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When we examined candlesticks it was noted that patterns cover very few time periods. When we talk of chart patterns, we usually talk of patterns which occur over longer periods.
It was said in Lesson 2 that a chart is a picture of the Market's psychology. In this lesson, we are going to look more closely at the charts to find out what that psychology is.
The chart will tell us one of three things; the buyers are stronger, the sellers are stronger or the market is neutral. If we can detect that the buyers are stronger (and we are able to detect this early), then we have found a stock which we can jump into and let the market take us up into profit. Similarly, the same principles apply if we get an early detection of selling.
So what should we look for in the chart to detect buying or selling?
Remember also in Lesson 2, the concepts of support and resistance. These concepts have already introduced us to situations where buying and selling occur. At support, a stock finds buyers, accumulating at that level, so much so that the sellers are unable to penetrate the support and the stock begins to rise again. Nearly all chart patterns stem from this concept of support and resistance.
An Ascending Triangle is formed when the market is bullish (over the time of formation of the ascending triangle) but cannot break through a particular resistance level.
The resistance may be formed by a large seller at price D, E and F selling a large block of shares. Most often it is where the market has seen resistance before and this encourages selling every time the stock reaches this price.
"I missed selling the stock at $1.53 last time it reached that price. I won't miss it again."
Likewise, short sellers may see the resistance price as a high and add to the selling pressure.
The resistance line only makes up one part of the ascending triangle. An upward support line forms the other part and this support line shows that there are bulls in the market.
So what happens after an ascending triangle forms?
If the bulls win, they will push the stock price past the line of resistance. A closing price above the resistance line of an ascending triangle signals a buy. This is because at this point:
An ascending triangle can be a continuation pattern (if formed in an uptrend) but can be a particularly powerful reversal pattern if formed in a downtrend.
Many technical analysts use the height of the triangles (i.e. A to B and D to C) to measure the price target. It is said that this height of the triangle will approximate the height above the breakout level. Using the same examples, the estimated target price of the continuation ascending triangle will be at E and the estimated target price of the reversal ascending triangle will be at F. Mathematically: E - A = A - B and F - C = C - D (or the distance between E and A = the distance between A and B... etc.) The two examples show the stock actually going further than the predicted target price.
As the stock price breaks up, old resistance becomes new support so if the stock closes back under the resistance line, a stop loss should be exercised.
The best ascending triangles occur when the stock breaks out about two thirds of the way along the triangle (from the right angle and one third before the apex). Volume should contract as the triangle forms (slight increases in volume on the upswings is good) and large volume should accompany the breakout.
As the name may suggest, the descending triangle is very similar to the ascending triangle but with the features reversed. A descending triangle is formed when the market (over the life of the chart pattern) is bearish yet cannot break down through a horizontal support level.
The support may be formed by a large buyer in the market at the price corresponding to the support line or this may be a previous support level which usually encourages buying when the stock nears this price again.
"I missed buying XYZ when it got back to $1.00 last time, I won't miss it again"
Likewise, the short sellers who missed taking profit the first time it bounced up off the new low, may well take profits when it next reaches this price.
So a descending triangle has a horizontal support line as one of its components. The other component is the downward sloping resistance line. The stock has support (as shown by the support line) but this downward resistance line shows that there are bears in the stock and they are trying to push the stock down.
So what happens after a descending triangle forms?
Should the bears win the battle, the stock should break down through the support line. A stock that trades and closes below the support line (after a descending triangle has formed) signals a sell. This is because at this point:
A descending triangle can be a continuation pattern (when formed in a downtrend) but when it occurs in an uptrend, it can be a very powerful reversal pattern.
Price target is measured by the support line price minus the height of the triangle. In the examples on the previous slide, the target price is the support line price minus the difference in price between A and B. For example, if the difference in price between A and B = $0.83 (83 cents) and the price at the support line is $5.93. The price target for the stock will be $5.93 - $0.83 = $5.10
If short selling at the breakdown, a stop loss should be set if the stock closes above the support line (now resistance line). A less tight stop could be placed above the old downward sloping resistance line.
The thinking behind this is that stocks tend to have trading ranges and certain volatility. A stock which has a large descending triangle with respect to the stock price will most likely trade with a similar volatility if it finds a new trading range.
Similar to the ascending triangle (and most triangles for that matter), the best results come when the breakout occurs about two thirds from the tip of the triangle. Volume should contract as the triangle is forming (optimal if small volume increases on the downward swings) and large volume should accompany the breakdown.
The symmetrical triangle is formed when the market is 'squeezed' into a smaller and smaller trading range. This chart formation is recognised by an upward sloping support line and downward sloping resistance line, both at an equal but opposite angle to the horizontal. It is from this symmetry that the name of the chart pattern is derived.
The symmetrical triangle shows a stock where the bulls and bears are truly equal in size and strength. Overall, the market is neither bullish nor bearish. Long and short positions are created and as the market becomes impatient and cannot wait any longer for a price movement, the stock usually breaks either up or down. If there is a break up through the downward sloping resistance line, buying frenzy is created and the short sellers rush to close their positions. An indicative target price can be sought by using the height of the triangle and adding this to the point of the breakout in a similar method used in the ascending and descending triangles analysis.
