What are classical chart patterns?
There are many different ways to analyze the financial markets using technical analysis (TA). Some traders will use indicators and oscillators, while others will base their analysis only on price action.
Candlestick charts present a historical overview of prices over time. The idea is that by studying the historical price action of an asset, recurring patterns may emerge. Candlestick patterns can tell a useful story about the charted asset, and many traders will try to take advantage of that in stock, forex, and cryptocurrency markets.
Some of the most common examples of these patterns are collectively referred to as classical chart patterns. These are some of the most well-known patterns out there, and many traders see them as reliable trading indicators. Why is that? Isn’t trading and investing about finding an edge in something that others have overlooked? Yes, but it’s also about crowd psychology. As technical patterns aren’t bound by any scientific principle or physical law, their effectiveness highly depends on the number of market participants paying attention to them.
A flag is an area of consolidation that’s against the direction of the longer-term trend and happens after a sharp price move. It looks like a flag on a flagpole, where the pole is the impulse move, and the flag is the area of consolidation.
Flags may be used to identify the potential continuation of the trend. The volume accompanying the pattern is also important. Ideally, the impulse move should happen on high volume, while the consolidation phase should have lower, decreasing volume.
The bull flag happens in an uptrend, follows a sharp move up, and it’s typically followed by continuation further to the upside.
The bear flag happens in a downtrend, follows a sharp move down, and it’s typically followed by continuation further to the downside.
Pennants are basically a variant of flags where the area of consolidation has converging trend lines, more akin to a triangle. The pennant is a neutral formation; the interpretation of it heavily depends on the context of the pattern.
A triangle is a chart pattern that’s characterized by a converging price range that’s typically followed by the continuation of the trend. The triangle itself shows a pause in the underlying trend but may indicate a reversal or a continuation.
The ascending triangle forms when there’s a horizontal resistance area and a rising trend line drawn across a series of higher lows. Essentially, each time the price bounces off the horizontal resistance, the buyers step in at higher prices, creating higher lows. As tension is building at the resistance area, if the price eventually breaks through it, it tends to be followed by a quick spike up with high volume. As such, the ascending triangle is a bullish pattern.
The descending triangle is the inverse of the ascending triangle. It forms when there’s a horizontal support area and a falling trend line drawn across a series of lower highs. In the same way as the ascending triangle, each time price bounces off the horizontal support, sellers step in at lower prices, creating lower highs. Typically, if the price breaks through the horizontal support area, it’s followed by a quick spike down with high volume. This makes it a bearish pattern.
The symmetrical triangle is drawn by a falling upper trend line and a rising lower trend line, both happening at roughly an equal slope. The symmetrical triangle is neither a bullish nor a bearish pattern, as its interpretation heavily depends on the context (namely, the underlying trend). On its own, it’s considered to be a neutral pattern, simply representing a period of consolidation.
A wedge is drawn by converging trend lines, indicating tightening price action. The trend lines, in this case, show that the highs and lows are either rising or falling at a different rate.
It might mean that a reversal is impending, as the underlying trend is getting weaker. A wedge pattern may be accompanied by decreasing volume, also indicating that the trend might be losing momentum.
The rising wedge is a bearish reversal pattern. It suggests that as the price tightens up, the uptrend is getting weaker and weaker, and may finally break through the lower trend line.
The falling wedge is a bullish reversal pattern. It indicates that tension is building up as price drops and the trend lines are tightening. A falling wedge often leads to a breakout to the upside with an impulse move.
Double top and double bottom
Double tops and double bottoms are patterns that occur when the market moves in either an “M” or a “W” shape. It’s worth noting that these patterns may be valid even if the relevant price points aren’t exactly the same but close to each other.
Typically, the two low or high points should be accompanied by higher volume than the rest of the pattern.
The double top is a bearish reversal pattern where the price reaches a high two times and it’s unable to break higher on the second attempt. At the same time, the pullback between the two tops should be moderate. The pattern is confirmed once the price breaches the low of the pullback between the two tops.
The double bottom is a bullish reversal pattern where the price holds a low two times and eventually continues with a higher high. Similarly to the double top, the bounce between the two lows should be moderate. The pattern is confirmed once the price reaches a higher high than the top of the bounce between the two lows.
Head and shoulders
The head and shoulders is a bearish reversal pattern with a baseline (neckline) and three peaks. The two lateral peaks should roughly be at the same price level, while the middle peak should be higher than the other two. The pattern is confirmed once the price breaches the neckline support.
Inverse head and shoulders
As the name suggests, this is the opposite of the head and shoulders – and as such, it indicates a bullish reversal. An inverse head and shoulders is formed when the price falls to a lower low in a downtrend, then bounces and finds support at roughly the same level as the first low. The pattern is confirmed once the price breaches the neckline resistance and continues higher.
Classical chart patterns are among the most well-known TA patterns. However, as with any market analysis method, they shouldn’t be viewed in isolation. What works well in a particular market environment might not work in another. So it’s always good practice to look for confirmation, meanwhile exercising proper risk management.