Identifying and Evaluating Chart Patterns
A chart pattern aims to explain the repeating behavior of human nature when trading the global financial markets.
What is a Chart Pattern? (our definition)
A chart pattern is a set of identifiable price formations that occur during the analysis of a data series. After filtering and eliminating the random market noise, a recognizable chart pattern can be used for evaluating the potential continuation or reversal of the master price trend.
General Insights about Patterns in a Time Series
In a time-series, a pattern is a formation of data that is based on a trend, on seasonality, or on both. There are three general categories of recognizable patterns:
(i) Trend Patterns (following a certain trend)
(ii) Seasonality Patterns (repeated over time)
(iii) Multiplicative Seasonality Patterns {(i) and (ii) combined}
Note that the chart pattern described below are based on a price trend (i), and not on seasonality (ii). Nevertheless, there are some types of financial patterns that are based on seasonality, and these patterns are called financial circles.
Chart Patterns
The ability to recognize chart patterns is very important, no matter the timeframe you trade. Chart patterns can reveal the real dynamics of the market, and at the same time, they can forecast the direction of the upcoming price action.
A chart pattern can emerge anywhere, from the 15-Minutes to the 1-Month timeframe, and it is able to spot both the continuation or the exhaustion of the trend.
Key Benefits from Identifying Chart Patterns
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Can be very helpful in analyzing the market dynamics
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Can spot trend reversal and trend continuation
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Can often explain the real price action when indicators can’t
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Can generate reliable trade signals
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Can be combined with any other technical analysis method
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Can be instantly visualized (in any timeframe)
The Major Components of any Chart Pattern
Chart patterns include some basic components. First of all, a chart pattern is based on the formation of certain highs and lows. A new high is an indicator that demand is still stronger than supply, or vice versa, in the case of a new low. The inability of the market to create a new high/low signifies the potential for a price reversal. The price action between highs and lows is also very important. The waves that are formed between highs and lows and the duration and the strength of the price retracements can tell a lot about the overall trend strength and the real dynamics of the market.
All chart patterns share the same basic components:
(1) Formation of Higher Highs/Lows, or Lower Highs/Lows
(2) Formation of Local Highs and Local Lows (Tops and Bottoms)
(4) Trend waves between Highs/Lows (we focus on the wave’s size, duration, and steepness)
(5) Depth and Duration of the price retracements
Usually, the formation of a chart pattern is not clear and distinct. There are thousands of variations for any chart pattern and the market noise can always disrupt the process of pattern recognition. Therefore, it is important for all traders to decode those chart patterns by filtering and ignoring the market noise. The best way to eliminate market noise is to focus exclusively on timeframes above M30.
Categorizing Chart patterns
All Chart Patterns are classified into two main categories: Continuation (momentum) patterns and Reversal (exhaustion) patterns.
A continuation pattern signifies that a price trend is acquiring momentum and it will continue moving in the same direction. A reversal pattern signifies that the price trend moves to an end, and it will probably 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 it is considered as one of the most reliable chart patterns.
Formation:
-The left shoulder is formed after a new high (A).
-Afterward, the head is formed at the highest high (B). The head (B) is higher than (A) but relatively close to it, and it can be seen as the last push of buyers.
-The right shoulder (C) is a new local high that is formed lower than the head (B). The right shoulder signifies the inability of the buyers to create a new high. Point (C) is a strong indication that the trend is reversing.
-The completion of the pattern and the confirmation of the trend reversal comes from the breaking of the neckline, and after, as the next high is unable to break through 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 timeframe of the Head & Shoulders pattern includes usually one week to several months
(2) Rounding Tops/ Bottoms Patterns
The occurrence of a Rounding Top / Bottom Pattern signifies the birth of a new strong trend. This pattern is also called as the Saucer Pattern.
A Rounding Top / Bottom is a rare pattern and it usually emerges after a long consolidation period. But when it emerges, it can offer some great advantages for trading.
Advantages of a Saucer Pattern:
(i) It can signal a strong price move that will last long
(ii) It evolves slowly and thus leaves a lot of time for reconsideration before entering the trade
(iii) It can be traded easily via the placement of a pending order (buy stop/sell stop)
(iv) Last but not least, it offers an exceptional Reward/Risk ratio, as the stop-loss can be placed very close.
