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Technical analysis is one of the key ways traders (and investors) analyse the stock markets. Chart patterns fall under the umbrella of technical analysis and represent powerful formations that help traders project where price action may be headed next. Employed by beginners and professionals across various financial markets, including foreign exchange (Forex) and, of course, the equity markets, chart patterns can form an integral part of a trading strategy.
In this article, we’ll break down five of the most essential stock chart patterns, offering a closer look at how they work and how to trade them.
The head and shoulders top pattern help traders identify potential bearish trend reversals. The pattern consists of three peaks: the left shoulder, the head, and the right shoulder. Importantly, the head and shoulders top pattern is best located following a prolonged uptrend or within a lengthy pullback in a downtrend.
As illustrated in the EUR/USD H1 chart above (similar formations can be found across the equity markets), the pattern’s neckline is drawn between the two troughs on either side of the head. A downside close beyond this neckline means the pattern has completed, and follow-through selling could unfold towards the pattern’s profit objective (measured by taking the vertical distance [value] from the head to the neckline and extending this from the breakout point).
The mirror opposite of a head and shoulders top pattern is called an inverted head and shoulders pattern, and offers bullish trend reversal structure within downtrends and in corrections in an uptrend.
The double top and double bottom patterns are two powerful reversal configurations found during periods of consolidation after an uptrend or downtrend, respectively. They form through two approximately equal highs (for a double top) or lows (double bottom), usually at a resistance or support level, and indicate that the current trend may be losing steam. They’re also identifiable by their ‘M’ or ‘W’ shape.
The intermediary support or resistance line between the two peaks or troughs is key to confirming the pattern. Once breached, it can be assumed that a trend reversal is due with traders plotting profit objectives by extending the vertical distance (value) from the most extreme high (low) to the support (resistance) in the double top (double bottom) formation from the breakout point.
As shown on the H1 chart above of Tesla (TSLA), a double bottom formed around $265.00 after a sizeable downward move. Price action subsequently closed above the resistance formed between the two troughs and continued to pursue higher ground.
An ascending triangle is a bullish continuation pattern that indicates a potential upside breakout (do note, however, that these formations can serve as trend reversal structure). It’s formed by an ascending support line with a horizontal resistance line covering the peaks and is typically found in a larger bullish trend. Effectively, the price bounces from the resistance level multiple times, absorbing supply and plotting higher lows. A key point to be aware of is the need for at least two tests of the resistance and ascending line to be a valid pattern.
When/if the stock price closes above the resistance line, the ascending triangle pattern is complete, indicating the upward trend will likely resume. Technically, traders outline profit objectives based on the distance between the base value (the vertical distance between the beginning of the ascending line and the resistance line) and extend this value from the breakout point.
The opposite of the ascending triangle is a descending triangle, which is commonly found in downtrends and is also viewed as a continuation signal.
The symmetrical triangle pattern is unique because it doesn’t necessarily indicate bullishness or bearishness (neutral pattern). Unlike the previous triangle pattern, which plots a series of higher lows, the symmetrical triangle works with two converging lines with no clear direction before the pattern’s formation (at least two tests of both converging lines are needed). Usually, after such compression, a volatile breakout can unfold in either direction.
Most often, price breaks in the direction of the broader trend, but not always. It’s considered best to wait for price to decisively close beyond either line before committing. Commonly, traders add filters to help avoid whipsaws. This, as just noted, can be as simple as employing a close filter: a defined close above/below the pattern’s outer limits, or a time filter: a pre-determined time for price to remain outside of the pattern’s space following the breakout.
The bullish (or bearish) flag pattern is one of the most common continuation patterns. It can be referred to as a half-mast pattern as it can form mid-way through a trend, thus marking the midpoint.
Importantly, these patterns must form within a trending environment (need not be long-term trends, but a defined move must precede the pattern). The structure is straightforward: a flagpole must form before the flag’s structure. After this, a flag is formed through two parallel lines (think of a mini channel formation) that are tested at least twice before validating the pattern. Following this, a breakout in the direction of the predominant trend will be anticipated, a move that encourages pattern traders to plot a take-profit target from the breakout point equal to the flagpole’s distance.
This article has hopefully helped serve as a foundation to begin exploring the vast array of chart patterns. Additional chart patterns that stock traders often seek to identify include pennant patterns, cup and handle patterns, rounding patterns, as well as more advanced harmonic formations, such as the AB=CD pattern.
Consider opening a demo trading account with FP Markets today and, using our broad selection of professional trading platforms, discover the wide array of patterns that emerge daily across key asset classes.
Charts: TradingView.
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