The Double Top is a reversal pattern and formed when the market cannot break through a certain resistance level twice. When the stock fails to break up through resistance it falls back, ready to give the resistance another go. When it fails a second time and when the stock falls further than the intermediate price (to which it fell back the first time), a double top has been formed and this also signals a SELL on the stock.
A Triple Top works on exactly the same principle, that is, the stock tries to break through a resistance level but fails. However, with a triple top, the stock tries to break through the resistance one more time. Again, if it fails and cannot even be supported at the intermediate pull back levels, a strong SELL signal is generated. A Triple top is a stronger signal that the double top as the stock has failed again confirming that the stock just can't break through the resistance.
In the examples given, the stock (moving upwards) encountered resistance at A. The stock then fell back but found support at B. Again the stock tried to gather positive momentum only to find resistance again at A. The stock then fell back and in the case of the double top, did not find support at the 'intermediate' price B. In the case of the triple top, the stock found support one more time at B and had bounced off this level for a second time. It found resistance at A for a third time and as it fell back, was not able to find support at B. The signal for selling the stock is just as the stock breaks through underneath the intermediate price at B. The target price for both the double and triple top is the price of the intermediate price minus the height between the top of the pattern and the intermediate price. In the examples above, this can be found at C. As old support becomes new resistance, after the stock has broken past the intermediate price, the stop loss should be set at that intermediate price. This makes for a nice trade. The potential profit can be quite large but the stop loss can be kept relatively small.
Increasing volume on the break down with both patterns is ideal.
The Double and Triple Bottoms work in the same way as the Double and Triple Tops but in reverse. Both the double and triple bottoms are reversal patterns in a downward trending stock and form when a stock fails to break a certain support level.
A Double Bottom is formed when the stock bounces off a low and up to an intermediate level (shown at C and B respectively in the example). It then tries to break the support (or the previous low) again but fails. The pattern is complete and a BUY signal is generated when the stock bounces off the support for a second time and rises above the intermediate price.
A Triple Bottom is the same except it tries to break the support one more time and again fails. The BUY signal is given as it bounces up past the two intermediate prices.
The target price for both patterns is the intermediate price plus the height between the support (bottom of the pattern) to the intermediate price. In the examples this is shown at A. As old resistance becomes new support, the stop level is set at the intermediate price.
Increasing volume on the breakout is ideal.
The flag pattern is so named because of its resemblance to a flying flag. It has two components, the flagpole and the flag itself. The flag is actually a consolidation pattern formed during a strong trend. (A consolidation in the stock market means the stock falls back slightly after a strong up trend - the stock 'takes a breather' - before continuing with the trend. The same occurs in reverse in a down trend). Flags are therefore continuation patterns and can occur in both up trends and down trends.
Taking the case of a flag in an up trend, the initial run becomes the flagpole and the consolidation is the flag itself. The consolidation trades only in a small trading range before the stock breaks out and continues the trend. The buy signal is given as the stock breaks the upward resistance line of the downward sloping channel. The price target is the price at this point plus the height of the flagpole. A stop loss is set at the price where the stock falls back through the resistance line (old resistance becomes new support).
Falling volume during the consolidation and (as with any breakout) an increase in volume on the breakout is ideal.
In a downtrend, the flag is upside down and the consolidation results in a small rise (with a tight price range) in the stock price. The sell signal is given on the breakdown through this small trading channel with a stop set at a price where the stock crosses back upwards above the old support line (old support becomes new resistance). Price target is the price of the breakout minus the height of the pole. Falling volume during the consolidation and an increase in volume on the breakout is ideal.
Some consider the Pennant to be a flag - the Pennant Flag. This consideration is justified because like the flag, the pennant has a flagpole but the 'flag' part is a small triangle, or pennant flag. There are other similarities to the flag. The pennant is a continuation pattern. The flagpole is the strong trend and the pennant is a consolidation in the trend before the trend continues. The pennant may be found in both up trends and down trends.
The small triangular consolidation trades in a very tight price range. A BUY signal is generated when the pennant is formed in an up trend and the stock breaks out above the downward resistance line that forms the top of the pennant. Like the flag, the target price is the price of the breakout plus the height of the flagpole. A stop loss should be set at the price of the projected upward support line of the pennant. A reduction in volume during the pennant formation and an expansion of volume in the breakout is ideal.
A SELL signal is generated when the pennant is formed in a downtrend and the stock breaks down below the support line that forms the bottom of the pennant. The target price is the price of the breakdown minus the height of the flagpole (which is the height of the downward run before the pennant was formed). A stop should be exercised if the stock runs up past the projected downward resistance line that made up the top of the pennant. A reduction in volume during the pennant formation and an expansion of volume in the breakdown is ideal.
