“Money won is twice as sweet as money earned”
Iron man has no superpowers; neither does Batman but still they managed to become superheroes and fall short of nothing but awesomeness. When we are born, some are born more equal than others with supernatural talents; others have to work hard for what they want but we are all equal before the great market.
As a trader, our focus is to develop an edge over other participants that will allow us to pump our wallets with gazillions of dollars but the work doesn’t come easy. One of the areas that traders can focus on, to develop such edge, is price patterns.
In a financial sciences textbook, price patterns would be defined as the natural phenomenon of fluctuations in the price of a financial instrument that is caused by a number of factors, including human behaviour – gosh that was long.
Another way to define it is a graphical presentation of price movement by using a series of trend lines and curves. This means that a trader armed with the knowledge required to recognise patterns; and more importantly, the skill to apply them to the decision-making process – has the potential to generate greater returns. However, the skill required to interpret the price patterns correctly takes practice and commitment to developing.
There are many different price patterns that are used in technical analysis with traders recognising and applying new ones every day. There are a few that have been favourites of seasoned traders and novices alike for many years and include head and shoulder formations, double and triple tops and bottoms, pennants, flags and wedges. These patterns are popular due to their easily recognisable pattern and accuracy. It is important for anyone interested in the field of technical analysis to first acquaint themselves with these fundamental patterns since they can be applied to any price chart.
One of the fundamental tools used in any technical analysis is the trend line. A trend line is constructed by joining two or more price points with a straight line. The purpose of this line is to identify the historical trend of the price movements and to indicate support and resistance levels.
When constructing a trend line it is useful to bear in mind that while a trend line can be constructed by connecting only two price points, the validity of the line is increased by having more price points touching it.
I recommend including the wicks of candlestick and bar charts but at the same time ignoring the outliers. This will help avoid whipsaws.
Also, when the prices in the market are moving either up or down we use sophisticated jargon like trending market to indicate that it has a sense of direction, on the other hand when a market runs sideways it is referred to as ranging.
The uptrend is described as a series of higher highs and higher lows.
The downtrend is a series of lower highs and lower lows.
THE RANGING MARKET
The sideways trend is a ‘flat’ market where the market ranges.
For better illustrations, we have made use of trend channels which are a combination of support and resistance lines forming a range which price can fluctuate in.
Continuations and reversal patterns:
Price patterns can be divided into two broad categories, continuation and reversal patterns.
Continuation patterns are a series of price movements that indicate that there is a temporary halt in the current prevailing trend, but that the current trend should continue after the break.
There are certain patterns that tend to re-occur and are therefore common. At times when people discover things to be common, they give them names. For Example: mean people are just called jerks. Some of the more common continuation patterns are pennants, flags and wedges, and like jerks, most of them show some resemblance to their name.
When the prices in a market are pulling a Tokyo drift on the highway and suddenly slow down and start ranging there are only one of two possibilities, either they were arrested by police or noticed a speeding camera and it is time to slow down.
A pennant is like being arrested by police, the price was speeding either up or down a mountain, and then it gets caged and breaks out of the pattern, only to continue what is was doing before – breaking the law.
A pennant is a price pattern where the price starts to range and the difference between the peaks and troughs start to decrease, in a horizontal manner and show similar features to a symmetrical triangle (that will be discussed later). As mentioned before when the price breaks out of the pattern it usually continues in the same direction, showing no signs of confusion as to where it should be.
When a pennant is identified it is important to wait for the price to breakout from the triangle in the direction of the prevailing trend. This is a clear indication that the pattern is, in fact, a continuation pattern and that the price will move in the expected direction.
Usually, the mast of the pennant (the size of the first move) is more or less the size of the breakout after the pennant.
Flags, on the other hand, are like running into a speeding camera; they show all the signs of slowing down and then do exactly the opposite, kind of like kids. They start off in a similar way too but instead of a decreasing price range, a flag is a secondary trend in the opposite direction of the primary trend.
Once it breaks out of the price pattern it continues in the same direction as before. A horizontal flag is recognised as a rectangle. In many ways a flag is similar to a pennant, apart from the obvious difference in appearance, very reliable and seldom produces a reversal in trend.
Wedges are also similar to pennants but not only by characteristics but also by appearances. Instead of moving horizontally, a wedge is when you have 2 converging trend lines that are pointing in either an upward or downward direction, like an arrow. When the price pattern breaks it is expected to continue in the same direction and comes out above or below the price trend lines. Wedges are very helpful when analysing short term to intermediate term reversals; and so are the wedges you can eat, a hungry trader is an unhappy trader.
Just like pennants, the magnitude of the next possible move can be approximated by the size of the rally before the wedge.
Wedges come in two types: rising and falling.
Triangles (also known as traps or trap doors) can either be symmetrical, ascending or descending.
The symmetrical triangle is a continuation pattern; it occurs when the market is in consolidation. The resistance and support must converge at similar angles to form an isosceles triangle. The price will fluctuate within the support and resistance until it reaches the apex where it will then break out upwards or downwards and continue to move in the breakout’s direction.
The price will in most cases retrace back to the breakout level, which provides a trading opportunity to bet in the direction of the breakout. An increase in volume is always a good confirmation tool to confirm the trend.
THE SYMMETRIC TRIANGLE
The next sibling in this family of triangles is the ascending triangle. Unlike the symmetric triangle which can either be a bullish or a bearish pattern depending on the initial price move, the ascending triangle is more bullish. The resistance line is flat and it meets an upward sloping support at the apex. The price will oscillate within these trend lines until it breaks out when it reaches the apex to the upside.
