Identifying Chart Patterns

 

Recognizing and Assessing Chart Patterns

A chart pattern reflects the recurring behavior of human nature observed in global financial market trading.

 

What is a Chart Pattern? (simple definition)

A chart pattern is a recognizable formation in price data that appears during the analysis of a time series. Once random market noise is filtered out, the pattern can be used to assess the potential continuation or reversal of the prevailing price trend.

 

Patterns and Time Series

In a time series, a pattern is a data formation based on a trend, seasonality, or a combination of both. There are three general categories of recognizable patterns:

(i) Trend Patterns (following a specific trend)

(ii) Seasonality Patterns (repeating over time)

(iii) Multiplicative Seasonality Patterns (a combination of (i) and (ii))

Note that the chart patterns described below are based on price trends (i), not on seasonality (ii). However, certain financial patterns are based on seasonality, and these are referred to as financial cycles.

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Introduction to Chart Patterns

 

The ability to recognize chart patterns is crucial, regardless of the timeframe in which you trade. Chart patterns can reveal the underlying dynamics of the market and help forecast the direction of upcoming price movements.

A chart pattern can appear on any timeframe, from 15 minutes to one month, and can signal either the continuation or the exhaustion of a trend.

Key Benefits of Identifying Chart Patterns

• Useful for analyzing market dynamics

• Able to identify both trend reversals and continuations

• Can clarify price action when indicators fall short

• Capable of generating reliable trade signals

• Compatible with any other technical analysis method

• Instantly visible across all timeframes

 

  

 

Basic Components of a Chart Part

Chart patterns consist of several basic components. Primarily, a chart pattern is defined by the formation of specific highs and lows. A new high suggests that demand remains stronger than supply, while a new low indicates the opposite. When the market fails to form a new high or low, it may signal a potential price reversal. The price action between these highs and lows is equally important. The waves formed, along with the duration and strength of price retracements, provide insights into the overall trend strength and the true market dynamics.

All chart patterns share the following basic components:

(1) Formation of higher highs/lows or lower highs/lows

(2) Formation of local highs and lows (tops and bottoms)

(3) Trend waves between highs/lows (focus on wave size, duration, and steepness)

(4) Depth and duration of price retracements

The formation of a chart pattern is rarely clear-cut. Thousands of variations can exist for each pattern, and market noise often disrupts pattern recognition. Therefore, traders must decode these patterns by filtering out noise. The most effective way to do this is by focusing on timeframes above M30.

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Categorizing Chart Patterns

All chart patterns fall into two main categories: continuation (momentum) patterns and reversal (exhaustion) patterns.

• A continuation pattern indicates that a price trend is gaining momentum and is likely to continue in the same direction.
• A reversal pattern indicates that a price trend is coming to an end and is likely to reverse.

 

(A) REVERSAL (EXHAUSTION) CHART PATTERNS

 

These are some key reversal chart patterns:

 

(1) Head & Shoulders Patterns

The Head & Shoulders pattern is widely used and considered one of the most reliable chart patterns.

Formation:

• The left shoulder is formed after a new high (A).

• The head is then formed at the highest high (B). The head (B) is higher than (A) but relatively close to it, representing the final push by buyers.

• The right shoulder (C) is a new local high formed below the head (B). It indicates the buyers' inability to create a new high. Point (C) strongly suggests a potential trend reversal.

• The pattern is completed and the trend reversal confirmed when the neckline is broken, followed by the next high failing to break above the neckline (see chart).

Chart: Head & Shoulders Pattern

There are two types of Head & Shoulders patterns:

(i) Head & Shoulders Top

(ii) Head & Shoulders Bottom

□ The typical timeframe for a Head & Shoulders pattern ranges from one week to several months.

 

(2) Rounding Tops/ Bottoms Patterns

The occurrence of a Rounding Top / Bottom pattern signifies the beginning of a new strong trend. This pattern is also referred to as the Saucer Pattern.

A Rounding Top / Bottom is a rare formation that typically appears after a prolonged consolidation period. However, when it does occur, it can offer significant trading advantages.

