Prior to the advent of computers and the proliferation of technical analysis, 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 bullish price action.
Price trends and patterns are visual representations of the interactions between 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 that haven’t changed over the millennia. Traders study stock analysis 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 complex of a trading catalyst as opposed to 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
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 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.) One strategy could be to buy at the support level and sell at the resistance level. Besides giving traders entry and target prices, these levels can also be used to manage risk. For example, if the trader bought near the $30 support level, but then the stock started trading below $30 for the first time in a while, this is a new development. It could mean that there is now less demand for the stock and the trader might want to exit and only suffer a small and manageable loss.
A price 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 over night 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 time frames. 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 higher highs and higher lows in a specified time frame, traders will often attempt to connect the higher lows with an uptrend line. Why would they do this? There are a couple of reasons. First, if an uptrend line can be drawn, the trader knows what the trend is and might not want to trade against it. Second, uptrend lines can offer an area of support. Recall that a support area is a price level where buyers overpower sellers and the stock tends not to go lower. Traders often will buy pullbacks to the supporting 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 below an uptrend line that has been consistently providing support, this is a new development, and traders might consider selling at least some of their long position.
Using bullish 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 breakout above 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, trend lines 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.
Beyond 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 suggests that 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.”
Bullish entry and profit target trading catalyst
Bullish symmetrical triangle – continuation pattern
The “bullish 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 highs touching the upper (descending) trendline and at least two lows touching the lower (ascending) trendline. This pattern is confirmed when the price breaks out of the triangle formation to close above the upper (descending) trendline. To calculate the target price, analysts measure the height of the triangle at its widest place (often called the base) and then take that amount and add it to the breakout price.
Bullish flag continuation pattern
A “bull flag” is another type of continuation pattern that forms after a steep or nearly vertical rise 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 downtrend. The sharp price increase 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 adding the ‘flagpole” height to the breakout price.
Double bottom – reversal pattern
The double bottom is a reversal pattern of a downward trend in a stock's price and marks a downtrend in the process of becoming an uptrend. It occurs when prices form two distinct lows on a chart and resembles a “W.” This shape is formed because prices fall to a support level, rally higher, and then fall to the support level again before increasing and eventually breaking through the rally high. The pattern is complete when prices rise above the highest high in the formation. The target price can be calculated by measuring the distance between the bottoms and the middle peak of the “W” and adding that amount to the middle peak.
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.