Technical analysis, like we said before, is not just about charts. It does, however, rely heavily on them and often uses chart patterns to assist in making trading decisions.
The underlying theory is that traders often expect chart patterns to repeat, and this prediction is what presents them with various trading opportunities.
The most common chart patterns are:
Chart patterns – Triangles
Triangles represent continuation patterns and there are three main types;
Symmetrical Triangles – Neutral pattern signaling breakout to either side, though usually a continuation pattern
So how do you spot a systematic triangle pattern?
Symmetrical triangles have distinct pattern signs and these can be seen in the image below
The slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle.
In the below example of a systematic triangle the market is making lower highs and higher lows. This type of price activity is called consolidation.
Traders who use symmetrical triangles are often looking for a breakout; i.e. when the pattern reaches a stage where the price moves decisively in one direction or the other. Much like we explained in the Bollinger “squeeze” a breakout often occurs after a consolidation as seen below; traders wait for the price to either move above the top trend line or below the bottom trend line.
Ascending Triangles – Bullish continuation pattern
Ascending triangles also have pattern traits with which you can identify it.
Ascending triangles are experienced in instances where there is a resistance level coupled with a slope of higher lows as seen below;
Again traders will often wait to see if the price finally breaks the resistance level, at which point the price could breakout decisively to the upside as seen below
The alternative occurs when the resistance level proves too strong for an upward break through and the price move reverses downwards.
Descending Triangles – Bearish continuation pattern
Finally there are descending triangles; Descending triangles are essentially the opposite of ascending triangles.
Upper trend line downwards sloping
Lower trend line horizontal / flat
Both trend lines converging together
Breakout to the downside through lower support
Above we can see a descending series of highs, which forms the upper line. The lower line is a support level in which the price cannot seem to move below.
Unlike with ascending triangles where traders are waiting for an uptrend breakthrough traders witnessing a descending triangle are expecting a bearish market and are waiting to see if the price eventually makes a breakout to the downside through the support level.
The alternative scenario will occur when the support level proves too strong for a downward break; the price will then be seen to “bounce” off of the support level and generally begin in an upward movement.
Double Tops – Reversal Pattern
A double top is a bearish reversal pattern that is formed after there is an extended move up.
The “tops”, as seen above, are peaks which are formed when the price hits a resistance level that appears it is unable to break.
We can see in the diagram above that having bounced off the support level slightly the price then returns to re-test the support again. If the price is unable to break through the support level for a second time and is seen to bounce off of that level again, a DOUBLE top chart pattern has been formed.
Referring back to the diagram above again we can see that the 2nd “top” was unable to break the high of the 1st. Traders often interpret this as a strong sign that a reversal is going to occur as this movement implies that the buying pressure is lessening.
When using double tops as a form of analysis traders will often look to go short below the level which is referred to as the “neck line”. When the price level falls below the neckline traders will expect the reversal of an upward trend.
Double Bottom – Reversal Pattern
A double bottom is the opposite of a double top. It is a bullish trend reversal formation, meaning that unlike with double tops traders are now looking for the price to reverse upwards after it has been coming down.
Head and Shoulders
Head and shoulders is another form of a reversal pattern which has two main types;
Head and Shoulders
Head and Shoulders is formed by a peak, known as the “shoulder” which is then followed by another higher peak, the “head”. Following on from this high peak [head] another shoulder is seen depicting a lower peak.
Finally we can see that there is a neckline which is drawn by connecting the lowest points of the two troughs. Although in this case the neckline is a straight line it can be either upwards or downwards sloping.
Much the same as double bottom and top formations traders using head and shoulders will also look to sell once the price falls just below the neckline as it is thought to imply an impending downward trend.
Reverse Head and Shoulders
A reverse head and shoulders is pretty self explanatory; it’s a head and shoulders formation, in reverse.
An inverse head and shoulders formation is a bullish reversal pattern and so traders will look to buy when the price increases above the neck line as they will be expecting an upward trend break through.
Japanese Candlestick Formations
Basic candlestick patterns – Spinning Tops
A spinning top is one of the most commonly seen candlestick patterns. This type of pattern is often regarded as neutral and indicates indecision between buyers and sellers and the future movements of an asset.
