Chart patterns play an essential role in technical analysis and provide visual indicators of breakout levels for reversal or continuation setups.
Chart patterns are a way of viewing a series of price actions that occur during a specified period. Chart patterns are fractal, meaning any time period may be used, including monthly, weekly, daily, or intra-day.
Chart patterns tend to repeat themselves because the repetition of price movement appeals to herd mentality and investor psychology. While technical indicators such as relative strength and momentum aid in identifying trends, chart patterns help to identify trend reversals and continuations at significant price levels.
Supply and demand
Supply and demand refer to the interaction of basic economic principles with security pricing. When demand for a security increases, the price goes up, and as demand decreases, the price goes down. Key supply and demand levels are noted by both price and volume.
Supply and demand are reinforced through emotions, biases, and psychology. As price levels appear to be significant on a price chart, more analysts and traders tend to see and react to the same price levels, which increases the significance.
Therefore, supply and demand on a price chart can be somewhat self-fulfilling.
Support and resistance
Support and resistance levels are price points where supply and demand interaction create levels of significance on a price chart. Support levels on a price chart are areas where investor demand overwhelms selling pressure. Resistance levels on a price chart are areas where buying subsides, and selling pressure overwhelms investor demand.
Entry and exit points for many trading strategies rely on support and resistance levels. Further, trading price retracements to support and resistance levels are also part of many strategies.
Previous highs on a price chart are associated with overhead supply, where investors who bought a previous top may be willing sellers at their original break-even price. These highs, then, become resistance levels to further price increases. If the rising price trend continues through the resistance level, a breakout occurs.
For example, if $100 appears to be a level of resistance on a price chart, there is typically a large number of shares offered at $100. Eager sellers that are “trapped” at the resistance level offer their shares for sale. Breakouts occur when demand for a security exceeds the shares available at the resistance level.
On the reverse side, support levels are often associated with previous lows on a price chart where a downtrend reversed and investor demand for a security supported price. When support levels hold, buying overwhelms selling, and price turns higher.
If support levels fail, new waves of selling may ensue. When a resistance level is eventually broken it tends to become support.
For example, if $100 is believed to be an area of resistance and the price pushes above $100 and later reverses, $100 becomes a logical support area. Investors who missed the first opportunity to buy the breakout over $100 may be eager to buy the re-test of the $100 level. Therefore, previous levels of resistance become areas of support.
The same is true of support levels. If a support level fails and the security rallies back to the same support level, that support level may act as resistance to further price increases. Support is associated with demand and previous lows on a price chart. Resistance is associated with supply and previous highs on a price chart.
Round numbers ($50, $100, $1,000, etc.) are often important psychological levels on a price chart for support and resistance. Investor psychology, the fear of missing out, and other biases play a key role in support, resistance, and breakouts from previously well-defined trading ranges. Support and resistance levels are often connected with trendlines on a price chart to form chart patterns.
The following chart patterns are widely followed in technical analysis. These chart patterns tend to repeat across timeframes and are frequently used in defining entry and exit points for trades. The patterns can be grouped together as continuation patterns or reversal patterns.
Continuation patterns continue the previous price trend and can be bullish or bearish. Reversal patterns occur at significant turning points in a trend and direct price in the opposite direction. Continuation patterns exhibit price consolidation, where the price of a security trades inside a tight range, before resuming the trend. Reversal patterns signal a trend running out of momentum.
While chart patterns can be interpreted without volume, volume is often a confirming indicator at breakout points. The size of the chart pattern can also yield important information as to the magnitude of the move expected from a breakout. The measured move describes the expected movement following a pattern breakout.
For example, the depth of the cup in a cup and handle pattern is the measured move for a breakout. Or, the length of the flagpole in a pennant or flag pattern is the expected magnitude of the price continuation following the breakout.
A pennant is a continuation pattern created when there is a significant move in a security, followed by a period of consolidation. This creates the pennant shape due to the converging trendlines. A breakout movement then occurs out of the pennant in the same direction as the previous move.
Pennants are similar to flag patterns and tend to last between one and three weeks. Pennants typically have trendlines that converge and are more cone-shaped, while flags have a more diagonal slope with parallel lines. So, pennants are triangular, while flags look more like rectangles.
The large move in the security leading up to the pennant resembles a flagpole, hence the name. There will be significant volume at the initial stock movement, followed by weaker volume in the pennant section and increased volume at the breakout. While the shape of the two is similar, pennants form over shorter time periods than wedges and are short-term continuation patterns.
The length of the flagpole in a pennant is the expected magnitude, or measured move, of the price continuation following the breakout.
Cup with handle
A cup with handle pattern is a continuation pattern that gets its name from the visual pattern it makes on the chart. The cup is a curved u-shape or rounded bottom, while the handle slopes slightly downwards.
In general, the pattern lasts from weeks to months on a daily chart. Volume tends to be higher on the left and right sides of the pattern and lower in the middle of the pattern. A breakout from the handle above the top of the cup signals a continuation of the previous trend.
