What Is A Stock Chart Pattern?
Charts are used to visually illustrate the price action of an underlying stock (or any financial trading instrument). When price action repeats itself consistently, it can form an almost predictive pattern based on history. This is called a chart pattern. While the patterns make sense and look obvious after the fact, it is important to note that with more and more traders and algorithms trying to outsmart each other, the actual patterns may not be exactly perfect as outlined in many books and articles.
Seasoned traders understand the mechanics behind the patterns and will give the patterns some leeway in order to play out. The key is to recognize patterns quicker than the next guy in order to take a position before the full transparency is revealed. Chart patterns are linear throughout all time frames, which mean that a pattern that forms on a 5-minute chart performs the same way it would on a daily time frame chart. The only different is the range of prices being larger for wider time frames. Chart patterns can also form within chart patterns. For example, a wider time frame daily bull flag pattern may contain a 5-minute cup and handle breakout pattern that forms first.
Why Do They Work?
Price action is created from buying and selling transactions. As both buyers and sellers are trying to profit or minimize losses, they are always jockeying for a more advantagious price. This causes prices to fluctuate consistently. This price fluctuation gives clues to the price levels where there may be more interest in buying or selling and the movement of these price levels help to determine trends, supports and resistance levels.
The patterns tend to repeat themselves and often become a self-fulfilling prophecy at times as traders and algorithms become adept at identifying and reacting early. However, when transparency becomes too obvious, these chart patterns can fail and cause a stronger movement in the opposite direction.
Ascending Triangle (Bullish)
An ascending triangle is a bullish price pattern illustrated with flat highs representing the immovable resistance followed by rising lows representing anxious buyers raising the support. Sellers have an oversupply of stock shares and are unwilling to lift their offer prices nor get shaken out on price pullbacks. Meanwhile, there are buyers raising their bid prices on each pullback that will ultimately overtake the sellers causing a breakout.
Flat highs and higher lows create a triangle when you draw the trend lines. The distance between the resistance and rising support gets smaller until the price breaks out through the prior resistance near the apex of the triangle. The breakout signals another uptrend forming.
How To Trade It
The buy trigger forms above the horizontal upper trend line and the stop-loss is below the rising lower trend line. The profit target is usually the distance of the lower start of the lower trend line and upper trend line. The closer your entry towards the apex, the tighter your stop-loss will be and therefore represents the lowest risk. However, the breakout should happen before the apex, or else it may actually trigger a pattern failure causing the stock to collapse.
Flag Patterns (Bull and Bear)
Flags are trend continuation patterns. They form after a very strong initial parabolic price push higher (bullish) or lower (bearish). The stock takes a rest in the form of a pullback with parallel trend lines representing lower highs and lower lows (bullish) and higher highs and high lows (bearish) until the stock breaks back through the upper trend line on bull flags or lower trend line on bear flags to resume the trend.
Bull Flags: The stock will spike higher, peak and sell-off with lower highs and lower lows forming a parallel upper and lower trend lines. When the stock closes back above the upper trend line of the flag, it can trigger another breakout to resume the prior uptrend as the stock proceeds to make new highs.
Bear Flags: The stock falls quickly and steeply and forms a reversion bounce composed of higher highs (upper trend line) and higher lows (lower trend line). The trend lines are parallel suggesting an orderly bounce attempt. When the stock falls back under the lower trend line, a breakdown triggers causing the downtrend to resume as stock falls to new lows.
How To Trade It
Bull Flags: These are continuations patterns, which allow traders to enter an uptrending stock on a pullback. Buy signals trigger when a breakout forms above the upper trend line and proceeds to make new highs. The stop-loss would be set at/under the upper flag trend line.
Bear Flags: This pattern lets traders sell or short-sell into a downtrending stock. Sell signals trigger when the stock breaksdown under the lower flag trend line with a stop-loss palce at/above the upper flag trend line.
Double Bottom (Bullish)
A double bottom indicates that support has stabilized on a falling stock by maintaining the same price lows against separate breakdown attempts. This indicates that sellers may finally be depleted, which causes buyers to step back into the stock and reversing the trend back up. This is a bullish reversal signal that often resembles a “W” on the price charts.
