5.
4: Technical Analysis: Chart Patterns
Pattern recognition plays an important role in trading. Traders look for
unique patterns on charts in order to find good opportunities.
Often the biggest problem is you can draw an endless number of patterns
on a chart. You will get an information overload. Maybe this would be nice
as a piece of art, but it’s NOT really useful as trading tool.
First determine what kind of patterns you’d like to trade. The majority of
chart patterns fall into two categories:
Reversal patterns indicate a change of trend and can be broken down
into top and bottom patterns.
Continuation patterns indicate a pause in trend and indicate that the
previous direction will resume after a period of time.
I don’t rely heavily on all of these patterns in my strategy, but it is very
important to know they exist, as a lot of traders look at these patterns,
recognize them, and trade based off of them. The self-fulfilling quality of
patterns on charts can’t be ignored.
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But price can do whatever it wants, and doesn’t need to obey what a
patterns says. Many patterns are ambiguous and can be classified as both
reversal and continuation pattern. Price depends on a lot of variables, so it
often doesn’t behave as predictable as many traders would like. That’s why
I look at price and the chart from 7 different perspectives, that are
independent from each other. To get the best view on a trade and only
make trades with the highest probabilities. You will learn all about this
system in my Pro course!
In this free lesson I will show you the most common reversal and
continuation patterns and what they indicate.
Reversal Patterns
Double Top
The Double Top is a bearish reversal pattern. As its name implies, the
pattern is made up of two consecutive tops that are roughly the same in
size, with a small trough in between.
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As is shown in the above image, the double top formation is confirmed
when price breaks below the neckline after the second top. This neckline
was previous support, and is now reversed to a possible reistance. So
before going short or selling your long position, you should wait for
confirmation of the double top. Wait for a a convincing break below the
neckline, preferably confirmed by a rise in volume. Even more
conservative is to wait for support-turned-resistance to hold when price
tests it for the first time, that is what I prefer, it look like this:
So at the (re)test you have a saver entry opportunity, but price doesn’t
always test a support or resistance after breaking it, so be careful.
Double top?
:
Tripple Top
Next to the Double Top, there are also Triple Top (and Triple Bottom)
patterns. These are basically the same, but as its name implies, it has 3
tops instead of 2:
Double Bottom
:
The Double Bottom is a bullish reversal pattern. As its name implies, the
pattern is made up of two consecutive bottoms that are roughly the same
in size, with a small peak in between.
As is shown in the above image, the double bottom formation is confirmed
when price breaks out above the neckline after the second bottom. This
neckline was previous resistance, and is now reversed to a possible
support. So before going long or closing your short position, you should wait
for confirmation of the double bottom. Wait for a a strong break above the
neckline, preferably confirmed by a rise in volume. Even more
conservative is to wait for resistance-turned-support to hold when price
tests it for the first time. But price doesn’t always test support when
breaking above it, so be careful.
Head and Shoulders
A Head and Shoulders pattern forms after an uptrend, and it
indicates trend reversal. The pattern is easily recognizable by its three
:
indicates trend reversal. The pattern is easily recognizable by its three
successive tops, the middle top or the head being the highest and the two
outside tops or shoulders, being lower and roughly the same in size. The
lows can be connected to form a neckline that acts as support. This
support doesn’t have to be horizontal, but can be diagonal, like a trendline.
The neckline has the same function as in the Double Top pattern.
:
In essence head-and-shoulders consists of just 3 steps:
1. price making a (final) higher high
2. then failing to make another higher high, closing below the previous
high (right shoulder).
3. Next it drops below the neckline, it also makes a lower low, confirming
the end of the uptrend.
The slope of the neckline is also an important indicator.
If the neckline slopes down, this signals bearishness, as price in fact
already made a lower low prior to the right shoulder.
An upsloping neckline indicates bullish potential.
I see the Head and Shoulders pattern very often. But again, when entering
or exiting the market one should rely on more than chart patterns alone. It
is the meaningful combination of independent tools that gives you the
most reliable signals.
Important lesson: often during the “left shoulder” the volume and
momentum are bigger than during the “head”, even though the
head makes a higher high. This divergence gives us an early signal
that the head probably is the highest high, and we can expect a
lower right shoulder next, confirming the head-and-shoulder
pattern.