Saucer bottoms or rounding bottoms are variations of a cup with handle pattern, but the saucer or rounding bottom is less deep than the cup and does not have a handle. The measured move for a cup with handle is the distance from the right-hand top of the cup to the bottom of the cup.
An ascending triangle is a bullish continuation pattern that typically appears during an upward trend. The ascending triangle is part of the ascending, descending, and symmetrical triangle trio. The differentiator between each of these is the slope of the triangle’s lines. An ascending triangle has a flat upper trendline and an ascending lower line. A breakout occurs above the flat upper line of the triangle.
Ascending triangles form as price action oscillates within a tightening range. The triangle’s lower support line is upward sloping as a series of higher lows typically leads to a breakout above the triangle’s horizontal resistance line.
The measured move for an ascending triangle is the distance between the upper and lower lines at the base of the ascending triangle. Volume tends to decrease near the apex of the triangle before the breakout occurs on increased volume.
The descending triangle is a bearish continuation pattern that typically appears during a downtrend. The descending triangle has a downward sloping upper trendline and a flat lower line. The descending triangle may occur at an important market top as price begins to decline.
Descending triangles form as price action oscillates within a tightening range. The triangle’s upper resistance line is downward sloping as a series of lower highs typically leads to a breakout below the triangle’s horizontal support line.
The measured move for a descending triangle is the same as for an ascending triangle: the distance between the upper and lower trendlines at the base of the triangle. Volume tends to decrease as the triangle builds towards the price chart’s right-hand side, with heavier selling on price declines near the flat lower trendline, and lighter buying on bounces near the descending trendline.
The symmetrical triangle, or coil, is a continuation pattern where the upper and lower trendlines converge in a symmetrical shape to form a triangle. The coil may develop in a downtrend or uptrend and is typically a consolidation that leads to a breakout in the direction of the previous trend.
Triangle patterns have multiple reversal points, with a series of lower highs and higher lows forming the triangle shape. Typically, four or more touches of the trendlines need to occur to form the triangle.
The tightening “coil” shape of the pattern gives the visual of pressure building in the security’s price action. The breakout occurs when the “coil” finally releases. The measured move and volume profile for a symmetrical triangle is similar to those of the ascending and descending triangles.
The triple bottom is a bullish reversal pattern with three troughs, or lows, at approximately the same price level. The triple bottom typically follows a long downward trend. The triple bottom and inverse head and shoulders are very similar; the main difference is the triple bottom pattern has equal bottoms.
The bottom trendline on a triple bottom is parallel to the triple bottom’s top trendline, and an advance over the top trendline on the right side of the pattern signals a breakout. The triple bottom shows support for a security at the same level multiple times. As shares available at the support level declines, demand overwhelms resistance on the right-hand side of the pattern.
The measured move for a triple bottom is the height of the pattern from top to bottom.
Inverse head and shoulders
The inverse head and shoulders pattern is a bullish reversal pattern signaling the reversal of a downward trend. The pattern is also called the "head and shoulders bottom" or even a "reverse head and shoulders."
The inverse head and shoulders pattern has a neckline forming the top of the pattern, a left shoulder, the head, and a right shoulder. The left shoulder and right shoulders are troughs, or lows, with approximately equal height and width. The head has a lower low than the two shoulders.
The more symmetry in the shoulders’ height and spacing around the head, the more recognizable the pattern. The neckline may be diagonal or sloping. A breakout occurs at the neckline on the right-hand side of the right shoulder. The measured move for an inverse head and shoulders pattern is the distance between the neckline and the bottom of the head.
The rounding bottom is a bullish reversal pattern representing a period of consolidation before reversing higher. This pattern is also called a "saucer bottom" and demonstrates a long-term reversal with the stock moving from a downward trend to an upward trend.
Rounding bottoms can build for a significant period, from several months to years. The pattern is similar to the cup with handle but has no handle and less depth. The difference between a rounding bottom, saucer, bowl, or cup is somewhat arbitrary and depends on the depth of the pattern.
Rounding bottoms occur at the end of a downtrend when price finds support. The rounding bottom may resemble a "V" at the bottom or be less pronounced. Volume typically declines at the bottom of the pattern and is higher on either side of the low-point. The measured move for a rounding bottom is the distance between the top and bottom of the pattern.
A flag is a continuation pattern created after a significant movement in a security, followed by a period of consolidation. The flag is similar to a pennant but has a more rectangular shape than the pennant’s converging lines.
The flag's rectangular shape develops from parallel trendlines, which form the support and resistance until the price breaks out. Flags have sloping trendlines, and the slope should move in the opposite direction of the original price movement. A breakout then occurs out of the flag in the same direction as the initial move.
The consolidation period of the flag typically lasts one to three weeks. The significant movement in the security leading up to the flag resembles a flagpole, hence the name. There will be significant volume at the initial stock movement, followed by weaker volume in the flag section and growth in volume at the breakout.
