For the uninitiated, a stock chart may look like a bunch of wacky squiggly lines, kind of like an ECG machine gone horribly awry.
But for the savvy investor, these seemingly random lines speak the language of profits when deciphered correctly. The one caveat to this, of course, is that chart vocabulary can sometimes appear to imitate the people from the Tower of Babel, where they are all trying to communicate with you, but they do so in scattered languages. Trade analysts who want to dive into the world of charts can quickly gain outstanding linguistic skills if they know how to read chart patterns.
What is a Chart Pattern?
Simply stated, a chart pattern is a distinctive formation on a stock chart that forms either a signal to trade or a sign of price movements in the future. As a rule of thumb, these patterns are vital to virtually all of the things investors look for when it comes to stock movement, such as detecting trends, figuring out when to dump their stock, and more.
While chart patterns tend to form signals that spur technical analysts to action, they aren’t necessarily something that forms agreement across the investing world. There’s a reason for this; namely, even though patterns can be used to extrapolate predictable theories, they are just that – theories. In the world of technical analysis especially, chart patterns derive their strength from the power of assumption. The cyclical tendencies of stock history lead to the creation of these patterns; as such, what can be learned from following chart patterns is underscored by the trust investors have in history repeating itself. Needless to say, this should be a pretty vocal indicator that you shouldn’t assume that you know exactly where the stock you’ve been eyeballing is headed.
With that being said, it should be noted that trusting in things like history and past performance exists for a reason. While you can’t be 100% sure of what the future may hold by recognizing and digesting chart patterns, you can at the very least get a pretty solid read on how things may shake down.
Two Pattern Categories Linked to Technical Analysis
Once an investor that deploys technical analysis gets familiar with chart patterns, two pattern categories emerge reversal and continuation. A reversal pattern acts as a sign that a previous trend will reverse itself once the pattern completes. In the case of a continuation pattern, the trend that is reflected in the pattern will remain ongoing once the pattern is finished. There is no time bound frame that holds these two patterns. They can found over charts at any given interval.
Even though there are two pattern types, there are different actual patterns that fall within the chart pattern umbrella. Knowing how to decipher these designs can be the key to interpreting the chart as a whole, because they can provide a deeper insight as to why a stock may be doing what it’s doing.
The Different Types of Chart Patterns
Technical analysts have a ton of different chart patterns to choose from. Each pattern will produce important information that the analyst can use to make informed decisions on a stock’s movement. However, each design produces this critical data in different ways.
The different chart patterns are as follows:
- Head and Shoulders – Considered to be one of the most reliable and popular chart patterns amongst technical analysts, this is a reversal chart pattern that signals a stock is likely to run counter to the previous trend. This pattern is known as an inverse head and shoulders when it’s used to signal a downtrend.
- Cup and Handle – This pattern displays a bullish continuation upswing where the upward trend has stalled out, but will continue to shoot upward once pattern confirmation occurs. The “cup” of the pattern represents the start of the trend, while the “handle” is representative of the trend temporarily moving sideways or even slightly downward before continuing its climb.
- Double Tops and Bottoms – This well-known and well-used chart pattern also signals trend reversals. The pattern is formed once a stock’s movement tests resistance or support levels twice without being able to break through. The pattern is typically used in intermediate and long-term trend reversal scenarios.
- Triangles – There are three variations to this particular chart pattern: symmetrical, ascending, and descending. The “angles” that form the various triangles are caused by two trendlines that converge toward each other. These angles are used to determine if the pattern is bullish (ascending), bearish (descending), or neutral (symmetrical).
- Flag and Pennant – These patterns are continuation patterns formed when a sharp price movement is followed by an action that goes sideways. The pattern wraps up when another sharp movement occurs, as long as that movement heads in the same direction as the initial move that began the trend.
- Wedge – This pattern, which could either be interpreted as a continuation or a reversal pattern, acts in a similar fashion to a symmetrical triangle pattern. There are two differences. Firstly, a wedge pattern, the lines slant in an upward or downward direction. Secondly, a wedge tends to form between three to six months, which is longer than a symmetrical triangle pattern.
- Gap – This pattern is not a pattern at all. Rather, it’s a space that crops up between a trading period and the next trading period. A gap will form when there’s a large difference in prices between two consecutive trading periods.
- Triple Tops and Bottoms – This reversal chart pattern act similarly to head and shoulder patterns and double tops and bottoms. The one difference is that this pattern shows a stock that flirts with support or resistance levels three times without breaking through.
- Rounding Bottom – This pattern is similar to a cup and handle pattern, except there is no sideways pattern to form the “handle.”
Where do you find all these glorious chart patterns and indicators? There is software for that.
Different Patterns, One Goal
Even though there are many patterns that a technical analyst can use to read a stock, they can all be used for the same goal. That is, to maximize profit and minimize risk. Because of this, the savvy investor can use patterns they feel comfortable using with confidence. It’s just up to them to know how they should be used.