In technical analysis, it’s assumed that prices tend to follow patterns as they have in the past due to similar reactions of investors. Technical traders scan price charts looking for patterns in price action or a technical indicator to signal a potential change in trend to help them build their weight of evidence in determining potential future price direction.
Analyzing chart patterns is one method that many traders use to identify a potential change in trend. Chart patterns can also be used to indicate that an existing trend is likely to continue
There are basically two types of chart patterns:
1. Reversal patterns – Signal potential reversals during existing up and downtrends.
2. Continuation patterns – Signal potential continuation of the existing up or downtrend.
Each chart pattern has a particular set of confirmation requirements that must be met before the trend reversal or continuation signal is considered to be confirmed. Additionally, some chart patterns only signal potential reversals while other patterns can signal potential reversals and/or trend continuations depending on how the pattern fully forms.
Timeframe and patterns
Pattern timeframes can play an important role in how a particular pattern is interpreted. Some patterns don’t take very long to form and occur more frequently. Other patterns take longer to form and don’t occur very often.
In short, it is generally believed that the longer the time frame covered by a particular pattern, the stronger the signal that ensues. For example, many traders believe that the longer price moves sideways within a relatively narrow channel then the more likely that the eventual breakout will result in a meaningful price movement in one direction or the other.
That being said, some very short-term patterns can also be very useful in signaling the future direction of impending market action. For example, a small tight narrowing price channel formed within the context of an uptrend is often viewed as a continuation pattern and suggests that higher prices will ensue.
Indicators and studies
Traders often use an analysis tool referred to simply as an “indicator” in conjunction with price movement and/or other indicators, in an effort to identify potential trading signals and/or to confirm trading signals from other indicators or chart patterns.
Another category of analysis methods used in technical analysis are often referred to as “studies”. Studies typically involve mathematical and/or statistical based formulas used to measure current conditions, as well as to forecast future price direction.
There are generally two types of indicators:
1. Leading indicators – These are indictors designed to signal an impending change in price movement in advance of the actual move. Some indicators may highlight an impending reversal in price direction while others may highlight an impending continuation of the current trend.
2. Lagging indicators – These are indicators that follow the price and describe past performance. They are primarily used to confirm price action. While they may not necessarily offer a predictive value, for trend-following investors, these indicators can be quite useful in terms of keeping a trader in gear with important trends for a given security.
While there are hundreds of different types of indicators and studies to choose from, many fall into one of several different categories. A small handful of these categories include:
- Volume indicators – These are typically used to confirm or deny the strength of an existing trend, breakout or price reversal. In theory, a price movement accompanied by above average trading volume is considered to be stronger – or of greater significance – than one accompanied by low volume.
- Trend or directional movement indicators – These are typically used in an effort to objectively designate the direction of a current trend as either up, down or sideways. Additionally, trend indicators can be used to measure trends of differing timeframes.
- Momentum indicators – These are typically used to measure the strength of a given trend, the speed at which price is changing, and to compare the relative strength of one security versus another.
- Overbought/oversold indicators - As the name implies, these indicators attempt to identify situations where price movement may have gotten too far extended in one direction and that a potential price reversal is possible.
Chart patterns can also be used in conjunction with other indicators and studies to help technical analysts with their forecasts. In any event, using just one indicator provides only a fraction of the whole picture. As a result, it can be very useful to utilize two or more indicators/studies/chart patterns in conjunction to try to get a better “weight of evidence,” or confirmation, on potential trade signals.
Trends themselves are considered an indicator. Trend is a lagging indicator that describes past price performance. But, because price action is so important in technical analysis, traders use trends to confirm price movement. Based on those trends, they can use the information to help them decide on potential entry and exit points.