Understanding different chart patterns and how they can make you a more successful trader
Charting is one of the corner stones of trading as a trader is able to glean huge amounts of information from a single chart. Chart patterns can indicate that a price direction is about to change or continue. Even those traders who are critics of technical analysis will also occasionally use charts, so being able to read a chart is vital. This article will review the commonly adopted western charting patterns that give you the ability to identify and predict potential trade setups based on the chart shapes occurring on your chart. After you become an expert on charts, that’s when you can start to incorporate further enhancements to it, like looking at volume and adding a further indicator. We hope the information in this article will improve your trading; you can find out more information about these and other chart patterns such as double tops and bottoms, triple tops and bottoms, and trend vs. chop at our website: Learn Forex Trading | Online forex course | Professional Forex Training.
So, what are Western Charting Patterns? Let’s start off with triangular patterns that form the shape of a triangle where two trend lines converge. A triangular pattern can be symmetrical (flat), descending or ascending. A symmetrical triangle is what is known as a continuation pattern - it signals a phase of consolidation in a trend, followed by a period of continuation of a previous trend. The triangle is created where a descending resistance trend line and an ascending support trend line meet. The point at which they meet is called the apex point, and from there, the two trend lines will have a similar slope (hence the name symmetrical). In a symmetrical triangle, the asset price will tend to bounce between the trend lines aiming for the apex, and eventually break out in the direction of the previous trend, as you can see in the chart below. For example, if the previous trend was downwards, you would look for a break below the ascending support line (and vice versa), although bear in mind that this does not always lead to a continuation of the previous trend. If the break is through the opposite direction of the previous trend, this could signal the formation of a new trend. The pattern will finish when the price breaks out from the triangle, so keep an eye out for an increase in volume.
The second type of triangle is the ascending triangle. An ascending triangle is a bullish pattern, showing you that the price is headed higher upon completion. This pattern is also created by two trend lines, but in this case there will be a flat line at a point of resistance and an ascending trend line acting as price support. The price will fluctuate between these trend lines until it breaks out above the flat line, and an upward trend usually follows. You need to keep an eye on the ascending support line, as will show you when sellers are starting to leave the market. This is important because, once sellers are out, the buyers are likely to take the price above the resistance point and continue an upward trend. This is shown in the chart below.
A descending triangle is the exact opposite of an ascending triangle and it is a bearish pattern since it shows you that the price will fall upon completion of the pattern. It is made up of a flat support line and a downward sloping resistance line. This pattern is a continuation pattern and it tends to be preceded by a downward trend line. It starts out with a decrease to a low point which sends the price higher. It will then test the descending trend line aiming for the apex until the price is unable to support the level - and this results in a downward trend.
The next type of chart patterns to consider are wedge patterns. These tend to signal a reversal in trend - looking similar to a symmetrical triangle - where the asset price is contained within a band, with a level of support and resistance. Wedge patterns tend to be a longer-term pattern than their triangular counterparts, and last for many months at a time. They are made up of converging trend lines which slant in either an upwards or downwards direction.
There are two types of wedges, rising and falling. A falling wedge pattern gives a bullish pattern signal. It shows the price break upwards through the wedge and resistance level into an uptrend. It is similar to a triangular pattern in that the price movement bounces between the two trend lines. The difference is that in a falling wedge, you’ll notice a larger gradient in the upper trend line. The lower trend line will be flatter, and this signals that selling pressure is easing. This means sellers will have trouble pushing the price down further. Thus, a buy signal will be created when the price breaks through the upper resistance line. Due to the long term nature of this pattern, though, it is wise to wait and make sure the price has successive closes above the resistance line.
A rising wedge pattern is the opposite of a falling wedge and gives a bearish pattern signal. It will show the price break downwards through the wedge and support level into a downtrend. As you can see from the chart below, again it’s similar to triangular patterns because the price movement bounces between the two trend lines.
