A Definitive Guide to Chart Patterns

guide-to-chart-patterns

Technical analysis is a wide topic and a broad trading discipline. It involves evaluating investments and identifying trading opportunities by analyzing trends and chart patterns. In the list below, the Investment Pips team has gathered some of the more common trading chart patterns analysts use in technical analysis.

1. Head and Shoulders Chart Pattern

The formation of a Head and Shoulders comes after an uptrend, marking a trend reversal upon its completion. The head and shoulders top pattern contains three successive peaks, with the head being the highest (the middle peak), and the two lower shoulders (lower peaks) being more or less equal. To draw the neckline, you connect the reaction lows.

The parts that play a role in the Head and Shoulders pattern are: a left shoulder, a head, a right shoulder, a neckline, volume, the breakout, the price target, and support turned resistance.

Head and Shoulders

There are steps to establish the Head and Shoulders pattern:

1.    There must be a prior uptrend for the pattern to form. Without a previous uptrend, we cannot confirm the formation of the pattern.

2. During the uptrend, the left shoulder forms a zenith that establishes the high point of the current trend. Afterward, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trend line, keeping the uptrend intact.

3. From the low of the first shoulder (left), an advance begins to form that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The uptrend line here usually is broken by the low of the decline, jeopardizing it.

4. The head of the right shoulder is formed by the advance from the low of the head (3). The peak of the right shoulder is lower than the head and is more or less equal with the high of the first (left) shoulder. This peak’s decline should break the neckline.

5. To form the neckline, connect the two low points which are:

●       Low point one: End of the left shoulder, the beginning of the head.

●  Low point two: End of the head, the beginning of the right shoulder.

The neckline can slope up, slow down, or be perfectly horizontal, depending on the relationship between the two low points. This will affect the pattern’s degree of bearishness. For example, a descending slope is more bearish than an upward slope.

Another part essential to keep in mind and to further validate this pattern is the analyzing of volume levels. During the advance of the left shoulder, the volume ideally should be higher than that of the head. Then we look for the volume increase on the decline from the peak of the head, then decreasing during the advance of the right shoulder.  If the volume further increases during the decline of the right shoulder, it’s a sign the pattern has been formed.

The price decline is found by measuring the distance from the neckline to the top of the head, after breaking the neckline support. Then we subtract this distance from the neckline to reach a price target.

2. Inverse Head and Shoulders Chart Pattern

The formation of an Inverse Head and Shoulders comes after a downtrend, marking a trend reversal upon its completion. The Inverse Head and Shoulders pattern contains three successive troughs, with the head being the deepest (the middle trough), and the two outside shoulders (higher troughs) being more or less equal. To draw the neckline, you connect the reaction highs. The price action is roughly the same as that of the Head and Shoulders but reversed. The biggest difference between the two is the more significant role volume plays in the Inverse Head and Shoulders chart pattern. An increase in volume on the neckline breakout is imperative in the Inverse Head and Shoulders chart pattern.

Inverse Head and Shoulders

The parts that play a role in the Inverse Head and Shoulders pattern are: a left shoulder, a head, a right shoulder, a neckline, volume, the breakout, the price target, and resistance turned support.

There are steps to establish the Inverse Head and Shoulders pattern:

1.    There must be a prior downtrend for the pattern to form. Without a previous downtrend to reverse, we cannot confirm the formation of the pattern.

2. During the downtrend, the left shoulder forms a trough that establishes the low point of the current trend. Afterward, an advance ensues to complete the formation of the shoulder. The high of the decline usually remains above the trend line, keeping the downtrend intact.

3. From the high of the first shoulder (left), a decline begins to form that exceeds the previous low and marks the low point of the head. After plunging and hitting bottom, the high of the subsequent advance marks the second point of the neckline.

4. The head of the right shoulder is formed by the decline from the high of the head (3). The bottom of the right shoulder is higher than the head and is more or less equal with the low of the first (left) shoulder. This bottom’s advance should break the neckline and completes the reversal.

5. To form the neckline, connect the two high points which are:

●       High point one: End of the left shoulder, the beginning of the head.

●  High point two: End of the head, the beginning of the right shoulder.

 The neckline can slope up, slow down, or be perfectly horizontal, depending on the relationship between the two high points. This will affect the pattern’s degree of bullishness. For example, an upward slope is more bullish than a downward slope.