Advantages of a Saucer Pattern:

(i) It can signal a strong, long-lasting price movement

(ii) It develops gradually, providing ample time to reassess before entering a trade

(iii) It can be easily traded using pending orders (buy stop/sell stop)

(iv) It offers an excellent reward/risk ratio, as the stop-loss can be placed very close

The Rounding Top / Bottom pattern consists of two main phases: (a) a consolidation phase and (b) a fast-trending phase. As the market transitions from phase (a) to phase (b), market gaps often appear. These gaps—especially if bullish—can further validate the pattern. This transition is typically accompanied by a surge in volatility and trading volume.

□ The timeframe for a Rounding Top / Bottom pattern usually ranges from several months to one year.

 

(3) Support & Resistance (S&R)

Support and Resistance are among the most reliable concepts in technical analysis. According to this approach, the price of a financial instrument tends to stop and reverse when it reaches certain predetermined levels. Levels above the current market price are called resistance, while those below are called support.

• Support is a price level or zone below the current market price where demand is strong enough to overcome selling pressure.
• Resistance is a price level or zone above the current market price where supply is strong enough to overcome buying pressure.

It is generally better to use support and resistance zones rather than specific price levels.

An interesting fact is that when the price breaks through a key support level, that level often becomes resistance. Conversely, if the price breaks through a key resistance level, it may turn into support.

When the market moves repeatedly between strong support below and strong resistance above, it is considered to be in a range without a clear trend.

□ There is no specific timeframe required to recognize a Support / Resistance pattern.

 

(4) Double Tops / Bottoms Patterns

Double Tops and Bottoms are common chart patterns that indicate very strong demand or supply levels. They are confirmed when the price tests a key support or resistance level twice but fails to break through.

□ The typical timeframe for Double Tops / Bottoms ranges from one week to several months.

 

(5) Triple Tops / Bottoms Patterns

These patterns are similar to Double Tops and Bottoms, except the price tests a support or resistance level three times without breaking through.

□ The typical timeframe for Triple Tops / Bottoms ranges from one week to several months.

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(B) CONTINUATION (MOMENTUM) CHART PATTERNS

These are some key continuation chart patterns:

 

(1) Cup & Handle Chart Pattern

A Cup & Handle pattern indicates that an uptrend has paused temporarily but is unlikely to reverse. Once confirmed, the uptrend typically becomes very bullish.

Note that if a potential Cup & Handle pattern fails to break previous highs, it becomes a confirmed Double Top pattern. As shown in the chart, line-A initially acts as a resistance level and later becomes a support line.

Chart: Decoding the Cup & Handle pattern

□ The timeframe for a Cup & Handle pattern can range from a couple of months to several years.

 

(2) Triangles

Triangles are chart patterns that indicate a strong continuation of a price trend following a consolidation period. Triangle formations are considered more reliable when occurring within an established trend.

There are three types of triangles:

(i) Symmetrical

(ii) Ascending

(iii) Descending

The basic formation of a triangle involves (i) the convergence of two trendlines (which can be flat, ascending, or descending) and (ii) the price moving between these two trendlines.

Chart: Example of a Symmetrical Triangle

□ The timeframe for the triangle formations includes usually one week to several months

 

(3) Flag & Pennant Patterns

Flag and Pennant patterns indicate a strong continuation of the main price trend following a sharp advance or decline. An increase in volume activity is a positive signal confirming the Flag or Pennant pattern.

Chart: Flag & Pennant Patterns

□ The timeframe for the Flag & Pennant patterns can range from one week to several months

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Conclusions

Chart patterns are the visible marks of collective psychology imprinted on price charts revealing an ongoing struggle between fear and greed. Identifying a pattern means recognizing a distinct, recurring mindset shared by market participants. This insight elevates pattern analysis beyond mere shape recognition, turning it into a profound exploration of behavioral finance and the dynamics of crowd behavior in the global financial markets.

As mentioned earlier, the formation of a chart pattern is rarely a clear-cut process, and thousands of variations exist for each major pattern. Additionally, market noise can disrupt pattern recognition and lead to false conclusions about actual market conditions. Therefore, avoid trying to identify patterns in timeframes shorter than M15. Longer timeframes, such as H4 and D1, have proven much more reliable for pattern recognition over time.

In any case, never underestimate fundamental changes, because when fundamentals shift, reliable pattern recognition becomes impossible. Finally, recognizing chart patterns can be very useful for confirming trading signals generated by other technical analysis methods (e.g., MACD Histogram and MACD Divergences).

 

■ Identifying and Evaluating Chart Patterns

George M. Protonotarios, November 2016

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