The Rounding Top / Bottom Pattern contains two main phases: (a) consolidation phase, and (b) fast-trending phase. When the market moves from phase (a) to phase (b) you will see often some market gaps. These gaps can confirm the pattern furthermore, given that they are bullish gaps. During the transition from (a) to (b) the market volatility booms and usually the volume activity too.
□ The timeframe for a Rounding Top / Bottom Pattern includes usually several months to one year
(3) Support & Resistance (S&R)
Support & Resistance is simply the most trustworthy chart pattern in technical analysis. According to the Support and Resistance approach, the movement of the price of a financial instrument has the tendency to stop and reverse when reaches certain predetermined levels. If these levels are found above the current market price they are called Resistance, and if these levels are found below they are called support.
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Support is a price level or a price zone under the current market price where the demand is strong enough to overcome any selling pressure.
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Resistance is a price level or a price zone over the current market price where the supply is strong enough to overcome any potential demand.
Note that it is far better to use Support / Resistance price zones than specific S&R price levels.
An interesting fact is that if the price breaks through a key support level then this level becomes a resistance level. On the other hand, if the price breaks through a key resistance level, then this level becomes a support level.
If the market moves constantly between strong support below and a strong resistance above, then it is a ranging market without any clear trend.
□ There is no specific timeframe for the recognition of a Support / Resistance pattern
(4) Double Tops / Bottoms Patterns
Double Tops / Bottoms are common chart patterns. These patterns signify the existence of very strong demand or supply level. Double Tops / Bottoms are confirmed when the price has hit twice a key support or resistance level and proved unable to breakthrough.
□ The timeframe for Double Tops / Bottoms includes usually one week to several months
(5) Triple Tops / Bottoms Patterns
The same patterns as the Double Tops / Bottoms, except the fact that the price has hit and tested a support or resistance level three times, and although failed to pass through.
□ The timeframe for Triple Tops / Bottoms includes usually one week to several months
(B) CONTINUATION (MOMENTUM) CHART PATTERNS
These are some key continuations chart patterns:
(1) Cup & Handle Chart Pattern
A Cup & Handle pattern signifies that an uptrend has paused temporarily, but it will not reverse. When the Cup & Handle is confirmed, the uptrend becomes very bullish.
Note that a potential Cup & Handle pattern that is unable to break the previous highs becomes a confirmed Double Top pattern. As you can see in the following chart, line-A starts as a resistance level, and then it becomes the line of support.
Chart: Decoding the Cup & Handle pattern
□ The timeframe for a Cup & Handle pattern includes usually some months to a couple of years
(2) Triangles
Triangles are chart patterns signifying the strong continuation of a price trend after a consolidation period. A triangle formation is considered much more reliable during an established trend.
There are three types of triangles:
(i) Symmetrical
(ii) Ascending
(iii) Descending
The basic formation of a triangle includes (i) the convergence of two trendlines (flat, ascending or descending) and (ii) the price is moving between the 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 & Pennant patterns signify the strong continuation of the master price trend after a sharp advance or decline. The increase of volume activity is a good sign for the confirmation of a Flag & Pennant pattern.
Chart: Flag & Pennant Patterns
□ The timeframe for the Flag & Pennant patterns includes usually one week to several months
Conclusions
As was mentioned before, the formation of a chart pattern is usually not a distinct process and there are thousands of variations for every major pattern. In addition, market noise can always disrupt any pattern recognition and lead to false conclusions regarding the real market conditions. Therefore, don’t try to identify patterns in short timeframes, less than M15. Longer timeframes such as the H4 and D1, have proved much more reliable for pattern recognition, over time.
In any case, don’t underestimate any fundamental changes because when the fundamental conditions change there is not such a thing as reliable pattern recognition. Finally, recognizing chart patterns can prove very useful for confirming the trading signals generated by other technical analysis methods (i.e. MACD Histogram and MACD Divergences).
■ Identifying and Evaluating Chart Patterns
George M. Protonotarios, November 2016
TradingFibonacci.com (c)
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