Technical Analysis: Chart Patterns

A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign
of future price movements. Chartists use these patterns to identify current trends and trend
reversals and to trigger buy and sell signals.
In the first section of this tutorial, we talked about the three assumptions of technical analysis,
the third of which was that in technical analysis, history repeats itself. The theory behind
chart patters is based on this assumption. The idea is that certain patterns are seen many
times, and that these patterns signal a certain high probability move in a stock. Based on the
historic trend of a chart pattern setting up a certain price movement, chartists look for these
patterns
to
identify
trading
opportunities.
While there are general ideas and components to every chart pattern, there is no chart pattern
that will tell you with 100% certainty where a security is headed. This creates some leeway
and debate as to what a good pattern looks like, and is a major reason why charting is often
seen as more of an art than a science. (For more insight, see Is finance an art or a science?)
There are two types of patterns within this area of technical analysis, reversal and
continuation. A reversal pattern signals that a prior trend will reverse upon completion of the
pattern. A continuation pattern, on the other hand, signals that a trend will continue once the
pattern is complete. These patterns can be found over charts of any timeframe. In this section,
we will review some of the more popular chart patterns. (To learn more, check out
Continuation Patterns - Part 1, Part 2, Part 3 and Part 4.)
Head
and
Shoulders
This is one of the most popular and reliable chart patterns in technical analysis. Head and
shoulders is a reversal chart pattern that when formed, signals that the security is likely to
move against the previous trend. As you can see in Figure 1, there are two versions of the
head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern
that is formed at the high of an upward movement and signals that the upward trend is about
to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the
right) is the lesser known of the two, but is used to signal a reversal in a downtrend.

Figure 1: Head and shoulders top is shown on the left. Head and shoulders bottom, or inverse head

and shoulders, is on the right.

Both of these head and shoulders patterns are similar in that there are four main parts: two
shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a
high and a low. For example, in the head and shoulders top image shown on the left side in
Figure 1, the left shoulder is made up of a high followed by a low. In this pattern, the neckline
is a level of support or resistance. Remember that an upward trend is a period of successive
rising highs and rising lows. The head and shoulders chart pattern, therefore, illustrates a
weakening in a trend by showing the deterioration in the successive movements of the highs
and
lows.
(To
learn
more,
see
Price
Patterns
Part
2.)
Cup
and
Handle
A cup and handle chart is a bullish continuation pattern in which the upward trend has paused
but will continue in an upward direction once the pattern is confirmed.

Figure 2
As you can see in Figure 2, this price pattern forms what looks like a cup, which is preceded
by an upward trend. The handle follows the cup formation and is formed by a generally
downward/sideways movement in the security's price. Once the price movement pushes
above the resistance lines formed in the handle, the upward trend can continue. There is a
wide ranging time frame for this type of pattern, with the span ranging from several months
to
more
than
a
year.
Double
Tops
and
Bottoms
This chart pattern is another well-known pattern that signals a trend reversal - it is considered
to be one of the most reliable and is commonly used. These patterns are formed after a
sustained trend and signal to chartists that the trend is about to reverse. The pattern is created
when a price movement tests support or resistance levels twice and is unable to break
through. This pattern is often used to signal intermediate and long-term trend reversals.

Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown on the
right.
In the case of the double top pattern in Figure 3, the price movement has twice tried to move
above a certain price level. After two unsuccessful attempts at pushing the price higher, the
trend reverses and the price heads lower. In the case of a double bottom (shown on the right),
the price movement has tried to go lower twice, but has found support each time. After the
second bounce off of the support, the security enters a new trend and heads upward. (For
more in-depth reading, see The Memory Of Price and Price Patterns - Part 4.)
Triangles
Triangles are some of the most well-known chart patterns used in technical analysis. The
three types of triangles, which vary in construct and implication, are the symmetrical triangle,
ascending and descending triangle. These chart patterns are considered to last anywhere from
a couple of weeks to several months.

Figure 4
The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward
each other. This pattern is neutral in that a breakout to the upside or downside is a
confirmation of a trend in that direction. In an ascending triangle, the upper trendline is flat,
while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern
in which chartists look for an upside breakout. In a descending triangle, the lower trendline is
flat and the upper trendline is descending. This is generally seen as a bearish pattern where
chartists
look
for
a
downside
breakout.
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. This pattern is then
completed upon another sharp price movement in the same direction as the move that started
the trend. The patterns are generally thought to last from one to three weeks.

Figure 5
As you can see in Figure 5, there is little difference between a pennant and a flag. The main
difference between these price movements can be seen in the middle section of the chart
pattern. In a pennant, the middle section is characterized by converging trendlines, much like
what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other
hand, shows a channel pattern, with no convergence between the trendlines. In both cases, the
trend is expected to continue when the price moves above the upper trendline.
Wedge
The wedge chart pattern can be either a continuation or 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.

Figure 6
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 is bullish and a
rising wedge is bearish. In Figure 6, we have a falling wedge in which two trendlines are
converging in a downward direction. If the price was to rise above the upper trendline, it
would form a continuation pattern, while a move below the lower trendline would signal a
reversal
pattern.
Gaps
A gap in a chart is an empty space between a trading period and the following trading period.
This occurs when there is a large difference in prices between two sequential trading periods.
For example, if the trading range in one period is between $25 and $30 and the next trading
period opens at $40, there will be a large gap on the chart between these two periods. Gap
price movements can be found on bar charts and candlestick charts but will not be found on
point and figure or basic line charts. Gaps generally show that something of significance has
happened in the security, such as a better-than-expected earnings announcement.
There are three main types of gaps, breakaway, runaway (measuring) and exhaustion. A
breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend
and an exhaustion gap forms near the end of a trend. (For more insight, read Playing The
Gap.)
Triple
Tops
and
Bottoms
Triple tops and triple bottoms are another type of reversal chart pattern 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; this signals a
reversal of the prior trend.

Figure 7
Confusion can form with triple tops and bottoms during the formation of the pattern because
they can look similar to other chart patterns. After the first two support/resistance tests are
formed in the price movement, the pattern will look like a double top or bottom, which could
lead
a
chartist
to
enter
a
reversal
position
too
soon.

Rounding
Bottom
A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that
signals a shift from a downward trend to an upward trend. This pattern is traditionally thought
to last anywhere from several months to several years.

Figure 8
A rounding bottom chart pattern looks similar to a cup and handle pattern but without the
handle. The long-term nature of this pattern and the lack of a confirmation trigger, such as the
handle in the cup and handle, makes it a difficult pattern to trade.
We have finished our look at some of the more popular chart patterns. You should now be

able to recognize each chart pattern as well the signal it can form for chartists. We will now
move on to other technical techniques and examine how they are used by technical traders to
gauge price movements.