Introduction to Stock Chart Patterns

Investing News

Stock chart patterns often signal transitions between rising and falling trends. A price pattern is a recognizable configuration of price movement identified using a series of trendlines and/or curves.

When a price pattern signals a change in trend direction, it is known as a reversal pattern; a continuation pattern occurs when the trend continues in its existing direction following a brief pause. There are many patterns used by traders—here is how patterns are made and some of the most popular ones.

Key Takeaways

  • Patterns are the distinctive formations created by the movements of security prices on a chart and are the foundation of technical analysis.
  • A pattern is identified by a line connecting common price points, such as closing prices or highs or lows, during a specific period.
  • Technical analysts and chartists seek to identify patterns to anticipate the future direction of a security’s price.
  • These patterns can be as simple as trendlines and as complex as double head-and-shoulders formations.

Trendlines in Technical Analysis

Since price patterns are identified using a series of lines or curves, it is helpful to understand trendlines and know how to draw them. Trendlines help technical analysts spot support and resistance areas on a price chart. Trendlines are straight lines drawn on a chart by connecting a series of descending peaks (highs) or ascending troughs (lows).

A trendline that angles up, or an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows.

Trendlines will vary depending on what part of the price bar is used to “connect the dots.”

While there are different schools of thought regarding which part of the price bar should be used, the body of the candle bar—and not the thin wicks above and below the candle body—often represents where the majority of price action has occurred and therefore may provide a more accurate point on which to draw the trendline, especially on intraday charts where “outliers” (data points that fall well outside the “normal” range) may exist.

On daily charts, chartists often use closing prices, rather than highs or lows, to draw trendlines since the closing prices represent the traders and investors willing to hold a position overnight or over a weekend or market holiday. Trendlines with three or more points are generally more valid than those based on only two points.

  • Uptrends occur when prices are making higher highs and higher lows. Up trendlines connect at least two of the lows and show support levels below price.
  • Downtrends occur when prices are making lower highs and lower lows. Down trendlines connect at least two of the highs and indicate resistance levels above the price.
  • Consolidation, or a sideways market, occurs where price oscillates in a range between two parallel and often horizontal trendlines.

Types of Stock Chart Patterns

A price pattern that denotes a temporary interruption of an existing trend is a continuation pattern.

Continuation Patterns

A continuation pattern can be considered a pause during a prevailing trend. This is when the bulls catch their breath during an uptrend or when the bears relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell if the trend will continue or reverse. As such, careful attention must be placed on the trendlines used to draw the price pattern and whether the price breaks above or below the continuation zone. Technical analysts typically recommend assuming a trend will continue until it is confirmed that it has reversed.

In general, the longer the price pattern takes to develop, and the larger the price movement within the pattern, the more significant the move once the price breaks above or below the area of continuation.

If the price continues on its trend, the price pattern is known as a continuation pattern. Common continuation patterns include:

  • Pennants, constructed using two converging trendlines
  • Flags, drawn with two parallel trendlines
  • Wedges, constructed with two trendlines that would converge if they were long enough, where both are angled either up or down
  • Triangles are among the most popular chart patterns used in technical analysis since they occur frequently compared to other patterns. The three most common types of triangles are symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can last anywhere from a couple of weeks to several months.

Reversal Patterns

A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These patterns signify periods where the bulls or the bears have run out of steam. The established trend will pause, then head in a new direction as new energy emerges from the other side (bull or bear).

For example, an uptrend supported by enthusiasm from the bulls can pause, signifying even pressure from both the bulls and bears, then eventually give way to the bears. This results in a change in trend to the downside.

Reversals that occur at market tops are known as distribution patterns, where the trading instrument becomes more enthusiastically sold than bought. Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the trading instrument becomes more actively bought than sold.

The longer the pattern takes to develop and the larger the price movement within the pattern, the larger the expected move once the price breaks out.

When a price reverses after a pause, the price pattern is known as a reversal pattern. Examples of common reversal patterns include:

  • Head and Shoulders, signaling two smaller price movements surrounding one larger movement
  • Double Tops, representing a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level
  • Double Bottoms, showing a short-term swing low, followed by another failed attempt to break below the same support level

Pennant

Pennants are continuation patterns drawn with two trendlines that eventually converge. A key characteristic of pennants is that the trendlines move in two directions—one will be a down trendline and the other an up trendline. The figure below shows an example of a pennant. Often, the volume will decrease during the formation of the pennant, followed by an increase when the price eventually breaks out.

A bullish pennant is a pattern that indicates an upward trending price—the flagpole is on the left of the pennant.

Image by Sabrina Jiang © Investopedia 2020

A bearish pennant is a pattern that indicates a downward trend in prices. In a bearish pattern, volume is falling, and a flagpole forms on the right side of the pennant.

Flag

Flags are continuation patterns constructed using two parallel trendlines that can slope up, down, or sideways (horizontal). Generally, a flag with an upward slope (bullish) appears as a pause in a down trending market; a flag with a downward bias (bearish) shows a break during an up trending market. Typically, the flag’s formation is accompanied by declining volume, which recovers as price breaks out of the flag formation.