Another crucial part of the Inverse Head and Shoulders chart pattern is the volume levels. The volume levels in the second half of the pattern are more important than the first. The advance from the low of the head should show an increase in volume. From the neckline’s second point (reaction high), the shoulder’s decline should reflect some light volume. It is only natural to encounter profit-taking after an advance. For a breakout to be considered valid, the advance from the low of the right shoulder should have an expansion of volume and so should the breakout. Once neckline resistance is broken, the Inverse Head and Shoulders pattern is complete.

3. Bullish Symmetrical Triangle Chart Pattern

A bullish symmetrical triangle is a bullish continuation chart pattern, characterized by two converging trend lines that are symmetrical to the horizontal line. Two lower highs and two higher lows appear in the pattern. The symmetrical triangle takes shape when these points connect, and the lines converge as they extend.

Line 1 is a bearish trend line creating the resistance, also called the resistance line. Line 2 is a bullish trend line creating the support, also called the support line.

bullish symmetrical triangle
Bullish Symmetrical Triangle

The symmetric triangle usually marks the continuation of the current bullish trend. However, there are some instances where a hint of essential trend reversals can be spotted. Regardless, a valid breakout must be determined in order to establish the direction of the next significant move.

Here are the steps to take to validate/confirm a bullish symmetrical triangle:

  1. An established bullish trend of at least two or three weeks should precede the pattern. This will qualify it as a continuation pattern.
  2. Two trend lines are required to form a symmetrical triangle; therefore, we need to plot at least four points to even begin considering establishing the pattern.
  3. Trading volume should diminish as the symmetric triangle extends and the trading range contracts.
  4. The duration we should be looking for is at least three months.
  5. Half-way to 3/4 of the way through the pattern’s development is considered an ideal breakout point. The pattern’s development can be measured form the convergence of the upper and lower trend line back to the start of the lower trend line (the base).
  6. To confirm the breakout, you should see an expansion in trading volume. You could apply a price or time filter to confirm validity. The price filter is a 3% break, and the time filter is the price sustained for a few hours.
  7. The apex can be used as a support or resistance. You can sometimes notice the price returning to the apex or support and resistance levels around the breakout before resuming its direction.
  8. To get a price target, you can measure the widest distance of the symmetrical triangle and apply a breakout point. Afterward, you draw a parallel trend line to the pattern’s upward sloping trend line. The potential breakout target is marked by the extension of this line.

The pattern is used by traders in conjunction with other forms of analysis that act as confirmation.

4. Bearish Symmetrical Triangle Chart Pattern

A bearish symmetrical triangle is a bearish continuation chart pattern, characterized by two converging trend lines that are symmetrical to the horizontal line. Two lower highs and two higher lows appear in the pattern. The symmetrical triangle takes shape when these points connect, and the lines converge as they extend.

Line 1 is a bullish trend line creating the support, also called the support line.

Line 2 is a bearish trend line creating the resistance, also called the resistance line.

bearish symmetrical triangle
Bearish Symmetrical Triangle

The symmetric triangle usually marks the continuation of the current bearish trend. However, there are some instances where a hint of essential trend reversals can be spotted. Regardless, a valid breakout must be determined in order to establish the direction of the next significant move.

Here are the steps to take to validate/confirm a bearish symmetrical triangle:

  1. An established bearish trend of at least two or three months should precede the pattern. This will qualify it as a continuation pattern.
  2. Two trend lines are required to form a symmetrical triangle; therefore, we need to plot at least four points to even begin considering establishing the pattern.
  3. Trading volume should diminish as the symmetric triangle extends and the trading range contracts.
  4. The duration we should be looking for is at least three months.
  5. Half-way to 3/4 of the way through the pattern’s development is considered an ideal breakout point. The pattern’s development can be measured form the convergence of the upper and lower trend line back to the start of the lower trend line (the base).
  6. To confirm the breakout, you should see an expansion in trading volume. You could apply a price or time filter to confirm validity. The price filter is a 3% break, and the time filter is the price sustained for three days.
  7. The apex can be used as a support or resistance. You can sometimes notice the price returning to the apex or support and resistance levels around the breakout before resuming its direction.
  8. To get a price target, you can measure the widest distance of the symmetrical triangle and apply a breakout point. Afterward, you draw a parallel trend line to the pattern’s downward sloping trend line. The potential breakout target is marked by the extension of this line.

