Chart patterns are specific formations on the stock price charts. These formations represent recognizable patterns that are repeatedly seen in the market, and are used to determine the future movement of the stock prices.
The patterns represent the psychology of the market and investors, and also determine the future behaviour of the market.
In a completely rational market, these patterns may not exist. However, investors, traders, and managers react with similar emotions all the time, and exhibit repeated behaviour, which leads to these patterns. We can say that the patterns reflect the collective psychology of the market.
Traders can read these patterns, and forecast the future market movement to their advantage.
The chart patterns can be broadly classified as reversal patterns and continuation patterns.
Reversal chart patterns signal the ending on an ongoing trend, i.e., it signifies a reversal of asset’s price direction. For example, if the reversal pattern forms when the price is moving upwards, this signifies that the upward movement is over and the prices will move downwards now, and vice versa. There are various types of reversal chart patterns, such as Double Top, Double Bottom, Head and Shoulders, Inverse Head and Shoulders, Rising Wedge, and Falling Wedge.
Continuation chart patterns, on the other hand, signal that the ongoing trend will continue for some time. This means that after the formation, the price movement will continue to follow the same trend as it was before the formation. So, if the prices were moving upwards before the formation, they will continue to move upwards after the pattern formation also. This kind of pattern is also called healthy correction. If the price moves downwards, it will quickly start moving upwards, as another set of investors will start buying. The long term trend will continue to be the same. There are various continuation patterns, such as wedges, rectangles, pennants, and flags.
Apart from reversal and continuation chart patterns, there are also bilateral chart patterns. These are a little confusing and signal that the prices and move in either direction; upward or downward. The most common type of bilateral formations is triangle formations. At the end of the triangle formation, the price can break either upwards or downwards. When seeing triangle formations, the traders should be prepared for the action taking place on either side to benefit from the movements.
Proper identification of an ongoing trend can be a tremendous asset to the trader. However, the trader must also learn to recognize recurring chart patterns that disrupt the continuity of trendlines. Broadly speaking, these chart patterns can be categorized as reversal patterns and continuation patterns.
Reversal Chart Patterns:
Reversal patterns are important because they inform the trader that a market entry point is unfolding or that it may be time to liquidate an open position.
Slides 22 and 23 illustrate the most common reversal patterns & their trading targets:
Continuation & Bilateral Chart Patterns:
A continuation pattern implies that while a visible trend was in progress, it was temporarily interrupted, and then continued in the direction of the original trend. The most common continuation and bilateral patterns & their trading targets are shown in Slides 24-26:
The proper identification of a strong continuation patterns may prevent the trader from prematurely liquidating an open position that still has profit potential.