Charting patterns are some of the most widely used price action technical tools used to trade the asset markets. Analyst and traders for years have used specific patterns to determine the future direction of the market, give historical movements in the markets that have occurred after a specific pattern has occurred. The goal of this article is to discuss some of these different patterns and show examples of how the markets have reacted after the pattern occurred.
Symmetrical triangles can be characterized as areas of indecision, and low volatility. A market pauses and future direction is questioned. When a symmetrical triangle occurs in the market, traders are jockeying for position, buying and selling assets which creates a period of consolidation. Typically, the forces of supply and demand at that moment are considered nearly equal. Attempts to push higher are quickly met by selling, while dips are seen as buying opportunities. Each new lower top and higher bottom becomes more shallow than the last, taking on the shape of a sideways triangle. During this period, both volume and volatility dip. Eventually, this indecision is met with resolve and the market bursts out in one direction or the other. Generally, the symmetrical triangle breakout resolves itself in the direction of the current trend. The breakout is accompanied with a large change in volume, and volatility generally increases along with volume. These patterns are an excellent consolidation pattern that can be used to recognize a trend that has paused only to refresh.
The ascending triangle is a variation of the symmetrical triangle. Ascending triangles are generally considered bullish and are most reliable when found in an uptrend. Similar to the Symmetrical the ascending triangle occurs when the market is consolidating. The top part of the triangle appears flat, while the bottom part of the triangle has an upward slant. In ascending triangles, the market becomes overbought and prices are turned back. There is supply pressure as market participants take profit on long positions and new traders place short positions into the market. Eventually, buying reenters the market and prices soon reach their old highs, where they are once again turned back. Buying then resurfaces, although at a higher level than before. In the ascending triangle, there are continuous higher lows and higher highs as the market consolidates. Prices eventually break through the old highs and are propelled even higher as new buying comes in. The breakouts are accompanied by high volume as the market is propelled even higher. Volatility usually increases with the increase in volume.
The descending triangle is also a variation of the symmetrical triangle. The descending triangle generally is a bearish pattern and often occurs during a downtrend. In the descending triangle the bottom part of the triangle appears flat. The top part of the triangle has a downward slant as prices make lower lows and slightly lower highs (or unchanged highs). Prices drop and are met with buying as the market becomes oversold and shorts cover their positions. Tentative buying comes in at the lows, and prices perk up. The higher price however attracts more sellers and prices re-test the old lows. Similar to the symmetrical triangle and the ascending triangle this is a consolidation pattern. Buyers then once again tentatively re-enter the market. As prices rise, more selling is attracted which creates resistance and pushes the market lower. As prices are pushed to new lows, buyers stop out of the market and shorts gain control and at to positions. Similar to the other triangles, when the break out comes (or break down in this case), volume and volatility increase during the inflection point.
The Head and Shoulders Pattern
The head and shoulders pattern is a reversal pattern and it is most often seen in at the end of an uptrend. It is also considered most reliable when found during an uptrend. Eventually, the market begins to slow down and the forces of supply and demand are generally considered in balance. Again, the market begins to consolidate as market participants jockey for position. Sellers come in at the highs (left shoulder) and push the market lower to test the neck line of the pattern. Buyers soon return to the market and ultimately push through to new highs which for the head of the pattern. The new highs meet resistance, and the market is pushed back down to support which continues to form the neck line. Buying re-emerges, and the market rallies once more, but this time the market fails to take out the previous high. This creates the right shoulder. The right shoulder is usually the same height as the right shoulder; but is can be slightly higher or lower as long as it is lower than the head. Buying dries up and the market tests the downside yet again. Support of the market is a trend line that creates the neck line. Volume and volatility initially rise during the first increase of the left shoulder, but fall as the market falls in forming the head pattern. As a reversal pattern, the market consolidates until the neck is tested after the forming of the right shoulder. New selling comes in and previous buyers get out. The pattern is complete when the market breaks the neckline. When this occurs, volume increases substantially as longs are stopped out of their positions. The break is magnified by new longs that entered the market at the neck line thinking that support would hold and the trend would continue.
Inverted Head and Should Pattern
The inverted head and shoulder is the opposite of the head and shoulder and is typically seen in downtrends. The inverted head should be made on lighter volume. The rally from the head however, should show greater volume than the rally from the left shoulder. Ultimately, the inverted right shoulder should register the lightest volume of all. When the market then rallies through the neckline, a big increase in volume should be seen.)
The wedge formation is also similar to a symmetrical triangle in appearance; however, wedges are distinguished by a noticeable slant, either to the upside or to the downside. Similar to triangles a falling wedge is generally considered bullish and is usually found in up trends. But they can also be found in downtrends as well. The implication however is still generally bullish. This pattern is marked by a series of lower tops and lower bottoms. The wedge pattern is a consolidation pattern and usually breaks in the direction opposite of the trend. A rising wedge is generally considered bearish and is usually found in downtrends. They can be found in up trends too, but would still generally be regarded as bearish. Rising wedges put in a series of higher tops and higher bottoms.
Flags and Pennants
Flags and pennants are similar to the symmetrical triangle and generally move in the direction of the trend. They are continuation patterns, and represent only brief pauses in a changing market. They are typically seen right after a big, quick move. The market is taking a respite from a large move and as it consolidates it forms a flag or pennant pattern. The market then usually takes off again in the same direction as the large move. Bullish flags are characterized by lower tops and lower bottoms, with the pattern slanting against the trend. But unlike wedges, their trend lines run parallel. Bearish flags are comprised of higher tops and higher bottoms, their trend lines run parallel as well. Pennants look very much like symmetrical triangles. But pennants are typically smaller in size (volatility) and duration. Volume and volatility usually contracts as the market consolidate and the flag or pennant is formed. Volume then explodes when the market bursts out.
In all of these patterns, volume is a consideration that helps form and end the patterns. Volume is the number of contracts or shares traded over a period of time. The contraction of volume during the formation of the pattern and the increase in volume as the market bursts out is an important guideline to follow. Volume theoretically should increase in the direction of the price. If the current trend is up, volume should be heavier on the up days and lighter on the down days. If the trend was down, volume should be heavier on the down days, with lighter volume on the up days. This makes sense as more buyers will push a price up in an uptrend and volume with increase. As the supply demand imbalance grows, prices will climb. The same is true and the market moves down in a downtrend.
Most of these patterns are consolidate patters. When the market moves sideways, often traders will avoid a market, preferring to commit their funds once a breakout is seen. However, while it’s typical for volume to diminish during these times, volume can give clues as to possible future direction by measuring the level of conviction of the buyers and the sellers. Watching to see if there’s heavier volume on the up days or on the down days could be useful in getting positioned during a sideways move or a formation of a pattern.