Just as the bullish symmetric triangle, this pattern is used by traders in conjunction with other forms of analysis that act as confirmation.

5. Rounding Bottom

Also known as a saucer, the rounding bottom pattern is a U-shaped trough with a flat bottom that represents a long-term reversal pattern. The pattern represents a consolidation period that turns a bearish bias to a bullish bias.

rounding bottom chart pattern
Rounding Bottom

You might see several bearish peaks in some cases, but the pattern’s validity remains intact. It usually is best suited for weekly charts as the recovery period may take weeks or even months to coalesce; thus, investors should be aware of the patience required to realize a full recovery in the currency price.

For any reversal pattern to established, there must be a prior trend. The first half of the rounding bottom pattern is the decline that leads to the low of the pattern. As the pattern is ideally seen in longer-termed charts, you might notice different forms of this decline. Some might be jagged with many reaction highs and lows, while others might be more linear.

The low of the pattern can resemble a U bottom but should not be too sharp and should take a few weeks to form. The other half of the U is the advance off of the lows, which should take around the same time as the prior decline. If the pattern is too quick to advance, we might question the validity of the rounding bottom.

When the pattern breaks above the reaction high at the beginning of the decline at the start of the pattern, we establish the bullish confirmation. 

Preferably, there should be an increase in volume on the advance and the breakout. Therefore, ideal volume levels should track the shape of the rounding bottom. High at the beginning of the decline, low at the end of the fall and rising during the advance.

The neckline of the pattern is the line across the top of the bearish and bullish trend before the breakout. Once drawn, you can measure the potential of your pattern by measuring the distance between the neckline and the lowest point of the pattern. This distance is the size of the rounding bottom pattern. When the price action breaks the neckline, it is an indication to go long.

6. Rounding Top

Also known as the inverse-saucer, the rounding top pattern is an inverted U-shaped trough with a flat bottom that represents a long-term reversal pattern. The pattern represents a consolidation period that turns a bullish bias to a bearish bias.

You might see several bullish peaks in some cases, but the pattern’s validity remains intact.

Rounding Top

For any reversal pattern to established, there must be a prior trend. The first half of the rounding top pattern is the advance that leads to the high of the pattern. As the pattern is ideally seen in longer-termed charts, you might notice different forms of this advance. Some might be jagged with many reaction highs and lows, while others might be more linear.

The high of the pattern can resemble an inverse U top but should not be too sharp and should take a few weeks to form. The other half of the inverse U is the decline off of the highs, which should take around the same time as the prior decline. If the pattern is too quick to decline, we might question the validity of the rounding top.

When the pattern breaks below the reaction low at the beginning of the advance at the start of the pattern, we establish the bearish confirmation. 

Preferably, there should be an increase in volume on the decline and the breakout. Therefore, ideal volume levels should track the shape of the rounding top. High at the beginning of the advance, low at the end of the advance and rising during the decline.

The neckline of the pattern is the line across the bottom of the bullish and bearish trend before the breakout. Once drawn, you can measure the potential of your pattern by measuring the distance between the neckline and the lowest point of the pattern. This distance is the size of the rounding top pattern. When the price action breaks the neckline, it is an indication to short.

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7. Pennant

A pennant pattern is a price formation that occurs when a strong trend in the currency pair is followed by a sideways movement as traders pause to catch their breath before taking the price further in the same direction. This consolidation move is reflected in the chart by a trading range which is formed by successive highs and lows and narrows over time. Pennants in Forex are classified as short-term continuation patterns that are usually short-lived, lasting generally for less than three weeks.

pennant chart pattern
Pennant

Once the pennant formation is completed with a breakout, forcing the price to bust out of the pattern, the currency pair heads in the same direction as the move that initiated the original trend.

The main difference between pennant and flag patterns, which are similar in terms of structure, can be spotted in the middle section of the price formation. After a big upward or downward move, this part in a pennant is formed by converging trendlines, much like what is seen in the symmetrical triangle patterns.

8. Cup and Handle

Cup and handle pattern, which usually has a bullish potential and creates a rounded bottom on the chart, was developed by William O Neil who first wrote about it in his book “How to make money in stocks”. Overall, it starts with a bearish price move, which gradually reverses.

