The Complete Guide to Technical Analysis Price Patterns.

TECHNICAL ANALYSIS: PRICE PATTERNS

Traders vote with their wallets & that wallet money appears in the form of price patterns charts. They will purchase a stock or commodity if they think it will rise in value. If they think a stock is going to fall in value, they will sell it. When their money is on the line, they can go to any length to be successful.  The acts of these self-interested traders often form price trends on the map.

Price patterns are chart formations that show what traders are thinking and feeling at different price levels. Learning to understand different market trends gives you a competitive advantage over traders who only use fundamentals or technical indicators.

Imagine being able to precisely define trade entry points when a stock breaks out, as well as reliably projecting how far a stock can go once it has broken out and begun travelling. This capacity is provided by price patterns.

Price patterns are classified into two categories:

  • Continuation Patterns.
  • Reversal Patterns.

CONTINUATION PATTERNS

Traders are constantly asking themselves, “Can this trend continue?” It is difficult to decide whether to enter a new trade in the middle of a trend or to leave the existing trade and take your money. You never know when a stock will reverse course and begin running in the opposite direction. Or can you tell?

Continuation trends warn you when a stock is likely to restart its trend after a brief consolidation phase, as well as how far the stock is likely to shift in that direction. Of course, continuation trends are not perfect, but they do increase the chances of success.

Spend some time getting to know the following price continuity patterns:

  • Pennants
  • Flags
  • Wedges
  • Triangles

Pennants:

Pennants are continuation trends that form when a stock’s price moves into a tighter and tighter consolidation range. They may be bullish or bearish, depending on the pattern preceding the formation of the pennant. It is a bullish continuation pattern if a stock was in an uptrend before the pennant started to develop. It is a bearish continuation pattern if a stock was in a downtrend before the pennant started to form. Pennants usually form over shorter time periods.

Pennants all have the following five characteristics (Refer Figure 1.1):

  • Resistance level (A): A level of resistance that is descending and converging with the support level.
  • Support level (B): An upward trending level of support that is converging on the resistance level.
  • Flag pole (C): The pattern that precedes the forming of the pennant. The flag pole spans the distance from the start of the trend to the highest point of the pennant (bullish pennant), or it spans the distance from the start of the trend to the lowest point of the pennant (bearish pennant).
  • Breakout point (D): The point at which a stock breaks up above the down-trending level of resistance (bullish pennant) or breaks down below the up-trending level of support (bearish pennant).
  • Price forecast (E): The price at which the stock is expected to fall after breaking out of the pennant formation (bearish pennant), or the price at which the stock is expected to rise after breaking out of the pennant formation (bullish pennant). The estimated movement of the stock is equal to the height of the flag pole.
Pennants
Figure 1.1 - Type of Continuation Pattern - Pennants

Flags:

Flags are continuation patterns that form when the price of a stock in a parallel channel pulls back from the dominant trend. They may be bullish or bearish, depending on the pattern preceding the formation of the flag. It is a bullish continuation pattern if the stock was in an uptrend prior to the formation of the flag. It is a bearish continuation pattern if a stock was in a downtrend before the flag started to form. Flags usually form over shorter time periods.

Flags all have the following five characteristics (Refer Figure 1.2):

  • Resistance level (A): A level of resistance that is down trending and parallel to the support level (bullish flag), or an up-trending level of resistance that is parallel to the support level (bearish flag).
  • Support level (B): A level of support that is down trending and parallel to the resistance level (bullish flag), or an up-trending level of support that is parallel to the resistance level (bearish flag).
  • Flag pole (C): The trend that occurs prior to the creation of the flag. The flag pole spans the distance from the start of the trend to the highest point of the flag (bullish flag), or it spans the distance from the start of the trend to the lowest point of the flag (bearish flag).
  • Breakout point (D): The point at which the stock breaks up above the down-trending level of resistance (bullish flag) or breaks down below the up-trending level of support (bearish flag).
  • Price forecast (E): The price at which the stock is most likely to fall after breaking out of the flag formation (bearish flag), or the price at which the stock is most likely to rise after breaking out of the flag formation (bullish flag). The estimated movement of the stock is equal to the height of the flag pole.
Flag Pattern
Figure 1.2 - Type of Continuation Pattern: Flag 

Wedges:

Wedges are continuation patterns that form when a stock’s price moves away from the prevailing trend and into a tighter and tighter consolidation range. They may be bullish or bearish, depending on the pattern prior to the formation of the wedge. It is a bullish continuation pattern if a stock was in an uptrend before the wedge formed. It is a bearish continuation pattern if a stock price was in a downtrend before the wedge formed. Wedges usually form over shorter time periods.

