Chart patterns can help us decide which trends are likely to continue or vice-versa.
There are mainly two kinds of patterns:
- Continuation Patterns - These include flags and pennants.
- Reversal Pattern - These include head and shoulders, inverse head and shoulders and double tops and bottoms.
Head and Shoulder:
The “head” is a price peak surrounded by two lower peaks or “shoulders”. A neckline connects the lows of declines from the left shoulder and the head.
A head and shoulder pattern can provide an approximate target for a new downtrend. This pattern also gives an excellent sell signal.
The author mentions some trading rules for a head and shoulder pattern:
- Sell when you can identify a head or the right shoulder of a head and shoulder pattern, based on low volume, a break of an uptrend, and a divergence between indicator and prices.
- The decline from the head establishes a neckline. If you are holding a long position, place a stop order below the neckline.
- When you sell short into the right shoulder, place your stop at the top of the head.
- After a neckline has been broken, and if the volumes are low, it is a short signal with a protective stop slightly above the neckline.
Inverse Head and Shoulder:
Inverse Head and shoulder is the exact mirror image of a head and shoulder, i.e., it looks like a person standing upside down. The head at the lowest point, surrounded by two shoulders.
The rules for inverse head and shoulders pattern are similar to a head and shoulders pattern.
If you trade at the bottoms of this pattern, the trades are riskier because prices at the bottom are more volatile.
A rectangle is a pattern that contains price movements of stocks between two parallel lines. The upper line of a rectangle identifies resistance, while the lower line of a rectangle identifies support. We can use Fibonacci Ratios and make a predictable price target.
Trading rules for a rectangle:
- If you buy at the lower boundary, place your protective stop slightly below the rectangle and if you short – sell at the upper boundary, place your protective stop slightly above the border.
- To find out whether an upside or a downside breakout is more likely, you should analyse the charts in a longer time frame than the one you’re trading in. For example, if you’re looking at a weekly chart, before making a decision look at the monthly chart. This can provide traders with a broader picture of the markets.
- Once you buy a breakout or sell short a downside breakout, place a protective stop slightly inside the rectangle.
Line and Flags:
A line is kind of a rectangle which is a correction of a primary trend. It is a congestion area whose height is approximately 3% of the current stock value.
A flag is a rectangle whose boundaries are parallel to each other and slant up or down. If a flag slants upward, a downward break is likely and vice-versa.
A triangle is a congestion area whose upper and lower boundaries converge on the right.
A small triangle whose height is 10 -15% of the preceding trend is likely to serve as a continuation pattern. Large triangles whose height equal a third or more of a preceding trend are likely to serve as reversal patterns.
Trading rules for Triangles:
1.If trading inside a triangle, oscillators such as stochastic help in catching minor swings.
2.Refer to the weekly chart when you’re deciding whether a triangle on a daily chart is likely to lead to an upside or downside.
3.When in an upside breakout, place a buy order slightly above the upper boundary of a triangle and vice-versa.
4.A pullback on heavy volume threatens to abort the breakout, but a pullback on light volume offers a good opportunity to buy.
Double Tops and Bottoms:
Double tops occur when the price of a stock rallies from the area of the previous high. Double bottoms occur when prices fall near the previous low. Buying at double bottoms and selling short at double tops offers some of the best trading opportunities to a trader.