This powerful chart pattern resembles a cup and handle where the right-hand side of the pattern, the cup section, typically takes the U-shape as the price initially declines, then levels off and begins to rise again. Then comes the handle, which reflects a sideways or declining price move that occurs with a slight downward drift near the lip of the cup.

 cup and handle chart pattern
Cup and Handle

This forex chart pattern could act as a reversal or continuation signal and its bearish equivalent could also appear after a downward price move. This depends on the price movement prior to the pattern formation.

Cup and handle pattern doesn’t have to be pretty to be effective. As such, traders often use it in conjunction with other forms of chart patterns that act as confirmation.

9. Ascending Triangle

The ascending triangle is a bullish continuation pattern, created by price moves that form flat upper side, and one sloping side, which is moving toward the flat horizontal part. In this manner, the swing highs of this triangle are on the same level and the bottoms are drawn along a rising trendline.

Ascending Triangle

Traders often watch for breakouts throughout the two lines forming the triangle pattern, which could occur to the upside or downside. The FX pair will typically break out the upper level (the flat side) in the same direction as the original direction that was prevailing just prior to the chart pattern formation.

The size of the subsequent price move is typically a 1:1 measured move, i.e it will be equal to the length of the triangle. Many traders look to enter long trades following a breakout from the upper line, as they expect the trend to continue, but note that it sometimes causes false signals and thus trapping your trades along the way.

10. Triple Bottom

The triple bottom is a bullish reversal pattern where three equal lows located roughly at the same level, and two highs between them, are typically followed by a break above the resistance line. The lower line that connects the lows is considered to be strong support as the price reverses three times from the level.

triple bottom chart pattern
Triple Bottom

Once the price breaks through the higher line that connects the pattern’s tops, this is likely interpreted by traders as a change in the prior downtrend and thus serving as a buy signal. Alternatively, if you want to be in the safe zone you can wait for a retest of the broken resistance instead of taking the breakout. This will ensure you’ll not get into a false bullish breakout through the established resistance range. In both cases, the profit target is placed at a similar distance between resistance level and the triple bottom support line.

For beginners, this chart figure is sometimes similar to the head and shoulders pattern, but what distinguishes a triple bottom is the three consecutive lows and the lack of a head between the two shoulders. This distinct feature helps identify and interpret each pattern.

11. Descending Triangle

As you probably guessed, this forex chart pattern is the exact opposite of ascending triangles that we explained above. A descending triangle occurs when there are a resistance level and a slope of lower highs coming into an area of support.

Descending Triangle chart pattern
Descending Triangle

The third price formation within this group is called ‘symmetrical triangle’ where the slope of the peaks and the series of bottoms converge together to a certain point on the chart. The three patterns keep putting pressure on the support or resistance levels and as a result, a breakout is bound to happen.

Although the descending triangle is typically a bearish chart pattern it happens in many cases the price goes up after this pattern was formed, so you should be aware of the bullish scenario as well. This also applies to other triangles.

We need two confirmations in both bullish and bearish scenarios. The first confirmation is breaking outside of the triangle range, either upside or downside. This initial move indicates the market structure and most traders will open a trade in the same direction since they do not want to trade against the prevailing trend. After getting the first signal, you have to look for the second one that will be a retest of broken resistance/support which should be then held to negate any false breakout scenarios.

12. Flag

A Flag is a continuation pattern of the preceding trend that is formed when the market consolidates in a narrow range after a steep rise (or fall), i.e it represents only a brief pause in a dynamic market.

The pattern has a “flagpole” appearance that illustrates the preceding trend followed by trading in a narrow price range (the small rectangle) and then finalized with a second steep move, just before the breakout or breakdown that continues the prior trend.

flag chart pattern

The starting point for the trend lines is connecting the highest highs or lowest lows to represent the pole portion, and then forms a short-term bearish trend with parallel rising upper and lower trend lines. While the trendline is sloping, they should remain relatively parallel to each other. Eventually, the price should break through the trend line triggering buyers or sellers to step into the market.

We often anticipate what direction of the breakout will be depending on the prior trend, but eventually, any side of the pattern could give in to continue or reverse the original move.

If you would like to learn more about forex trading, visit our FX Academy.

We used several different sources to put together this list and we always keep it up-to-date. Some of the sources our team used to put together this article are: Wikipedia, StockCharts and Central Charts.