With one month of trading down in 2022, we thought it would be the perfect time to put together a crash course of our favorite chart patterns. Now if you don’t know what chart patterns are, then this is the perfect place to start. For those who have more experience but had a difficult January (don’t worry you’re not alone) then stick with us while we walk through what to look for in chart analysis.
What is a chart and why do we use it?
To start off, let’s go over the basics of a chart and how they help us be better traders. Charts provide a visual representation of how the price of a stock has moved over the past few days, weeks, months, quarters, and even years. Stock prices tend to move in trends and patterns. When it comes to creating our analysis, history indeed does repeat itself with price movement. Therefore reading previous movements in the charts gives us, as traders, an idea or an understanding of how price may move in the future in a stock we want to invest in.
Out of the many varied ways to utilize technical analysis, chart patterns are perhaps the most utilized and most researched. The reason for this may be entirely organic because the vast majority of strategies in technical analysis require a type of breakout to occur before we can execute a trade.
The most common chart patterns are shapes such as rectangles and triangles.
Chart patterns can be a blessing and a curse because every trader has an internal bias that will easily spot patterns that benefit their position, and can unconsciously filter patterns against their position.
Now let’s jump into our breakdown of the different patterns you might encounter.
To start we have a pattern called a “head and shoulders” with the reasoning behind it made clear by the image above, you have 3 peaks where the two on the outside resemble a pair of shoulders and the peak in the middle resembles a head. The head and shoulders pattern is believed to be one of the most reliable trend reversal patterns. It is one of several top patterns that signal, with varying degrees of accuracy, that an upward trend is nearing its end.
Simple enough right? This type of pattern is considered a reversal from bullish to bearish. The “Neckline” is the support level in which the stock has not fallen below. Now in terms of how would we want to trade when we see this pattern emerging? When the current price falls below the neckline, this could be an indicator that the price is going to start heading downwards, giving us the expected reversal or bearish downtrend.
Following up, we have the Inverse head and shoulders, which is the opposite of a Head and shoulders pattern. Therefore it is considered a bullish reversal pattern, where we expect the price to change from a negative trend to a positive trend. The way we would trade this pattern would be the same as the normal head and shoulders, having patience and watching the price action. When the price of the stock breaks the “neckline” we can potentially wait to see if the price break towards an upward trend. If the price holds above the neckline we can look towards the price target we want to trade for.
Getting the price target using Head and Shoulders or Inverse Head and Shoulder
Getting the price target from these two patterns is very simple.
If you using the Head and Shoulders pattern;
Find the difference between the top of the head and the neckline support level.
For example; the top of the head is $15, neckline line support level is $10. The difference is $5.
Now you’re going to subtract this difference from the neckline and that will be your price target.
Neckline – difference = $10 – $5 = $5 price target.
How to trade a Cup and Handle chart pattern
By now, I hope you guys are following along on the naming trend, they are all named after what they look like more or less. So now we are at the “Cup and Handle” pattern, which is a bullish, continuation trend. This pattern resembles the shape of a teacup on a chart and there is an uptrend before the formation of the cup and handle. Some may say it is more so shaped like the letter “U” – which is also a great description.
When beginning our analysis here, the cup itself is also important: it should be a nicely rounded formation, like a semi-circle where we can see the price consolidated. If the shape of the cup is too sharp (or quick), it is not considered a true consolidation phase in the upward trend and thus weakens the potential trade signal. So how would we want to trade this pattern? When forming the game plan here, we want to see the price of the stock hold above the neckline of the “handle”. From that point, if it holds, it can be an indicator that the price will be moving upward in price.
Okay folks, here we have two reversal patterns that can signal either the ending of a downtrend or the ending of an uptrend. It entirely depends on if we are seeing the top or the bottom as shown in the charts above.
When it comes to trading these, let’s start with what we want to see from the double bottom chart. The double bottom looks like the letter “W”. It touches a low / support level twice and then bounces back up. The double bottom pattern always follows a major or minor downtrend in particular security and signals the reversal and the beginning of a potential uptrend.