Image by Sabrina Jiang © Investopedia 2020 


Wedge

Wedges are continuation patterns similar to pennants in that they are drawn using two converging trendlines; however, a wedge is characterized by the fact that both trendlines are moving in the same direction, either up or down.

A wedge angled down represents a pause during an uptrend; a wedge angled up shows a temporary interruption during a falling market. As with pennants and flags, volume typically tapers off during pattern formation, only to increase once price breaks above or below the wedge pattern.

Wedges differ from triangles and pennants in that they reflect only upward and downward price movements, so the wedge generally appears angled.

Optuma


Ascending Triangle

An ascending triangle is a continuation pattern marking a trend with a specific entry point, profit target, and stop loss level. The resistance line intersects the breakout line, pointing out the entry point. The ascending triangle is a bullish trading pattern.

thinkorswim

Descending Triangle

The descending triangle is the opposite of the ascending triangle, indicating that demand is decreasing, and a descending upper trend line suggests a breakdown is likely to occur. 

thinkorswimg

Symmetrical Triangles

Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur—there is no upward or downward trend. The magnitude of the breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle, as shown in the figure below.

Image by Sabrina Jiang © Investopedia 2020


Cup and Handle

The cup and handle is a bullish continuation pattern where an upward trend has paused but will continue when the pattern is confirmed. The “cup” portion of the pattern should be a “U” shape that resembles the rounding of a bowl rather than a “V” shape with equal highs on both sides of the cup.

The “handle” forms on the right side of the cup in the form of a short pullback that resembles a flag or pennant chart pattern. Once the handle is complete, the stock may breakout to new highs and resume its trend higher.

Image by Sabrina Jiang © Investopedia 2020


Head and Shoulders

Head and shoulders is a reversal pattern that can appear at market tops or bottoms as a series of three pushes: an initial peak or trough, followed by a second and larger one, and then a third push that mimics the first.

An uptrend interrupted by a head and shoulders top pattern may experience a trend reversal, resulting in a downtrend. Conversely, a downtrend that results in a head and shoulders bottom (or an inverse head and shoulders) will likely experience a trend reversal to the upside.

Horizontal or slightly sloped trendlines can be drawn connecting the peaks and troughs between the head and shoulders, as shown in the figure below. Volume may decline as the pattern develops and spring back once the price breaks above (in the case of a head and shoulders bottom) or below (in the case of a head and shoulders top) the trendline.

Image by Sabrina Jiang © Investopedia 2020 


Double Top and Bottom

The double top or bottom are reversal patterns, signaling areas where the market has made two unsuccessful attempts to break through a support or resistance level.

A double top often looks like the letter M and is an initial push up to a resistance level followed by a second failed attempt, resulting in a trend reversal.

A double bottom, on the other hand, looks like the letter W and occurs when the price tries to push through a support level, is denied, and makes a second unsuccessful attempt to breach the support level. This often results in a trend reversal, as shown in the figure below.

Image by Sabrina Jiang © Investopedia 2020 

Triple tops and bottoms are reversal patterns that aren’t as prevalent as head and shoulders, double tops, or double bottoms. But, they act similarly and can be a powerful trading signal for a trend reversal. The patterns are formed when a price tests the same support or resistance level three times and cannot break through.

The double bottom occurs when there are two troughs at the same height, indicating that sellers are in a weaker position than they were.

Gaps

Gaps are reversal patterns. They occur when there is space between two trading periods caused by a significant increase or decrease in price. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or other news.

There are three main types of gaps: Breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps form near the end of the trend.

Image by Sabrina Jiang © Investopedia 2020


How Many Types of Chart Patterns Are There?

Depending on who you talk to, there are more than 35 patterns used by traders. Some traders only use a specific number of patterns, while others may use much more.

What Is the Strongest Chart Pattern?

The strongest chart pattern is determined by trader preference and methods. The one that you find works best for your trading strategy will be your strongest one.

What Are the Different Graph Patterns?

There are generally three groups of patterns: continuation, reversal, and bilateral. Some traders classify ascending, descending, and symmetrical triangles in a separate group called bilateral patterns, and some only include symmetrical triangles in the bilateral group.

What Do Chart Patterns Mean?

Traders use chart patterns to identify stock price trends when looking for trading opportunities. Some patterns tell traders they should buy, while others tell them when to sell or hold.

The Bottom Line

Price patterns are often found when the price “takes a break,” signifying areas of consolidation that can result in a continuation or reversal of the prevailing trend. Trendlines are important in identifying these price patterns. Some that can appear are flags, pennants, and double tops.

Volume plays a role in these patterns, often declining during the pattern’s formation and increasing as price breaks out of the pattern. Technical analysts look for price patterns to forecast future price behavior, including trend continuations and reversals.

Articles You May Like

Debt-To-Equity (D/E) Ratios for the Utilities Sector
Today’s Mortgage Rates & Trends – September 28, 2022: Rates soar
Stocks making the biggest moves premarket: Nike, Micron, Amylyx and others
Best Stocks to Buy for a Massive Rebound Rally
Pimco’s Ivascyn sees a mild recession ahead and several investing opportunities