:
Reversed Head and Shoulders
The reversed head-and-shoulders is an opposite pattern that forms
after a downtrend and signals a possible reversal to the upside. It is a
very successful bullish chart pattern, consisting of three swing lows.
It has a very high probability.
This pattern is confirmed by a break above the neckline.
Falling Wedge
A Falling Wedge pattern consists of two downsloping trendlines that form
a resistance line and a support line:
As the lines slope down, price makes lower highs and lower lows,
indicating bearishness. The two lines converge as buyers and sellers
come closer together. The lower support line is less steep, indicating
the lows are getting less low and downward momentum is
decreasing.
:
:
This is why a Falling Wedge is generally regarded as a bullish pattern.
But in my experience a Falling Wedge pattern can occur before both a
trend reversal and continuation.
A bullish breakout is confirmed by a close above the
resistance. Conservative traders wait for the more reliable signal when
price test the resistance as support and it holds.
A bearish breakout is confirmed when price breaks below support and
it subsequently holds as resistance as price tests it.
For a breakout to be reliable it should also be confirmed by increasing
volume.
The Rising Wedge is the exact opposite pattern and is a generally seen
as a bearish signal. But in my experience it can also be a bullish signal.
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Neutral Patterns
Symmetrical Triangle
Symmetrical triangles can be both a reversal and a continuation pattern.
The pattern must at least consist of:
two lower highs
two higher lows
So it basically looks like this:
:
The difference between a pennant (a pattern that also slopes horizontal –
read below) and a symmetrical triangle, besides the fact that the pennant
is normally a continuation pattern and the symmetrical triangle could be
both a reversal and continuation pattern, is:
a pennant can be formed by 3 or 4 individual candlesticks only
a symmetrical triangle needs more than that (as you see in the above
image).
Another difference is that pennants (flags as well) are more common
during explosive price spikes, occurring in the middle of the move, and are
considered “half masts”. To me pennants are in essence short
symmetrical triangles.
Breakout
An important characteristic of chart patterns, which also applies to
symmetrical triangles, is that the direction of the next major move can only
be determined after a valid breakout.
:
As the triangle extends, price consolidates, and the triangle gets narrower,
you should see volume start to decrease (the quiet before the storm).
But what is a valid breakout?
A valid breakout is confirmed by an increase in volume at the same time.
The direction can’t be determined before the breakout, don’t try to do this
anyway, as it is very dangerous and unpredictable. There are also “false
breakouts”, where price spikes out of the triangle but only to fall back into
it later.
That’s why I prefer to wait for valid breakouts by only trading conservative
entries, which means after a successful test of the previous resistance as
support:
Rectangle
:
A rectangle is a trading range that acts as a pause in the trend. It is often
called a continuation pattern, as most of the times the trend continues
after a rectangle. Although it is widely known as a continuation pattern, in
my experience it is neutral.
I also come accross it quite often as reversal pattern at the top and
bottom of trends. The pattern is easily identifiable by two equal highs and
two equal lows that are connected to form the parallel resistance and
support lines, respectively the top and bottom lines of the triangle.
Near support buyers push the price back up
near resistance sellers push the price back down
These are called trading ranges, and are areas where price consolidates.
As with most patterns, the end is characterized by a break out of the
pattern. Volume doesn’t always decrease during the development of a
:
pattern. Volume doesn’t always decrease during the development of a
rectangle though, as we have seen with other patterns. Sometimes it just
fluctuates. But it is always best to look for breakout confirmed by an
increase in volume.
Continuation Patterns
Flag and Pennant (and Wedge)
As said, Wedges can signal both a reversal and a continuation. They look a
lot like the Flag and Pennant chart patterns. Though Flags and Pennants
are considered to be only continuation patterns. So all 3 can be
considered continuation patterns. To make the difference between these 3
continuation patterns clear I made this visual comparison:
:
These are all continuation patterns that show a small consolidation before
the previous trend is resumed. Important to notice that these continuation
patterns are almost always preceded by a big price jump or drop and
look like a pause in the middle of the run up or drop down. Without such a
sharp initial advance or decline I wouldn’t consider it to be a reliable
pattern actually. The sharp rise and drop in front of the pattern is often
called the “flagpole”. The Flag and Wedge are usually sloping against the
trend, the Pennant is usually sloping neutral. Again a breakout of the
pattern signals a trend continuation (or sometimes a trend reversal in case
of the Wedge).
