Last week in Part 8, we looked at Trends, Support & Resistance. We take those ideas one step on this week, into the concept of patterns on price. Many think pattern analysis is created from a mystical land and disregard it without a second look! There can be strange names associated to the various patterns and this probably doesn’t help their legitimacy, but if you stop and think what the price is doing within these patterns, you can see the economics of supply and demand at work and this is why these patterns make sense and can be so effective.
The purpose of chart patterns?
Their purpose is to organise price movement into two buckets – prices that continue and prices that reverse, with the aim of giving the user some clues as to what the price will do next. When a trend is developing, it normally has a period of time when it evolves into one of these two camps: reversal or continuation. This evolution into its future direction is captured by price patterns.
What are they?
They are simply pictures or formations of price which appear on your price chart in any time frame, whether it be FX, Commodities, Stocks etc, that can be classified into different categories that have some predictive and probabilistic value.
Under the two main camps of continuation and reversal, they are split further down into unique individual patterns:
We will take a look at a couple of those reversal patterns – the double bottom and the head & shoulders:
The ‘double bottom’: named because of its 2 touches on the resistance line, aka the ‘W’.
The ‘head & shoulders’: another obviously named pattern, simply from the way it looks.
Rules of the reversal:
- There must be an existence of a prior trend coming into the reversal pattern.
- First signal of reversal is often breaking an important trend line.
- The larger the pattern, the greater the subsequent move.
- Topping patterns are usually more volatile than bottom patterns.
- Bottom patterns have similar price ranges and take longer to build.
- Reversal points normally coincide with heavier traded volume.
- Volume is usually more important on the upside.
An example of various patterns playing out on WTI Crude Oil (NB. The drawing of these patterns IS NOT an exact science) (Charts: TradingView):
With continuation patterns, you are looking to move out of an instrument’s sideways holding period and to continue in the way of the previous trend. The continuation pattern is often shorter in duration than the reversal and happens most frequently in the near term or intermediate time frame.
There are 4 main types of triangle based continuation pattern:
- Symmetrical: (Look for 4 touches inside the pattern; breakout often occurs 2/3rds along the triangle; time limit point where two lines meet.)
- Ascending: (Price Height of pattern at widest add onto breakout point for price target.)
- Descending: (Target measurement as ascending but in reverse.)
- Expanding/ Broadening: (Quite rare & hard to spot; 3 higher peaks 2 declining troughs.)
These triangles can also be classified as ‘wedges’ – either falling and rising. The difference is that they have a more noticeable slant. Both have converging highs and lows.
All that is left is 2 very popular patterns – the Flag and the Pennant. Again named for obvious reasons. These are very common and reliable patterns, are very similar to one another and show a brief ‘pause’ in market activity:
An example of various continuation patterns playing out on the FTSE100 (NB. The drawing of these patterns IS NOT an exact science) (Charts: Stockopedia):
As we’ve seen, these patterns can be used as tools to estimate possible future price targets. There are a couple of further rules you need to be aware of around this:
- The price target in an up-trend is measured from the start point of the trend (the breakout point at the base of the trend or most recent congestion pattern) to the highest high.
- The move is then projected up from the point of breakout (from the triangle, flag or pennant pattern), to arrive at the target.
- The target for a reversal pattern is calculated from the highest peak to the lowest trough in the wedge pattern.
- The objective is calculated by projecting the target up/down from the breakout point.
Further reading and learning:
If you are interested in learning more about price patterns then the following reading may help:
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Chart patterns are a very useful addition to your analysis, as they have a strong predictive ability of future price action. Frustratingly for some, the application of chart patterns is not an exact science and a lot is down to the subjectivity of the analyst. In my experience, I find it difficult to solely rely on these patterns and find they work much better in conjunction with indicators and other forms of analysis.
Next time: Technical Analysis (Part 10): Direct Price Analysis (DPA) – Moving Averages