Wedges all have the following five characteristics (Reference Figure 1.3):

  • Resistance level (A): A level of resistance that is down trending and converging with the support level (bullish wedge), or an up-trending level of resistance that is converging with the support level (bearish wedge).
  • Support level (B): A downward trending level of support that is converging with the resistance level (bullish wedge), or an upward trending level of support that is converging with the resistance level (bearish wedge).
  • Flag pole (C): The trend that occurs prior to the creation of the wedge. The flag pole spans the distance from the start of the trend to the highest point of the wedge (bullish wedge), or it spans the distance from the start of the trend to the lowest point of the wedge (bearish wedge).
  • Breakout point (D): The point at which the stock rises above the down-trending level of resistance (bullish wedge) or falls below the up-trending level of support (bearish wedge).
  • Price forecast (E): The price at which the stock is most likely to fall after breaking out of the wedge formation (bearish wedge), or the price at which the stock is most likely to rise after breaking out of the wedge formation (bullish wedge). The estimated movement of the stock is equal to the height of the flag pole.
Wedges
Figure 1.3 - Type of Continuation Pattern: Wedges

Triangles:

Triangles are continuation patterns that form when a stock’s price reaches a flat level of support or resistance and starts to move into a tighter and tighter consolidation range. They may be bullish or bearish, depending on the pattern prior to the formation of the wedge. It is a bullish continuation pattern if the stock was in an uptrend before the triangle formed. It is a bearish continuation pattern if a stock was in a downtrend before the triangle formed. Triangles usually develop over longer time periods.

Triangles all have the following five characteristics (Refer Figure 1.4):

  • Resistance level (A): A horizontal level of resistance (bullish or ascending triangle) or a downward-trending level of resistance that is converging with the support level (bearish, or descending triangle).
  • Support level (B): An up-trending level of support that is converging with the resistance level (bullish, or ascending triangle), or a horizontal level of support (bearish, or descending triangle).
  • Flag pole (C): The trend that occurs prior to the creation of the triangle. The flag pole spans the distance from the start of the trend to the highest point of the triangle (bullish, or ascending triangle), or the flag pole spans the distance from the start of the trend to the lowest point of the triangle (bearish, or descending triangle).
  • Breakout point (D): The point at which the stock rises above the horizontal level of resistance (bullish, or ascending triangle) or falls below the horizontal level of support (bearish, or descending triangle).
  • Price forecast (E): The price at which the stock is most likely to fall after breaking out of the triangle formation (bearish, or falling triangle), or the price at which the stock is most likely to rise after breaking out of the triangle formation (bullish, or ascending triangle) (bullish, or ascending triangle). The estimated movement of the stock is equal to the height of the flag pole.
Type of Continuation Pattern: Triangles
Figure 1.4 - Type of Continuation Pattern: Triangles

Reversal Patterns

As we all know, stock traders are constantly asking themselves, “Will the pattern continue?” It is difficult to determine whether a trend has ended and whether it is time to trade against the previous trend. You never know when an stock will reverse and begin heading in the opposite direction. Or can you tell?

Reversal trends indicate when a stock is likely to reverse and begin a new trend, as well as how far the stock is likely to shift in the opposite direction. Of course, reversal trends are not infallible, but they do increase the chances of success.

Spend some time getting to know the following market reversal patterns:

  • Double tops/bottoms.
  • Triple tops/bottoms.
  • Head-and-shoulders top/bottoms

Double Tops/Bottoms:

Double tops/bottoms are reversal patterns that occur when a stock price reaches a support or resistance level twice before turning around and moving in the opposite direction. Double tops are bearish reversal patterns and double bottoms are bullish reversal patterns. A double top is formed when a stock is in an uptrend. In a downtrend, a stock will form a double bottom. Double tops/bottoms are more likely to shape over longer time period.