The stock will make sharp lows and then rebound before selling back down to re-test the low before bouncing harder to reverse the trend back up. The longer in between the first and second test of the lows, the stronger the breakout can be. Usually the low candle will be a reversal candlestick like a hammer, which indicates capitulation.
How To Trade It
The buy trigger forms off the second bottom using a momentum indicator like a stochastic with a 20-band cross up or a bottoming pattern like a market structure low (MSL) which is a three-candle formation composed of a low, lower low and higher low with the buy trigger set just above the high of the higher low band. A secondary buy trigger forms when the prior resistance from the bounce off the first bottom breaksout. The stop-loss would be placed just under the low of the second bottom.
Double Top (Bearish)
A double top indicates the ceiling on a stock’s price as it peaks out twice at the top of the range. Buyers give up after the second top as sellers get nervous and take profits while short-sellers step into the fray. Double top patterns are the opposite of double bottoms and resemble an “M” shape.
The stock will make sharp low and then rebound before selling back down to re-test the low before bouncing harder to reverse the trend back up. The longer in between the first and second test of the lows, the stronger the breakout can be. Usually the low candle will be a reversal candlestick like a hammer, which indicates capitulation.
How To Trade It
The sell/sell-short trigger forms off the second top using a momentum indicator like a stochastic with aa 80-band cross down or a topping pattern like a market structure high (MSH) which is a three-candle sequence composed of a high, higher high and higher and lower high with the sell/sell-short trigger set on the rejection off resistance forming a second top. A secondary short trigger forms when the prior bounce area after the first top breaks down. First. The stop-loss would be placed just above the high of the second top.
Pennants (Bull and Bear)
Pennants start off like flags with a strong surge up (bullish) or down (bearish), but instead of forming a short-term downtrend channel with parrallel upper and lower trend lines, they form a symmetrial triangle with opposing upper and lower trend lines leading to an apex point where the stock should break the lower trend line (bearish) or upper trend line (bullish) to resume the the prior trend.
Bulish Pennants: The stock spikes sharply before peaking out and forming a short-term downtrend composed of lower highs and higher lows. As the flag trend lines get closer, buyers step up to the plate and thrust the stock back up through the upper flag trend line triggers a buy signal as it breaks out through the previous top to resume the uptrend to new highs.
Bearish Pennants: The stock falls sharply to form the flagpole and bounces. Each bounce makes a lower high and a higher low forming a falling upper trend line versus a rising lower trend line. As the trend lines get closer to each other, the stock will then breakdown through the lower trend line triggering a sell/short-sell signal. When the stock falls through the previous low of the flagpole, it panics out more sellers as the downtrend resumes.
How To Trade It
Bulish Pennants: Traders can buy the breakout through the upper flag trend line or when the previous high and top of the flagpole breaks. Stop-losses can be placed under the lower flag trend line. Nominal price targets can range from the distance between the high and low of the flag trend lines or the high and low of the flagpole. However, it’s best to have another method of taking profits as targeting is really selling ahead of the next resistance level, which will vary according to the underlying stock.
Bearish Pennants: Traders can sell/short-sell the breakdown through the lower flag trend line or a breakdown through the low of the flagpole and set a stop-loss above the upper flag trend line.
Bullish Cup and Handle
This pattern is composed of two parts. The first part is a steep sell-off from the lip to form a rounding bottom that recovers the stock back to the beginning of the sell-off (lip) This forms a “U” representing the cup, which rejects any further attempts higher. The second part is composed of either a bull flag or bullish pennant on the pullback that forms the handle. When the stock rallies back up through the upper flag trend line to breakout through the lip, it triggers the pattern resulting in an uptrend.
The pattern starts with a steep drop from the lip. The choppy rounding bottom should take some time to form as opposed to a sharp bottom and quick bounce that resembles a “V” shape. The cup should generally resemble a “U” shape, which includes a choppy consolidation period that flattens out before recovering up back to the lip price area where it rejects again forming the handle portion of the pattern. The handle usually resembles a bull flag or bullish pennant.
How To Trade It
The buy trigger can be taken above the handle upper trend line or on the breakout through the lip resistance area. Trades can place a stop-loss under the lip, which should be a new support level.