows on strong volume.
This happens when The Street becomes extremely bearish and, subsequently, a stock looks like it's done for.
Most analysts consider descending triangles to be the most reliable of all chart patterns because it's easy to define the supply-and-demand relationship.

Technical Analysis Takes Shape

In addition to triangles, technical analysis is full of other patterns, most aptly named for the type of shape they make.
Below, I'll describe a few of the more common ones for you that are considered classic longer-term patterns.

While there are a considerable number of patterns, many of them shorter-term in nature, the following will give you a solid grasp of the basics you need to become a pro at reading the charts.

Double-Bottom

A double-bottom occurs when prices form two distinct lows on a chart. A double-bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double-bottom is a reversal pattern of a downward trend in a stock's price. This formation marks a downtrend in the process of becoming an uptrend.
Double-bottoms are among the most common of the patterns. Because they seem to be so easy to identify, the double-bottom should be approached with caution by the investor.
A double-bottom consists of two well-defined lows at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing.

The two lows should be distinct. According to technical analysis experts Robert D. Edwards and John Magee, the second bottom can be rounded while the first should be distinct and sharp. The pattern is complete when prices rise above the highest high in the formation. The highest high is called the confirmation point.
Traders should pay close attention to volume when analyzing a double-bottom.
Generally, volume in a double-bottom is usually higher on the left bottom than the right. Volume tends to be downward as the pattern forms. However, volume picks up as the pattern hits its lows.
Volume increases again when the pattern completes, breaking through the confirmation point.


Double top

 

A double-top occurs when prices form two distinct peaks on a chart. A double-top is only complete, however, when prices decline below the lowest low—the “valley floor”—of the pattern.
The double-top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend.
Sometimes called an “M” formation because of the pattern it creates on the chart, the double-top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double-top should be regarded very carefully.
As illustrated above, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double-top occurs when prices are in an uptrend.
Prices rise to a resistance level, retreat, and return to the resistance level again before declining. The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point.
A double-top often forms in active markets that are experiencing heavy trading. A stock's price heads up rapidly on high volume. Demand falls off, and the price falls, often remaining in a trough for weeks or months.
A second run-up in the price occurs, taking the price back up to the level achieved by the first top. This time volume is heavy but not as heavy as during the first run-up. Stock prices fall back a second time, unable to pierce the resistance level.
These two sharp advances with relatively heavy volume have exhausted the buying power in the stock. Without that power behind it, the stock reverses its upward movement and falls into a downward trend.
Generally, trading volume in a double-top is usually higher on the left top than the right. Volume tends to dissipate as the pattern forms. However, it picks up as the pattern hits its peaks.
Volume increases again when the pattern completes, breaking through the confirmation point.

Cup-and-Handle

As the name would suggest, a cup-and-handle pattern includes an elongated U-shape followed by a short period of consolidation of 1–2 weeks in duration, which tends to be downtrending.
The pattern is similar in appearance to a coffee cup with a right-side handle, and indicates the potential for an uptrend.

 

The depth of the cup indicates the potential for a handle and subsequent breakout to develop. The cup should be fairly shallow.
The handle tends to be down-sloping and indicates a period of consolidation. Consolidation occurs when the price seems to bounce between an upper and lower price limit. You can track the down-sloping angle of the handle by drawing trendlines across the upper and lower price limits.
If the price ascends outside of the trendlines, then it has the potential for breakout. If the price ascends beyond the upper right side of the cup, then the pattern is confirmed, particularly if it is accompanied with a sharp increase in volume.
Volume tends to parallel the price pattern. Consequently, during the cup formation, as price descends, volume tends to decrease. Following a period of relative inactivity (at the bottom of the cup), the price pattern starts an upward turn and volume tends to increase.
During the handle formation, the volume decreases. However, you will notice an increase in volume when the price breaks out beyond the right side of the cup.
Cup-and-handles are long-term patterns that can be observed from about three weeks to several years.