THE ASCENDING TRIANGLE
Next, in line, we have the descending triangle. The name gives it away because this is a bearish continuation pattern. In this instance, the support lies flat while the resistance has a down slope. The price will come into the triangle in a downtrend and will break out at the apex through the support.
THE DESCENDING TRIANGLE
Rectangles are known as price consolidation patterns that indicate that a war is raging between buyers and sellers. This is what is known as a ranging market.
The support and resistance have to be hit several times and depending on the distance between them, you can sell when the price hits the resistance and buy when it hits the support. Your stop losses should be tight if you are to use this trading system.
When the price breaks out of this pattern it is usually harder to interpret since it is uncertain as to how the prices are going to act. Reversal price patterns such as double tops and bottoms, and triple tops and bottoms usually unfold in rectangles that are usually at the top or the bottom of a trend, more on that will be discussed later.
This type of price pattern is the warning light that goes off when prices are about to change direction. These types of price patterns tend to occur either at the very top or at the very bottom of a trend. At the top, it is known as a distribution pattern and indicates that more instruments are being sold than bought. At the bottom it is known as an accumulation pattern where stocks have built up at low prices, it is at this time when more instruments are being bought than sold. Common reversal price patterns are head and shoulders, double tops and bottoms and triple tops and bottoms.
It is important to note that these patterns are difficult to accurately identify while they are forming. It is wise to wait until the pattern is confirmed before entering into a position.
Head and Shoulders:
Head and Shoulders textbook style
The head and shoulders is a type of a reversal pattern. These are price patterns that indicate a potential change in direction of the trend. The head and shoulders are one of the most common types of reversal patterns and occur at the very top or bottom of a trend.
A head and shoulders pattern has three distinct features:
- A temporary high point,
- A second high point which is higher than the first,
- A third top that is lower than the second.
Head and Shoulders
When facing a head and shoulders formation the trader should draw a trend line connecting the two low points formed during the dip from the first and second top points. This line is called the neckline and when the price falls below the neckline it is seen as a confirmation that the trend is reversing and the trader should act accordingly
The entry point is where the second shoulder breaks through the neckline. The take profit target is the same distance as the distance from the neckline to the top of the head. This height is a rough estimate of the expected breakout from this formation. A large distance from head to neckline would indicate a large break out once price breaks the neckline; this is also a measure of potential profit.
You also get inverted head and shoulders patterns.
Inverse Head and Shoulders
Double tops and bottoms
One of the most commonly found reversal patterns is the double top or bottom formation. Double tops or double bottoms are a phenomenon where you have two peaks reaching the same resistance or two troughs reaching the same support, shaped to resemble the alphabetical letters ‘m’ at the top and ‘w’ at the bottom. This type of reversal pattern appears when a market is trying to reach new horizons but is struggling to break a support or resistance zone.
The trader must first draw a horizontal trend line in the valley between the two high points and once the price level breaks through that line the trader can confirm the reversal and make the trade.
Double top and bottoms price patterns
When referring to a double top or bottom, one tends to assume that they have to reach the same resistance or support this is not necessarily true. Sometimes when the right peak is lower than the left peak this means that the drop in price will be more significant. Also, when the right trough is higher than the left trough it means that the price move will be more significant.
It is not uncommon to see the price retrace back to the support (if double top) to form a new resistance or back to the resistance (if double bottom) to form a new support. This is known as trader’s remorse and is a small price correction before a continuation in trend.
Triple tops and bottoms
In the beginning, we referred to price patterns being related to consumer mentality and all peaks and troughs can usually be explained using human activity. At the bottom of a trough traders and investors will notice that prices are low and therefore would like to buy at a discounted value. When demand increases so does price up to the point where investors start to take profits causing the price to dip. When this pattern repeats its self 3 times we get a triple top or bottom.
The triple tops and bottoms are similar to double tops and bottoms. The only difference is that we now have three peaks or troughs to work with; the bears and bulls battle it out for a while longer over a sustained period thus forming an extra peak or bottom. For the double tops, we short as soon as the price goes below the support followed by increased volume. The triple top is a bearish pattern while the triple bottom is a bullish pattern.
The triple top pattern closely resembles the head and shoulders formation. The triple top differentiates itself only with regards to the height of the second top point. In a head and shoulders price pattern the head’s price plateau is significantly taller than the other tops. The triple top, instead, has a price chart with three peaks of almost equal height.
The process of confirming the trend reversal with a triple top pattern is similar to the method used for the head and shoulders formation. The investor should draw a trend line connecting the low price points in the valleys between the three peaks. If the price level drops below this line it can safely be assumed that the prevailing trend has reversed.
Diamonds are not as common as the other price patterns and are not easily recognised. It is quite rare and usually occurs at the market tops. A diamond that occurs at the market top is a reversal pattern that is formerly known as the diamond top reversal.
There is an uptrend leading to the diamond top formation and this pattern looks like a diamond that is leaning to one side. In the first part of the diamond, price hits higher highs and lower lows forming a broadening triangle. In the second part, it closes up.
The diamond pattern usually only occurs at the top of a chart with an uptrend, and usually, breaks out into a down trend.
The use of price patterns
The use of pattern recognition in the investment decision-making process has the potential to unlock a chamber of wealth. For an investor to successfully trade using technical analysis, however, it is important that he/she knows how to accurately identify the different patterns commonly encountered in the financial landscape.
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