Prior to the advent of computers and the proliferation of technical indicators and studies, hand drawn price charts were the primary tools used by technical analysts. Even today, a picture is worth a thousand words. Being able to utilize chart drawing tools can be valuable in helping traders identify basic price patterns and give clues to potential future bearish price action.
Price trends and patterns are visual representations of the interactions of market participants and thus to a certain extent are based on psychology. Traders and investors are, after all, human beings, and human beings have emotions such as fear, greed and indifference which haven’t changed over the millennia. Traders study charts looking for specific trends and patterns believing that if a stock moved in a particular direction after a pattern formed in the past, then there is a chance it could do so again. History doesn’t necessarily repeat itself, as they say, but it can often rhyme.
Considerations for chart pattern trading
Chart pattern trading is considered more of a complex trading catalyst than just using technical indicators because it’s important to look for several specific price movements in conjunction with charting tools to help determine entry and exit points.
The importance of basic chart tools in chart pattern trading
Having a good understanding of how to use basic chart tools and what they show is a critical component in identifying chart patterns. Two tools that traders should be familiar with when utilizing a chart pattern trading catalyst are:
- Support and Resistance Lines
- Trend Lines
Support and resistance
Charts can sometimes offer clues to where buying or selling pressure might materialize. For example, if in the past, prices have repeatedly declined to a certain level but not lower, it seems reasonable to assume that for whatever reason, buyers are interested at that price and therefore might be so again. Chartists would call this a “support” level. Or, if prices have repeatedly risen to a certain price level but not higher, it would seem that sellers are eager to sell at that price, and might be so again creating a “resistance” level.
Traders can use these simple concepts of support and resistance to help them develop trading strategies and fine tune entries and exits. The chart below offers a simple example.
XYZ has repeatedly attracted buyers around $30 (a support level) and sellers around $33 (a resistance level.) A logical bearish strategy could be to sell short near the resistance level and buy back near the support level. Besides giving traders entry and target prices, these levels can also be used to manage risk. For example, if the trader sold short near the $33 resistance level, but then the stock started trading above $33 for the first time in a while, this is a new development. It could mean that there is now more demand for the stock and the trader might want to exit and only suffer a small and manageable loss.
A trend is simply the overall direction of stock or commodity. At first blush it seems that identifying a trend’s direction is obvious. But think about this for a moment: would a single session trader who doesn’t like to hold overnight evaluate a trend in the same way as a trader who likes to hold for several months at a time? Probably not. So when traders are trying to determine what the trend is, they must consider timeframes. A rough guideline some traders use is to look back two to three times their anticipated holding period to evaluate the trend’s direction in a meaningful timeframe. Once the trend direction is established, many traders will attempt to draw trendlines to help them look for potential trades and manage risk.
For example, if there has been a series of lower highs and lower lows in a specified timeframe, traders will often attempt to connect the lower highs with a downtrend line. Why might they do this? For a couple of reasons. First, if a downtrend line can be drawn, the trader knows what the trend is and might not want to trade against it. Second, downtrend lines can offer an area of resistance. Recall that a resistance area is a price level where sellers overpower buyers and the stock tends not to go higher. Traders often will sell rallies to the resisting trendline so they can join the trend without chasing the stock. Trendlines can also give guidance on when to exit a position. If a stock starts trading above a downtrend line that has been consistently providing resistance, this is a new development, and traders might consider buying back at least some of their short position.
Using bearish chart patterns as a catalyst to enter trades
Chart pattern trading involves drawing and extending lines across a chart of previous price action and looking for either a particular pattern to form or for price to fall below a particular line as a trigger to take action.
Basic chart pattern concepts
Chart patterns can be thought of as an array of prices developing within boundaries. The boundaries could be horizontal support or resistance lines, trendlines or curved lines. Traders often initiate trades when a stock moves outside of the pattern’s borders, and over the years they have developed some rough guidelines regarding how far a stock might initially move after it “breaks out” of the pattern.
Besides just identifying patterns, analysts who have studied patterns have also come up with some general guidelines when using them:
- Patterns are considered to be “fractal”. In other words, patterns can appear in different timeframes, such as on weekly, daily or intraday charts and have the same characteristics and outcomes.
- How long a pattern takes to form can suggest how long it might take for the target price to be reached. For example, if a pattern takes a month to form and then the stock “breaks out,” it could take up to a month for the stock to achieve the target price.
Analysts also group patterns into general categories, such as continuation patterns and reversal patterns.
- Continuation patterns form when a stock has been trending in one direction, pauses for a while and then breaks out of the pattern in the same direction it entered. Common types include “triangles” of different types and “flags.”
- Reversal patterns, as the name suggests, occur when a stock enters the pattern in one direction and exits in the opposite direction. These include, among others, “double tops”. and “double bottoms.”
Bearish entry and profit target trading catalyst
Bearish symmetrical triangle - continuation pattern
The “bearish symmetrical triangle” is a common continuation pattern. This pattern shows two converging trendlines, the lower one is ascending, the upper one is descending. The formation occurs because prices are reaching both lower highs and higher lows. The pattern will display as at least two lows touching the lower ( ascending) trendline and at least two highs touching the upper (descending) trendline. This pattern is confirmed when the price breaks out of the triangle formation to close below the lower (ascending) trendline. To calculate the target price, analysts measure the height of the triangle at tis widest place (often called the base) and then take that amount and subtract it from the breakout price.
Bearish flag continuation pattern
A “Bear flag” is another type of continuation pattern that forms after a steep or nearly vertical drop in price. It consists of two parallel trendlines that form a rectangular flag shape. The Flag can be horizontal (as though the wind is blowing it), although it often has a slight uptrend. The sharp price decrease is sometimes referred to as the "flagpole" or "mast." The pattern is considered confirmed when the price breaks out of the cloth portion of the flag in the direction it entered. Traders calculate the target price by subtracting the ‘flagpole” height from the breakout price.
Double top - reversal pattern
The double top pattern, sometimes called an "M" formation because of the pattern it creates on the chart, is a reversal pattern of an upward trend in a security's price. The double top marks an uptrend in the process of becoming a downtrend and consists of two well-defined, sharp peaks at approximately the same price level. The two tops are distinct and sharp. The pattern is considered complete when prices decline below the lowest low in the formation, the trough of the “M.” The target can be calculated by taking the distance between the tops and the trough, and subtracting this amount from the trough price.
There are probably as many ways to select trades as there are traders. Any technique has its own pluses and minuses. Examining charts and looking for patterns and trends is one popular method of generating trading ideas and can provide traders with at least some guidance on when and where to enter and exit positions.