Classical Chart Patterns
As we have discussed in the previous section, that market can be either in the trending phase or in a range-bound phase. No trend generally lasts forever in the market. After prolonged or medium or shorter duration up and downtrend, the market often reverses and a move starts in the opposite direction of the prior move. Often we find that well defined geometrical patterns are formed in the chart which provides a good indication of price reversals. These patterns are called reversal classical chart patterns. When they are formed as a bullish reversal pattern they are said to be part of accumulation. On the other hand, if they are formed at the top of a price move just before a bearish reversal, then they are part of the distribution.
However, a geometrically shaped consolidation does not necessarily mean price reversal. Often price resumes the erstwhile trend post the consolidation move. These are called continuation classical chart patterns. We will discuss a few of them in the upcoming sections of our module.
Head and Shoulder & Inverse Head & Shoulder
Head and Shoulder pattern is a bearish reversal pattern. This pattern appears after an uptrend. This pattern is formed with three consecutive tops with the middle one being higher than the other two. The middle top is called the head and the two side peaks are called the shoulders. On joining the intermediate troughs, we get the neck-line. On an ultimate break below the neckline, usually, a short trade is taken with a stop-loss above the top of the nearest shoulder. The target is usually considered as the distance between the neckline and head, projected from the point of break. If the volume in the down leg of the right shoulder is on the higher side and breakout happens with high volume, the conviction is on the higher side for the reversal.
An Inverse Head and Shoulder is just a mirror image of the Head and Shoulder pattern. This should appear after a sustained down trend, the rule of stop loss and target are similar. This often acts as a very effective bullish reversal pattern.
Double Tops and Bottoms
These chart patterns are well-known patterns that signal a trend reversal – these are considered to be one of the most reliable patterns and are commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. These patterns are created when price movement tests support or resistance levels twice and is unable to break through. These patterns are often used to signal intermediate and long-term trend reversals.
Triple Tops and Bottoms
These are another set of reversal chart patterns in chart analysis. These are not as prevalent in charts as Head and Shoulders and Double Tops and Bottoms, but they act in a similar fashion. These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through. They signal a reversal of the prior trend. Trade entry is initiated at the break of a neckline with a small stop-loss and the target is measured as the distance between peaks/troughs and the neckline.
Triangles are one of the most well-known chart patterns used in technical analysis. The three most common types of triangles, which vary in construction and implications, are Symmetrical Triangle, Ascending Triangle, and Descending Triangle. These chart patterns are considered to last anywhere from a couple of weeks (ideally more than 12 weeks) to several months. These are areas of consolidations after a trending move and are generally continuation patterns, i.e. the erstwhile trends resume after the breakout. However, in certain cases, they act as reversal patterns. They can appear both in up-trend and down-trend.
Flag and Pennant
These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. The patterns are generally thought to last from one to three weeks (Can last from 1 to 12 weeks but ideally they should last between 1 and 4 weeks). They can appear both in up-trend and down-trend.
The Wedge chart pattern can be either a continuation or a reversal pattern. It is similar to a Symmetrical Triangle except that the Wedge Pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that Wedges tend to form over longer periods, usually between three and six months. The fact that Wedges are classified as both continuation and reversal patterns, can make reading signals confusing. However, at the most basic level, a falling wedge in and is bullish and a rising wedge in a downtrend is considered bearish.