October 16, 2017
Chart patterns are a very effective tool for a trader. They are used to for signaling reversal or continuation of the current trend, and to identify entry and exit points of a position.
Chart patterns are formed over time and consist of multiple candlesticks. They have the ability to predict future price-action with a high probability, making them very popular among traders in the forex market.
Chart patterns can be grouped into three main groups:
- Reversal chart patterns
- Continuation chart patterns
- Bilateral chart patterns
Reversal chart patterns signal that the underlying trend is about to reverse. During an uptrend, reversal chart patterns hint that a fall in price might be ahead. And during a downtrend, these chart patterns signal that a rise in price could come soon.
Let’s cover some of the most popular reversal chart patterns next.
Double Tops and Double Bottoms
Double tops are formed on a top an uptrend, making two swing highs at around the same price level. In the following chart a Double Top formation is shown, with points (1) and (2) showing two highs at the same price level. This is an indication that buyers have no power to push the price up, and that a change in trend could come soon. The red line below the formation is called the “neckline”. A break of the neckline signals the potential for opening a short position, with the target being the same distance as the height of the formation from the neckline (marked with the red arrow).
Double bottoms are similar to double tops, only that they form during a downtrend. The following chart shows a double bottom formation. Points (1) and (2) are the swing lows of the double bottom formation, with both lows around the same price level. Point (3) is the neckline of the formation. Just like a double top, the take profit level is set at the height of the double bottom formation from the neckline to the low (red dotted arrows).
What is a Head and Shoulders Pattern and How to Trade It
A head and shoulders pattern is a chart formation that predicts a bullish-to-bearish reversal, and is considered one of the most reliable chart formations in technical analysis. This pattern occurs at the top of an uptrend, signaling that bulls have lost steam and a reversal might be ahead. Let’s take a look at a head and shoulders pattern in a chart.
The chart above shows a head and shoulders formation on the 4-hour USD/CHF pair. Points (1) and (3) are the shoulders of the formation, while point (2) is the head. That’s why this formation is called “head and shoulders”. Line (4) is the neckline of the formation, the break of which signals the opportunity to enter a short position. The exit point is the height of the formation from the neckline to the top of the head, marked with the red arrows.
What is a Wedge Chart Pattern and How to Use It
A wedge pattern is another popular reversal chart pattern. Wedge patterns can be divided into rising wedges, and falling wedges.
A rising wedge is a bearish formation that forms at the top of an uptrend, and signals that a change in trend is ahead. Conversely, a falling wedge is a bullish formation that forms at the bottom of a downtrend, just before a start of a new uptrend.
A rising wedge is shown at the chart above. As you can see, this formation begins wide at the beginning, and narrows by the end of the pattern while making higher highs and higher lows. In contrast to a falling wedge, a rising wedge slopes up. The break of the lower trendline signals an opportunity to enter a short position, with the exit point being the height of the formation in its early beginning (red arrows).
Similarly, a falling wedge makes lower highs and lower lows, and slopes down. A break of the upper trendline signals the opportunity to enter a long position, with the exit target being the height of the wedge in its beginning.
What is a Rectangle Chart Pattern and How it’s Used to Trade Breakouts
A rectangle pattern forms when the price fluctuates between parallel support and resistance lines. This pattern is a continuation pattern, which means that it signals that the previous trend is about to continue. Rectangle patterns can be bullish and bearish, depending where they form.
A bullish rectangle forms during an uptrend, and suggests that the price will continue to trade higher. Conversely, a bearish rectangle forms during a downtrend a hints that the downtrend is about to continue.
The following chart shows a bullish rectangle pattern.
The break above the upper resistance line is the point where you should open a long position. Just like the other mentioned patterns, the exit point is the height of the formation, i.e. the height of the rectangle in this case.
What are Bullish and Bearish Pennants and How to Trade them
Pennants are chart formations very similar to triangles. They are continuation patterns which form after strong up or down moves. In the forex market, strong moves in price are usually followed by signs of exhaustion, and this is where correction moves and pennants often form, before the trend continues its direction. Depending on the trend, pennants are classified into bullish and bearish pennants. The following chart shows a bullish pennant on the USD/CHF chart.
The red lines on the chart show the formation of a pennant after a strong upmove. As you can see, the form of the pennant is very similar to a rectangle. A buy order is places after the break of the upper trendline, and a stop loss order just below the pennant. Unlike other chart formations, pennants signal a much stronger move and the exit target is the height of the earlier move (red dotted line). Bearish pennants are similar to bullish pennants, only that they form during a strong downtrend. This can be seen on the next chart.
You will enter a short position after the lower trendline breaks, with the exit target equal the height of the previous move. In this case, stop loss orders are placed just above the pennant formation.
What are Triangle Chart Patterns and How to Trade them
Triangle chart patterns are so-called bilateral chart patterns, because they can signal that the price can move either up or down.
Triangle chart patterns can be grouped into three groups:
- Ascending triangles, with the upper trendline being horizontal and the lower having an up-slope
- Descending triangles, with the lower trendline being horizontal and the upper having a down-slope
- And Symmetrical triangles, where both trendlines slope in different directions and narrow by the end of the triangle.
Let’s give an example for all three of them.
The following chart shows an ascending triangle, with a horizontal upper trendline and up-sloping lower trendline. A break above the upper trendline signals a buy opportunity, while a break below the lower trendline signals a sell opportunity, like in our example. The target price is the height of the triangle (red dotted arrows), while a stop-loss can be placed just above the upper trendline.
A descending triangle has a horizontal lower trendline, and a down-sloping upper trendline. A break above the upper trendline is a buy signal, and a break below the lower trendline is a sell signal, like in our example. The price target is the height of the triangle, and a stop-loss should be placed just above the upper trendline.
A symmetrical triangle, just as its name suggests, has symmetrical upper and lower trendlines which narrow by the end of the formation. Again, a break of the upper trendline signals that the price may trade higher, while a break of the lower trendline signals that the price may trade lower. In our example, you would enter a long position with the break of the upper trendline, with the target being the height of the triangle, and a stop-loss order placed just below the lower trendline.
Test Your Knowledge: Why Charts are so Important
0 of 3 questions completed
Why Charts are so Important
You have already completed the quiz before. Hence you can not start it again.
Quiz is loading...
You must sign in or sign up to start the quiz.
You have to finish following quiz, to start this quiz:
0 of 3 questions answered correctly
Time has elapsed
You have reached 0 of 0 points, (0)
Question 1 of 3
Which of the following is NOT one of the three main chart pattern groups:Correct
Question 2 of 3
Double Tops occur during:Correct
Question 3 of 3
A rising wedge is a bullish formation that forms at the top of an uptrend, and signals that a change in trend is ahead.Correct