Now a double top is the complete opposite of that a Double Top. You can say that the double is shaped like an “M”.
The double signals the potential end to an upward trend meaning that price may soon start to head downward.
Now moving onto the ascending triangle, when it comes to this pattern, oftentimes it requires some patience. As you can see the pattern is formed by two distinct trendlines: a flat trendline being a point of resistance and a rising trendline acting as price support level. It will take time for the price to begin to consolidate in this fashion, and you will want to look for the breakout when getting into a trade based on this pattern. The time it takes for the price to consolidate can kill the premium on a short-term trade, so patience or a longer-term position is key here. Ascending triangles are considered a continuation pattern, as the price will typically break out of the triangle in the price direction prevailing before the triangle, although this won’t always occur. A breakout in any direction is noteworthy. A bullish trade is taken if the price breaks above the top of the pattern. A bearish trade is taken if the price breaks below the lower trendline.
Here we can see the opposite of the previous ascending triangle, it is a bearish pattern that requires patience to set up a short-term position. The descending triangle is constructed with a flat support line and a downward-sloping resistance line. The first part of this pattern is the fall to a low that then finds a level of support, which sends the price to a new high, rejects it, and goes back to the support level. This is repeated until the price is unable to hold the support level and falls below, resuming the downtrend. We will want to wait for the final break below the support level with a short-term trade to catch the fall before it finds its next support level.
Bear with us here, I know the name of the pattern may sound like it will be a continuation of a bearish trend, but here we will be looking for a breakout upwards from the downward trend. The trendlines of this pattern converge, with both being slanted in a downward direction as the price is trading in a downtrend.
The falling wedge upper resistance trendline should have a sharper slope than the support level in the wedge construction. When the lower (or support) trendline is clearly flattered as the pattern forms, it signals that selling pressure is weakening, as sellers have trouble pushing the price down. This indicates that prices will start to go up. The buy signal is formed when the price breaks through the upper resistance line, this breakout move should be on the heavier of buying volume.
Now, I don’t make the rules when it comes to trading, but the Rising Wedge will be our bearish trend pattern. The trendlines of this pattern converge, with both trend lines slanted in an upward direction. As the price moves towards the apex of the pattern, momentum is weakening. A move below the lower support would be viewed by traders as a reversal in the upward trend. This dropoff in buying interest is our signal to enter the trade. When the price breaks below the lower support line, this breakout move should be on the heavier side of selloff volume.
Bullish Flag Pattern
We made it to the end of this installment of our crash course in trading. But last but not least we have 1 more bullish pattern to go through. This chart pattern occurs when a stock is in a
strong uptrend. It is called a flag pattern because when you see it on a chart it looks like a flag on a pole and since we are in an uptrend it is considered a bullish flag. See, that wasn’t so bad, now there are a few other key points you will want to look out for, to use as confirmation.
- The stock has made a strong move up on high relative volume, forming the pole
- Stock consolidates near the top of the pole on a lighter volume, forming the flag
- Stock breaks out of consolidation pattern on high relative volume to continue the trend
Now Frank has a pretty outlined plan on how he would like you guys to trade this pattern, so I will outline it below for you guys.
- Stock is surging up on high relative volume, preferably from a news
- Prices consolidate at or near highs with a defined pullback pattern.
- Buy when prices breakout above the consolidation pattern on high
- Place stop orders below the bottom of the consolidation pattern.
- Profit targets should be at least 2:1 risk/reward. So, if you are risking 25
cents, then first PT is 50 cents from your entry price.
For everyone who’s made it to the end, I want to congratulate you on your commitment to getting better at analyzing charts and thank you for sticking with me through this guide. There is no fast way to be a good trader. Overnight success doesn’t happen in stocks but with time and commitment to learning to read the signals the market gives us, it is possible to be successful. Here at Tiger-Wolf we are committed to helping you guys achieve that success whether you are a part of our discord community or subscribe to our weekly newsletter, we are here to help you guys reach your trading goals.