Pennants differ from symmetrical triangles in that they are exclusively a continuation pattern and they also tend to form over much smaller periods of time.
A Wedge gets its name because of its doorstop wedge shape. Wedges are therefore triangular and like the triangles, they can be both a continuation pattern or a reversal pattern. Unlike the other triangles, the wedge has both the support and resistance both pointing up or both pointing down. As the stock forms the wedge, the price continues to trade in one overall direction but the stock is being squeezed into the tip of the wedge. As we have seen with other patterns that have the stock being 'squeezed', the market can become impatient with a lack of volatility in the stock. It then only takes a small move in one direction to make the market 'jump on board' the trend or have traders neutralize their position if they have traded the stock the wrong way. This is also the principle behind the wedge.
A BUY signal is generated when a downward sloping wedge is formed and when the stock breaks up above the resistance line that forms the top of the wedge. The price target depends on whether the wedge has been formed as part of a continuation pattern or as a reversal pattern. If the downward sloping wedge has been formed in an up trend and the stock breaks up, the wedge is a continuation pattern and the target price is the price of the breakout plus the height of the trend before the wedge was formed (similar to the height of a flagpole). This said, downward sloping wedges only represent buying opportunities. (Conversely, upward sloping wedges only represent selling opportunities). The stop loss is the price at which the stock falls beneath the projected support line that makes up the wedge.
If the downward sloping wedge has been formed in a down trend and the stock breaks up out of this wedge, the wedge has acted as a reversal signal. The BUY signal is still when the stock breaks up above the downward sloping resistance line that forms the top of the wedge but the target price is slightly different. The target price is the price of the breakout plus the height of the wedge from the top to the apex. A stop loss is still set at the projected support line that makes up the bottom of the wedge.
As with most pattern formations, a reduction in volume during formation of the pattern and an increase in volume on the breakout is ideal.
A SELL signal is generated when an upward sloping wedge is formed and the stock breaks down through the support line that forms the bottom of the wedge. Again the price target depends on whether the wedge acted as a reversal pattern or as a continuation pattern. If the upward sloping wedge was formed in an up trend then the wedge is a reversal signal. The price target is the price of the break down minus the height of the wedge from the bottom to the apex. The stop loss is set at the price that the stock trades back up and above the projected resistance line.
If the upward sloping wedge has been formed in a down trend, the price target is the price at the breakdown minus the height of the trend before the wedge was formed. The stop loss is still the same. A reduction in volume during formation of the pattern and an increase in volume on the breakout is ideal.
The Head and Shoulders pattern derives its name from the shape of the chart when this pattern is formed.
The head and shoulders is a bearish formation. The left shoulder is found between points A and B. The Head is located between B and C and the right shoulder is found between C and D. The horizontal line between A and D is called the neckline. The first shoulder forms when the market tries to push the stock to higher levels yet the sellers win and push the stock back to a consolidation point (support). The head is formed as the buyers have a second attempt at pushing the stock to higher levels. This time the buyers push harder, pushing the stock to higher levels, yet they are still defeated as the stock is pushed back to the initial support. The right shoulder is the buyers making one last effort to push the stock higher. This time it cannot penetrate the previous high and can only manage to make the highs of the left shoulder. It then falls back to the neckline for a third time. A break in the neckline works like a break down through any support line. The buyers who have bought at higher levels become impatient and begin to sell. Some may panic as they try to limit their losses and the sellers who have previously been selling their stock in a higher trading range must now sell in a new lower range if they still wish to sell. Short sellers may also wish to join the trend hoping to make money on the fall in price, thereby pushing the stock even lower.
The SELL signal comes after the stock has broken down through the neckline after the right shoulder has been formed. Optimum results arise from higher volume on the breakdown. The target price is the price at the neckline minus the height from the top of the head to the neckline. A stop loss should be set at the price of the peak of the right shoulder or, for a much tighter stop, if the stock breaks above the neckline (old support becomes new resistance)).
Just as the Head and Shoulders is a bearish pattern, the Inverted Head and Shoulders is a very bullish pattern. The pattern looks and works exactly the same as the head and shoulders, but in reverse. That is, the stock falls and rises to form the inverted left shoulder, falls and rises little further to form the inverted head and then the sellers attempt one more push down to form the right inverted shoulder.
The BUY signal is formed as the stock rises back up and breaks the neckline. Optimal breakout is usually accompanied by an increase in volume. The target price is the price at the neckline plus the height from the bottom of the head to the neckline. The stop loss should be set at the price at the bottom of the right inverted shoulder, or for a tighter stop, if the stock falls below the neckline (old resistance becomes new support).
This concludes the lesson on Chart Patterns
We have seen that a number of both bullish and bearish chart patterns exist within technical analysis. Chart patterns are nearly all derived from the concepts of support and resistance and because of this they are possibly the most powerful tool in the technical analysts arsenal. Chart patterns are relatively simple concepts. They are taking a picture of the market's psychology - where the market is buying and where the market is selling. As we will see in the next lesson, technical analysis can involve a lot more than the concepts of support and resistance.