Picturing Technical Objectives

When prices form pictures on charts, you can obtain realistic objectives for later moves. One of the most reliable chart formations is the head-and-shoulders top or bottom. This easily recognizable chart pattern signals a major turn in trend.

The main advantage of the head-and-shoulders pattern is it gives you a clear-cut objective of the price move after breaking out of the formation. Measure the price distance between the head and the neckline and add it to the price where the neckline is broken. This projects the minimum objective. Although the head-and-shoulders gives no time projection, it predicts a very strong trend in the future.

In most cases, a head-and-shoulders formation will be symmetrical, with the left and right shoulders equally developed. Although the neckline doesn't have to be horizontal, the most reliable formations stray only a little.

Flags and pennants are consolidation patterns which give objectives for further moves. As the formation develops, price action in an uptrending market will look like a flag flying from a flagpole as prices tend to form a parallelogram after a quick, steep upmove. Flags "fly at half-staff." The more vertical the flagpole, the better.

A price objective is obtained by measuring the flagpole and adding it to the breakout point of the formation. The flagpole should begin at the point from which it broke away from a previous congestion area, or from important support or resistance lines. Flags in a downtrending market look like they are defying gravity and slant upward.

Continuation patterns

A pennant also starts with a nearly vertical price rise or fall. But, instead of having equal move reactions in the consolidation phase like a flag, pennant reactions gradually decrease to form short uptrend and downtrend lines from the flagpole.

The same measuring tools used in flags are used in pennants. Add the length of the flagpole to the breakout point to get the minimum objective. Remember,flags and pennants are usually continuation patterns in an overall trend which resumes after the breakout of the consolidation area.

Also, the coil formation, or symmetrical triangle, appears while prices trade in continually narrower ranges, forming uptrend and downtrend lines. This pattern doesn't tell you much about the direction of the next move. After breaking one of the trendlines, the objective is found by adding the width of the coil's base to the breakout point.

Springing from coils

The formation gets its name from the way prices contract and suddenly spring out of this pattern like a tight coil spring. One caution about this formation: It's best if prices break out of the formation while halfway to three-quarters of the way to the triangle's apex. If prices reach the apex, a strong move in either direction is less likely.

Ascending and descending triangles are similar to coils but are much better at predicting the direction prices will take. Prices should break to the flat side of the triangle.

Price objectives from ascending and descending triangles can be obtained two ways. The easiest is to add the length of the left side of the triangle to the triangle's flat side.

Another method of projecting price is to draw a line parallel to the sloping line from the beginning of the triangle. Expect prices to rise or fall out of the triangle formation until they reach this parallel line.

More objectives

In the chapter on trends, we mentioned double and triple tops and bottoms. These formations also provide us with objectives. Once a double bottom is completed, prices should rise at least as far as the distance from the bottom of the "W" to the breakout point.

A double bottom is confirmed when prices close above the center of the "W" formation. This is referred to as the breakout. The difference from the bottom of the formation to the top gives a price objective. Targets for price declines from double tops are figured the same way.

Often, prices will retest the breakout point after completing the formation. After a double top is completed, prices may briefly rebound to test the resistance, which is the same point where the original double top was completed.

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Descending triangle

Ascending triangle

Symmetrical Triangle

Reverse Head and shoulders

Head and Shoulders

Double top or M top

Double top or M top is a chart pattern formed after an uptrend or a rally.
The profitable action to take is to sell when price breaks below the neck line.
After selling, the objective is to buy back when the price dropped as much as the amount from double top to the neck line.

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Double Bottom or W bottom

A double bottom is one of the most recognizable chart patterns. It typically resembles a "W" and forms after a downtrend. A double bottom forms as part of a consolidation process, in which one group of traders is liquidating a position as another group is accumulating. Typically, the left side of the W is formed as part of a larger downtrend. Once that low is set, the stock bounces higher before coming back to retest the first low. If the retest is successful, the chart begins to look like a "W". Once the "W" is formed, the stock must clear the neckline, which is typically in line with the center peak of the "W". It is important to note that a double bottom is not valid until the price closes above the neckline.

The entry point to buy is at the time price breaks the neck line.

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