The following four features are shared by all double tops/bottoms:

  • Resistance level (A): Horizontal, or slightly angled, level of resistance.
  • Support level (B): Horizontal, or slightly angled, level of support.
  • Breakout point (C): The point at which the stock breaks up above the horizontal level of resistance (double bottom), or the point at which the stock breaks down below the horizontal level of support (double top).
  • Price projection (D): The price to which the stock will most likely fall after it has broken out of the double-top formation, or the price to which the stock will most likely rise after it has broken out of the double-bottom formation. The distance the stock is projected to move is equal to the distance between the support and resistance levels.
Figure 1.5 - Type of Reversal Pattern: Double Top

Triple Tops/Bottoms:

Triple tops/bottoms are reversal patterns formed when a stock price hits a support or resistance level three times before turning around and moving in the opposite direction. Bearish reversal patterns are triple tops, whereas bullish reversal patterns are triple bottoms. A triple top is formed when a stock is in an uptrend. In a downtrend, a stock will create a triple bottom. Triple tops/bottoms are more likely to form over time.

Triple tops/bottoms all have the following four characteristics:

  • Resistance level (A): Horizontal, or slightly angled, level of resistance.
  • Support level (B): Horizontal, or slightly angled, level of support.
  • Breakout point (C): The point at which the stock breaks up above the horizontal level of resistance (triple bottom), or the point at which the stock breaks down below the horizontal level of support (triple top).
  • Price projection (D): The price to which the stock will most likely fall after it has broken out of the triple-top formation, or the price to which the stock will most likely rise after it has broken out of the triple-bottom formation. The distance the stock is projected to move is equal to the distance between the support and resistance levels.
Figure 1.6 - Type of Reversal Pattern: Triple Top

Head-and-Shoulders Tops/Bottoms:

Head-and-shoulders tops are reversal patterns that emerge when a stock’s price reaches a resistance level (creating the first shoulder), then breaks through that level and hits a higher resistance level (creating the head), and then reaches the first resistance level again (creating the second shoulder).

Head-and-shoulders bottoms are reversal patterns that emerge when a stock’s price hits a support level (creating the first shoulder), then breaks through that level and hits a lower support level (creating the head), and then hits the first support level again (creating the second shoulder).

Bearish reversal patterns are head-and-shoulders tops, whereas bullish reversal patterns are head-and-shoulders bottoms. In an uptrend, a stock will form a head-and-shoulders top. A head-and-shoulders bottom forms when a stock is in a downtrend. Long amounts of time are normally required for the formation of head-and-shoulders tops and bottoms.

Head-and-shoulders tops/bottoms all have the following five characteristics:

  • Left shoulder (A): Horizontal or slightly inclined level of resistance (head-and-shoulders top) or horizontal or slightly inclined level of support (head-and-shoulders bottom).
  • Head (B): A higher horizontal, or slightly slanted, level of resistance (head-and-shoulders top), or a lower horizontal, or slightly slanted, level of support (head-and-shoulders bottom).
  • Right shoulder (C): A horizontal, or slightly angled, level of resistance aligned with the left shoulder (head-and-shoulders top), or a horizontal, or slightly slanted, level of support aligned with the left shoulder (head-and-shoulders bottom).
  • Neckline (D): Horizontal or slightly angled level of support (head-and-shoulders top), or horizontal or slightly angled level of resistance (head-and-shoulders bottom).
  • Breakout point (E): The point at which the stock rises above the neckline (head-and-shoulders top) or falls below the neckline (head-and-shoulders bottom).
  • Price projection (F): The price at which the stock is expected to fall after breaking out of the head-and-shoulders top formation, or the price at which the stock is expected to climb after breaking out of the head-and-shoulders bottom configuration. The distance between the head and the neckline is equivalent to the predicted movement of the stock.
Figure 1.7 - Type of Reversal Pattern: Head & Shoulder Top
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