Four patterns every trader should know
THE financial markets can be a fickle beast. After all, you can attempt to model and predict every possible outcome, but prices are driven by human decisions, with traders staying in a position longer than they know is wise, or panic buying in a rally. But armed with a knowledge of some common chart formations, you can get a better feel for what is ahead in a short amount of time. According to David Jones, chief market strategist for IG Markets: “None of these patterns are fool proof, but they can give a quick feeling for how strong sentiment is for the market in question and help set up a trade.”
There are two types of pattern in technical analysis, a continuation pattern and a reversal. A continuation suggests that the price will continue on it’s trend upon completion of the pattern, and a reversal pattern is a sign that the price may be about to move in the opposite direction. Here, David Jones guides us through both types of chart pattern with four examples.
CONTINUATION | HEAD AND SHOULDERS FORMATION
THE head and shoulders chart formation is a relatively easy formation to spot. “Head and shoulders is probably a phrase that many who haven’t even looked at a chart will be familiar with,” says Jones. “The reasoning behind it is perfectly logical – the pattern being completed at the end of an uptrend when the third peak (the right shoulder) ends up running out of steam before the previous ones.”
A head and shoulders formation can be a clear warning that momentum is fading from the market. The top of the head of the movement is formed with volumes dropping.
REVERSAL | INVERSE HEAD AND SHOULDERS FORMATION
AS you may have guessed, the inverted head and shoulders formation is the same as the head and shoulders, just turned on its head. It can be considered a buy signal when the price breaks above the neckline. This formation is typically seen after a long downtrend. In the case of an inverted head and shoulders formation, volume generally plays a larger role than in a regular head and shoulders, requiring an increase in volume for a breakout from the neckline.
The inverted left shoulder is formed by an increase in volume, the inverted head of the chart is accompanied by lighter volume, and then a big jump in volume on the rally from the inverted head. As the price breaks through the neckline, you should see a big increase in volume.
An inverted head and shoulders is confirmed with the upside penetration of the neckline.
REVERSAL | TRIANGLE FORMATION
TRIANGLE patterns do what they say on the tin, with two trend lines converging into a triangle, and the price moving between these lines. According to Jones: “Triangle formations are traditionally viewed as a sign that traders need to have a bit of patience and wait for the breakout from the pattern.”
There are three kinds of triangles. Symmetrical triangles are seen as a suggestion that the trend is in a period of consolidation before continuing with the trend. An ascending triangle suggests that the price will head higher upon completion, whereas a descending triangle suggests a bearish movement.
REVERSAL | DOUBLE TOP FORMATION
DOUBLE top and double bottom chart patterns are straightforward to spot and can be seen across a range of different time frames, both in long and short-term charts.
“It’s not about some special voodoo predicting what’s going to happen next,” says Jones. Instead, he says that it should be seen as a sign of some lack of momentum creeping in where, in an uptrend for example, the market fails to break the previous high.
This pattern should be seen as a set up for a possible trend reversal, and so traders should wait for the price to break below the neckline before entering the trade.