Chart patterns are a key part of technical analysis that traders can use to assess market conditions and manage their risk.
Chart patterns fall into three categories;
- Reversals: these chart patterns indicate a change in the current trend
- Continuations: these chart patterns indicate the current trend will continue, and
- Bilateral: a movement in either direction is possible with these chart patterns.
Reversal patterns are usually found at the end of a trend and signal that a change in direction may be about to occur.
Double Bottoms/Double Tops
The double top and double bottom chart patterns appear when the price tries to break through an important resistance or support level, but fails each time.
A double top is preceded by an upward trend and is often shaped like an ‘M’. The double top is a bearish signal since the pattern shows that the price tried to break above a resistance level twice but failed.
A double bottom is preceded by a downward trend and is often shaped like a ‘W’. The double bottom is a bullish signal since the pattern shows that the price tried to break a support level twice but failed.
There are also corresponding patterns for when the price hits a support or resistance three times, known as triple bottoms and triple tops. These patterns are not as common as double tops or double bottoms.
The chart below shows a triple top followed by a double bottom. Following a double top or double bottom, candlestick analysis or volume can be used to look for confirmation.
Head and Shoulders
The Head and Shoulders pattern is often found after an uptrend and indicates a reversal may be imminent. The pattern is formed of three peaks, one for the shoulders, one slightly higher peak for the head and another lower peak similar to the first shoulder.
The neckline is drawn along the low points and acts as an entry point once the price turns south. The chart below shows the Head and Shoulders pattern along with the neckline. Once the price breaks below the neckline, we should look to enter a short position. The height of the pattern, from the neckline to the peak of the head, tells us how far the price may fall after moving below the neckline.
The height of the Head and Shoulders pattern is around $300 in the example above. We see that once the price broke below the neckline, the price of bitcoin fell $300 in the first 2-hour candle and proceeded to fall further to lows near $9,800.
An inverse Head and Shoulders pattern is the same as a Head and Shoulders pattern but is found after a downward trend and is upside down.
Continuation patterns indicate that the current trend will remain intact and that the price will continue to move in the same direction. The most popular continuation patterns are: pennants, rectangles, flags, and triangles.
Pennants are made up of two trend lines that converge with each other, where one is drawn with an upward slope and the other with a downward slope. An example of a bullish pennant is displayed below. Look for a decrease in volume as the pennant is being formed and once the price breaks out of this pattern, we should see an increase in trading volume.
As the chart above shows, volume started to fall as the pennant chart pattern was forming. Once there was a close outside of the pennant, volumes were starting to pick up again and you would have entered a long position on the close of the 15-minute candle around $10,064. Alternatively, for a better entry (but more risky), you can enter a position once the price breaks out of the pennant instead of waiting for the close.
An example of a bearish pennant is shown below.
Rectangles are another continuation pattern and is formed when the price is bounded by horizontal support and resistance levels. The price will test these levels until a breakout occurs, which is usually in the direction of the preceding trend.
For example, the chart below shows a rectangle chart pattern that occurs during a downward trend. The price stays within this range for a while before breaking out to the downside. The height of the rectangle often indicates how far the price will move after breaking out.
As a general rule, the breakout will extend at least as far as the height of the rectangle. In the example below, the rectangle length is $160, so we would expect at least a $160 drop in price once there is a breakout to the downside.
An example of a bullish rectangle chart pattern is shown below.
Flag patterns are where the highs and lows of the price of an asset form a sloped channel. These highs and lows can be connected with a trend line to form what is known as the ‘flag’.
As a continuation pattern, bullish flags are found during an uptrend while bearish flags are found during a downtrend. An example of a bearish flag is shown below.
The first requirement for a bearish flag is a large downward move, which forms the flagpole. Then prices consolidate in a range forming a parallel channel that is sloped to the upside. Once the price breaks below the flag, another downward leg ensues.
An example of a bullish flag is shown below.
Notice that a channel sloping downward was formed after a strong upward move (known as the flag pole). Price eventually broke out of the range and continued higher, with the move equal to or larger than the height of the flag.
There are three variants of the triangle chart pattern; symmetric triangles, ascending triangles and descending triangles.
A symmetrical triangle is formed when the price exhibits lower highs and lower lows and tells us a breakout is imminent. Symmetrical triangles do not tell us the direction of the breakout, only that we should be ready to anticipate one.
An example is displayed below. To take advantage of a symmetrical triangle pattern, we can place entry orders on either side of the triangle. Once the price breaks out of the triangle, one of the limit orders will be triggered (and we can cancel the other order), allowing us to ride in the direction of the breakout.
With the chart above, we would have placed limit orders to buy just above the triangle, while we would place limit orders to sell just below the triangle. Once the price broke below the triangle, BTC-USD fell from $9,600 to lows around $7,400 which is approximately equal to the height of the triangle.
Ascending triangles are formed when the price exhibits higher lows and tests a horizontal resistance level. An example of an ascending triangle is shown below.
Usually, the price will break the resistance and go onto establish a bullish trend. However, sometimes the resistance may be too strong and the price will break out to the downside instead.
The example above shows a breakout to the upside. Notice that the height of the triangle is about $600 and once the price broke the resistance level, the price rose from around $10,450 to near $11,000. Therefore, the height of the triangle tells you how far the breakout may extend allowing you to exit the trade once the price has moved around $600.
To take advantage of ascending triangles, place limit buy orders just above the horizontal resistance. Alternatively, you can enter a short position if there is a breakout to the downside.
Descending triangles are formed when the price exhibits lower highs but is bounded by a horizontal support level. An example of a descending triangle is shown below. Usually, the price will break the horizontal support level and continue to head lower. However, sometimes the support level may be too strong and may break out to the upside.
The height of the triangle can be used to obtain potential targets. For instance, the triangle below is about $1,000 in height. After breaking below the support level, the price of bitcoin fell by over $1,000.
To take advantage of descending triangles, place a limit order to sell just below the support level. Alternatively, wait for a breakout above the triangle and enter a long position.
Bilateral Patterns: Wedges
While there are many bilateral patterns, the most frequently used is the wedge.
The wedge chart pattern is formed by drawing trend lines in the same direction that converge on each other. Wedges can serve as continuation patterns but can also hint at reversals.
If a falling wedge is found after a downward trend, then it is a reversal signal and indicates an uptrend will form imminently. However, if a falling wedge is formed after an uptrend, then this pattern signals that the trend will continue.
An example of a falling wedge is shown below. Notice that the pattern forms after a large downward move. Once the price breaks out of the chart pattern, we can expect the price to rise by at least the height of the wedge.
As with falling wedges, rising wedges can be reversal or continuation patterns depending on where they are found. If a rising wedge is found after an uptrend, then it is a reversal pattern while if found after a downtrend, the rising wedge indicates a continuation of the trend.
Chart patterns are often found in periods of consolidation and are useful in identifying breakouts in the price.
There are three main types of chart patterns that traders can use; reversal patterns such as a double bottom, continuation patterns like pennants and bilateral chart patterns, which can indicate a reversal or continuation depending on where they appear.
Make sure you incorporate volume into any analysis of chart patterns, as we should see volume falling as the pattern is forming and then rising on a breakout.