In a rising wedge, the gradient of the lower trend line will be greater and the upper trend line flatter. This shows you that momentum is easing; so buyers have trouble pushing the price up further when the asset is under pressure. Thus, a sell signal will be developed when the price breaks through the lower support line. This shows you that sellers are starting to gain momentum. Again, though, due to the long term nature of wedge patterns, you’re better off making sure the price has successive closes below the support lines.
Pennant patterns form where there is a large price movement followed by a sideways movement, which creates a pennant. You can tell the pattern is complete when it breaks out in the same direction of the sharp price movement. You will usually see a similarly sharp move in the same direction as the previous move - this is because after a significant price movement, it takes time for the market to consolidate before resuming its trend. As you can see in the chart below, a pennant looks a lot like a symmetrical triangle, made up of support and resistance trend lines which converge to an apex. However, the direction of a pennant in usually quite flat.
Also, in a pennant pattern, there is no need to test the support and resistance lines several times (as a triangular pattern does). This is because this style of pattern usually has quite a short time frame due to the large market movement.
Flag patterns are much like pennants, in that they are formed following a move in one direction, then the pair consolidates sideways within a range before the range is finally broken.
They can be thought of as a failed double top, which is why you should always wait for confirmation of a signal, because there are numerous chart formations which, until confirmed by a break of a level, will suggest moves in the opposite direction. Flags should be traded in the same way as a pennant. Wait for a break above the top of the flag for a bullish pattern, before entering at the first retracement back to the broken level.
There is literature suggesting that profit targets beyond the top of the flag should be equal the size of the flag pole, however, this is more of a guide than a hard rule, so aim for that price but be on the lookout for trend exhaustion. As usual, remove risk as quickly as possible by placing stops to breakeven once a good way into the continuation. These patterns are of course possible in both directions, merely draw the flag upside down with a downtrend followed by sideways consolidation before a break to the downside.
A tip: Keep your eye on the volume - it’s a key aspect to look for on breakouts and will confirm a good signal.
The Head and Shoulders pattern is primarily traded as a reversal pattern. The pattern consists of a left shoulder, a head, a right shoulder and a neck line, as can be seen in the chart below:
Note the daily timeframe on these charts and how long they took to play out. They are relatively rare patterns on daily charts but work wonderfully when they appear. The head is the largest of the 3 peaks and the shoulder should never exceed the neckline. Typically, the neckline can slope in any direction as long as it is consistent across the pattern. Many people talk about downward sloping necklines playing out better although this has never been formally tested.
Typically, the trading strategy is simple. You place a sell order below the neckline of the right shoulder, and aim for the distance between the top of the head and the neckline as a target. The reason this typically works is that is shows some market sentiment around the currency pair in question. Essentially the left shoulder is an initial test of highs that struggles back towards the neckline but finds more buyers who push it higher. This test clears the orders initially eroded at the right shoulder, and makes a new high the head. This then collapses as sellers take hold. Typically, the right shoulder then comes as you attempt to erode orders once again at the neckline and get some minor profit taking from people who sold at the head. This finally results in another failed run at the highs, the head set at the right shoulder as market sentiment changes. This results in more sellers than buyers at the neckline, and hence we break through. It’s a nice pattern to run your multiple targets and exits on as well, booking profit at your 2:1 reward vs risk and letting the rest trail to see a much larger move. The counter of the head and shoulders pattern is the inverse Head and Shoulders. The principle is simple here, reverse the pattern above for a buy signal.
These are both really nice breakout plays and can be combined with a lot of chart patterns to form a really nice trading plan. Although this style can work on various timeframes, it generally seems to be more effective on higher timeframes as the patterns have more orders behind them. However, like many patterns, a lot of the skill comes in the experience of spotting them and then the patience of waiting to enter your signal. The reason it is key to wait on this one and have an order below the neckline is that if you were too short at the right should the pattern may not be confirmed, and you might find that instead there is another run to highs and you therefore get stopped out. For stops, typically put these above the right shoulder and tail them down, thus giving the trade room to breath if there is volatility.