Ascending Triangle
The ascending triangle is a bullish pattern that usually forms as a
continuation pattern in an uptrend.
Sometimes ascending triangles act as a reversal pattern at the end of a
downtrend. But they are generally known as continuation patterns.
:
The pattern shows us that momentum is building up, pushing against the
resistance, as support is making higher lows. Resistance keeps sloping
horizontally, as it makes equal highs. The upsloping support line consists of
a minimum of 2 lows, the horizontal reistance consists of a minimum of 2
highs.
Similar to the symmetrical triangle, the ascending triangle also shows
volume decreasing as the triangle develops. A breakout should also be
confirmed by an increase of volume in order to have a high probability.
Compared to the symmetrical triangle, that was more neutral, the
ascending triangle is a true bullish pattern. Often the horizontal resistance
is caused by some big sell orders at that level, but as the pattern indicates,
buying pressure is building up. Once it “eats” through the sell wall, often
the only way is up.
Descending Triangle
The descending triangle is the opposite of the ascending triangle pattern.
Two equal lows make a horizontal support line, and two highs make up the
downsloping resistance. It is a bearish continuation pattern, as price is
making lower highs. This is what it looks like:
:
Volume also decreases while the triangle develops, and should increase
when price breaks out of the triangle. While it is known to be a
continuation pattern, sometimes it acts as a reversal pattern at the end of
an uptrend.
Price Channel
A price channel looks similar to the rectangle we discussed earlier. The
difference is that a price channel slopes up or down and is a true
continuation pattern. It consists of an upper trendline that acts as
resistance and a lower trendline acting as support.
Downsloping price channels are considered bearish
Upsloping price channels are considered bullish
:
In a downtrend the resistance is the main trendline, the parallel
support line is also called the channel line.
In an uptrend, the support is the main trendline and the parallel
resistance is called the channel line.
Ideally the main trendline and the channel line are each based on 2 highs
or 2 lows. In an uptrend, traders often want to buy near the support line, or
sell near the resistance line.
Drawing Tips
Try to include as much wicks as possible when drawing your chart
patterns:
Most experienced traders use logarithmic (“log”) charts. New traders often
stick to the default “linear” charts.
:
The difference between a linear and logarithmic chart:
A linear chart has a scale with units that have equidistance spacing
between them.
On a logarithmic scale the distance between the units is increasingly
smaller. But 2 equal % changes have the same distance on the scale.
For example:
If price grows 100% from $10 to $20 (a $10 growth), then the space
between these units is the same, as when price grows 100% from $50 to
$100 (a $50 growth).
So instead of measuring the absolute change, it measures the %
change.
Here in a more schematic form:
:
Final words
I am skeptical when traders solely use one piece of information, like chart
patterns, in their trading method. I always look for meaningful
confirmation by independent perspectives. I’m not particularly impressed
by the usefulness of all these kind of chart patterns, unless they are used
complementary to other independent analytical tools.
As you have probably already seen, I use “candlestick” charts. In the next
chapter I will tell you everything you need to know about candlesticks.
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Free Lessons
1: What is Cryptocurrency?
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1: What is Cryptocurrency?
2: What is Blockchain?
3: Trading Psychology
4: Risk Management
4.1: Risk Management Basics
4.2: Risk Management Advanced
4.3: Position Size Calculator
5: Technical Analysis
5.1: Technical Analysis: Markets
5.2: Technical Analysis: Support and Resistance
5.3: Technical Analysis: Trendlines
5.4: Technical Analysis: Chart Patterns
5.5: Technical Analysis: Candlesticks
5.6: Technical Analysis: Candlestick Patterns
5.7: Technical Analysis: Indicators
5.8: Technical Analysis: Divergences
5.9.1: Technical Analysis: Elliott Wave Theory
5.9.2: Technical Analysis: Fibonacci Retracements
6: Chapter 1: Introduction to Pro Course
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