We can see above that the body of the spinning top is small despite there possibly being a large amount of price fluctuation during the day. It is also either green or red in colour, indicating an upward or downward sentiment.
Traders use the presence of a spinning top to predict whether there is an impending up or downward trend. For example if after a long uptrend a spinning top forms this generally means that buyers have begun to lose interest and it is indicative of an impending downtrend. The opposite is also true.
Basic candlestick patterns – Marubozu
Marubozu pattern at first glance looks very similar to the spinning top candlectick formation described above.
The main differences between the two are that the marubozu are larger in size and unlike spinning tops do not have shadows. Again the two colours, green and red, indicate whether the market is bullish or bearish.
We can see for example in a bullish market that the open price = low price and that the high price = close price. The green marubozu pattern is often seen as the first part of a bullish continuation or a bullish reversal pattern and so may traders will buy into a market in which they see a bullish marubozu.
The opposite here is the bearish marubozu which is seen in red. In this case the low price = close price and open price = high price. A bearish marubozu implies an impending bearish reversal or a bearish continuation and so many traders use the red marubozu as an indication to sell into the market.
Basic candlestick patterns – Doji
Doji candlesticks are said to be “neutral” as they do not indicate a definitive upward or downward trend and so indicate indecision amongst traders.
Doji candlesticks are in a way similar to spinning top candlesticks in that they have very small bodies, in the case of Doji the body is simply a bar as seen below. Also similar to spinning tops, Doji candlestick patterns can be seen to display long shadows.
There are four main types of Doji candlesticks;
First let us look at the long-legged Doji – here we can see that opening and closing prices were essentially equal. This long legged Doji implies that there is almost equilibrium between supply and demand and that there may be a turning point in the prices direction approaching.
Next there is the dragonfly Doji – similar to the long-legged Doji the dragonfly Doji also forms when an assets opening and closing prices are equal. The long bottom shadow however means that this equilibrium took place at the high of the day. Again it implies that the direction of the trend is nearing a major breakthrough with the longer lower shadow implying the possible reversal of a bearish trend.
A gravestone Doji is essentially the opposite of the dragonfly Doji explained above. It forms when the opening and closing prices are equal and occur at the end of the day. The long upper shadow implies that the days buying pressure was countered by sellers and that a bullish uptrend is about to be reversed.
Finally a four price Doji is a candlestick formation where the day’s high, low, open and close price were all equal. This is the most neutral of all the Doji candlestick formations and does not occur often. It is seen mostly in times where there is a very low volume of trading such as after hours and is often disregarded by traders as being a result of bad data.
Although Doji Candlesticks are important, it is their combination with preceding patterns which traders look most at. For example, if a Doji candlestick appears after a series of candlesticks with long green bodies it is an indication that buying pressure is weakening. Conversely, if a Doji candlestick is seen after a series of red candlesticks this is an indication that selling pressure is weakened.
Basic candlestick patterns – Hammer and Hanging man
The hammer and hanging man look very similar with short bodies and long lower tails, but they have very different indications.
The hammer, which can be seen above on the left in green, is a bullish reversal pattern that forms during a downtrend. When prices are falling hammers signal that the support level has been approached and prices may well begin to rise again. Traders often take a hammer man as in indication of an impending price rise, but it is always safer to wait a while and confirm a bullish trend before buying.
The hanging man, which can be seen above in red, is the opposite of the hammer man. It is a bearish reversal pattern that often is seen to mark a top or strong resistance. When price rises the formation of a hanging man is often taken by traders as an indication that selling pressure is larger than upward buying pressure.
Basic Candlestick Patterns: Inverted Hammer & Shooting Star
The inverted hammer occurs when a falling price indicates the possibility of a reversal. Its long upper shadow as seen below showing us that buyers are attempting to counter the downwards pressure and were able to close the session near its open as opposed allowing the price to be pushed down further.
The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when prices have been rising.
Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. Conversely to the inverted hammer the shooting star shows us that sellers countered the upward pressure of buyers and were able to keep the day’s close almost equal to its open and avoid any further upward pressure.