Chart Patterns and Formations

The two basic elements of technical analysis, and the study of chart patterns in particular, are the concepts of support and resistance and trend lines. The Dow Theory of trends, for example, is based on support and resistance and states that a market is in an uptrend when it makes higher highs and higher lows, and is in a downtrend when it makes lower lows and lower highs. The highs are formed at resistance levels where selling is strong enough to reverse the rally in prices while the lows are formed at support levels where buying is strong enough to reverse the decline in prices. However, support and resistance lines, which are horizontal lines, are often confused with trend lines, which are lines that slope in the direction of the trend.

Continuation Patterns

The Ascending Triangle Pattern

The ascending triangle pattern is similar to the symmetrical triangle except that its upper trend line is a horizontal resistance line. Ascending triangles are generally bullish in nature and are most reliable when they appear as a continuation pattern in an uptrend. In these patterns, buyers slightly outnumber sellers. The market becomes overbought and prices start to drop. However, buyers then re-enters the market and prices are driven back up to the recent high, where selling occurs once more. Buyers re-enter the market, but at a higher level than before. The result is a steady high at more or less the same level but series of higher lows. Prices eventually break through the resistance level where the high peaks were formed and are propelled even higher as new buying comes in and volume increases.

The Descending Triangle Pattern

The descending triangle pattern is similar to the symmetrical triangle except that its lower trend line forms a horizontal support line. Descending triangles are bearish in nature and are most reliable when they appear as a continuation pattern in a downtrend. In these patterns, sellers slightly outnumber buyers. The market becomes oversold and prices start to climb. However, sellers then re-enters the market and prices are driven back down to the recent low, where buying occurs once more. Sellers re-enter the market, but at a lower level than before. The result is lower highs with a steady low. Prices eventually break through the support line where the lows were formed and are propelled even lower as selling increases along with an expansion in volume.

Symmetrical Triangles

Symmetrical triangles are chart patterns that can appear in an uptrend or a downtrend and are characterized by a series of higher lows and lower highs. When the support trend line joining consecutive lows and the resistance trend line joining consecutive highs are drawn, they result in a convergence of two trend lines with a degree of symmetry. These symmetrical triangles indicate a period of indecision when the forces of supply and demand in the market are nearly equal. During these conditions attempts to push the price up are met with selling and attempts to push the price down are met with buying. There is also a tendency for volumes to drop off during the formation of this pattern. Eventually the price will break out of the triangle, usually this break out is accompanied by an increase in volume, and is usually in the direction of the preceding trend. Elliott Wave practitioners also see symmetrical triangles as part of a correction that interrupts the larger trend, though the symmetrical triangle can also be part of a complex correction.

The Pennant Pattern

The pennant pattern is another short-term continuation pattern that marks the mid-point of a longer movement. It is similar to the flag pattern with the consolidation period forming a small triangle rather than a parallelogram or a rectangle. The pennant is the consolidation phase that forms after a rapid, near vertical movement, and is usually characterized by a decrease in volumes. The consolidation period formed by profit taking by traders that entered before the sharp movement, and traders who missed the initial movement and see this phase as a opportunity to enter the trade. The formation of the pennants coincides with a decline in volumes until the break out, which usually occurs within 15-20 periods.

The Flag Pattern

The flag pattern is one of the short-term continuation patterns. It is quite similar to the pennant pattern with the “flag” representing a relatively short consolidation period following a sharp price movement and marks the mid-point of a longer price movement. It is not a reversal pattern.

The flag pattern occurs when the chart tracks a rapid, near vertical price movement that is followed by a short period of congestion or consolidation that is characterized by lower volumes. The initial near vertical movement forms the “flagpole” while the congestion area forms the actual flag and is caused by the profit taking of traders that were fortunate enough to be in the correct position before the flagpole formed, and by traders who missed the initial movement who are now entering the market.

Rectangle Pattern

A rectangle is formed when the price moves between a support and resistance line several times, touching both on each occasion. These support and resistance lines are usually horizontal but may slope upward or downward, forming a channel. Regardless of whether the lines are horizontal or sloping; they must be parallel lines. The rectangle is formed when the price moves up from a support line (1) to a resistance line (2), then back to the same support line (3) and finally back to the previous resistance line (4) where it bounces off to complete the fourth point in the rectangle. A rectangle can also be formed when the price moves from a resistance line to a support line, then back to the resistance line and finally back to the support line. Four is the minimum number of points required for a rectangle, with two points touching the upper resistance line and two points touching the lower support line. If the price does not bounce off the fourth point, but breaks the channel line instead, then a rectangle has not been formed.

Reversal Patterns

The Double Top

The double tops is a bearish trend reversal pattern that often marks the end of an uptrend and the start of a down trend. It consists of two consecutive peaks that reach a resistance level at more or less the same high value, with a valley separating the two peaks. The low of the valley is important for price projection purposes, but the shape that the peaks take is not important despite some traders talking about Adam and Eve tops. Volume is also of importance, with the volume on the second peak preferably lower than the volume on the first peak.

At times, the double top pattern can form a third top, creating a triple top pattern.

The Head and Shoulders pattern

The Head and Shoulders pattern is one of the most reliable trend reversal patterns and is usually seen in uptrends, where it is also referred to as Head and Shoulders Top, though they can appear in downtrends as well, where they are also referred to as Head and Shoulders Bottom or Inverse Head and Shoulders. As they are trend reversal patterns, the Head and Shoulders patterns requires the presence of an existing trend.

Head and Shoulders Top

Head and Shoulders Top is formed when a higher high in an uptrend is followed by a lower high. The result is a series of three peaks where the center peak, the head, is higher than the two peaks, the shoulders, on either side of it. The two shoulders do not need to be the same size or the same height, but they must be lower than the head.

Head and Shoulders Bottom

Head and Shoulders Bottom or Inverse Head and Shoulders is the opposite of Head and Shoulders Top and is formed in a downtrend when a lower low is followed by a higher low. The result is a series of three lows or dips where the low of the middle dip, which is the head, is lower than the dips, or the shoulders, on either side of it. As with the Head and Shoulders Top, the two shoulders do not need to be the same size or the same height, but their lows must be higher than the low of the head.

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