The flagpole's length is the expected magnitude of the price continuation following the breakout. Flags tend to have a high success rate, especially when preceded by a strong uptrend.
The double top is a bearish reversal pattern with two peaks, or highs, at approximately the same price level. The double top typically follows a long uptrend, and its "M" shape is easily recognizable, making it one of the simplest chart patterns.
The double top and rectangle patterns are very similar, with the main difference being the twin tops of the double top pattern instead of multiple touches of resistance with the rectangle pattern. The upper trendline on a double top is parallel to the bottom trendline. A drop below the bottom trendline on the right side of the pattern signals a breakout lower.
The double top shows resistance for a security after testing the same level multiple times before supply overwhelms demand on the pattern’s right-hand side. Volume is typically higher on the first top and lighter on the second top signaling exhaustion of the uptrend's momentum. The measured move for a double top is the height of the pattern from top to bottom.
The double bottom is a bullish reversal pattern with two troughs, or lows, at approximately the same price level. The double bottom typically follows a long downward trend, and its "W" shape is easily recognizable.
The double bottom and rectangle pattern are very similar, with the main difference being the twin bottoms of the double bottom pattern instead of multiple touches of support on the with the rectangle pattern. The bottom trendline on a double bottom is parallel to the top trendline. A move above the top trendline on the right side of the pattern signals a breakout.
The double bottom shows support for a security after testing the same level multiple times before demand overwhelms resistance on the right-hand side of the pattern. Volume is typically higher on the first bottom and lighter on the second bottom, signaling decreased selling pressure on the second test of the low.
The measured move for a double bottom is the height of the pattern from top to bottom.
A rectangle formation is a continuation pattern where price consolidates in a range before continuing in the direction of the previous trend. Rectangles have a series of approximately equal highs and approximately equal lows to form two parallel trendlines. Rectangles form a “box” shape and breakouts from the “box” serve as trading signals.
The upper trendline of a rectangle forms resistance while the lower trendline of a rectangle forms support until price breaks out of the formation, typically in the direction of the previous trend. Price touches both the upper and lower trendlines multiple times before breaking out.
A shortfall or partial retracement of price may signal an imminent breakout as price does not fall all the way back down to support (signaling a potential breakout higher) or rise all the way up to resistance (signaling a potential breakout lower).
The measured move for a rectangle is the distance between the two trendlines. Rectangles are often traded by selling at resistance and buying at support until a breakout occurs.
A channel formation is a continuation pattern where price consolidates in a range before continuing in the direction of the previous trend. Channels have a series of lower highs and lower lows to form two parallel trendlines in the shape of a channel or a series of higher highs and higher lows. Channels differ from wedges and triangles because of their parallel lines compared to wedges and triangles converging towards an apex.
The upper trendline of a channel forms resistance while the lower trendline of a channel forms support until price breaks out of the formation, typically in the direction of the previous trend. Price touches both the upper and lower trendlines multiple times before breaking out.
The measured move for a channel is the distance between the two trendlines. Like rectangles, channels are often traded by selling at resistance and buying at support until a breakout occurs.
A falling wedge is a bullish continuation or reversal pattern, depending on where the falling wedge appears. Wedges are similar to triangles but slope counter to the previous trend.
For example, an uptrend falters and a falling wedge forms before breaking out higher. Whereas triangles have a symmetrical slope, both trendlines on a falling wedge are downward sloping.
The falling wedge has a series of lower highs and lower lows, but the lower lows are less pronounced than the lower highs, creating more of a wedge than a triangle shape. Volume is higher at the end of the falling wedge as increased buying at support overwhelms selling, and the downtrend reverses higher. Breakouts from falling wedges often have “throwbacks” where the price retraces to the breakout in a test of the breakout rally.
The measured move for a falling wedge is the highest point on the wedge's left side, minus the lowest point on the wedge’s right side.
Head and shoulders
The head and shoulders pattern is a bearish reversal pattern signaling the reversal of an uptrend. The head and shoulders pattern is also called the “head and shoulders top” and is perhaps the most widely konwn and reliable chart pattern. Many other patterns, such as the rectangle or triple top, are variations of the head and shoulders pattern.
The head and shoulders pattern can be found around many major market tops as an uptrend loses momentum, makes a new high, falters, and then fails to make another high before reversing lower.
Three well-defined peaks are the hallmark of the head and shoulders top. The head and shoulders pattern has a neckline forming the bottom of the pattern, a left shoulder, the head, and a right shoulder. The two shoulders have lower peaks than the head, creating the classic head and shoulders look. The more symmetry in the shoulders’ height and spacing around the head, the more recognizable the pattern. The left shoulder and right shoulders are peaks, or highs, with approximately equal height and width. The head has a higher high than the two shoulders. The neckline may be diagonal or sloping.
Volume is typically lighter on the third peak, or right shoulder, before increasing on the neckline break. A breakout occurs at the neckline on the right-hand side of the right shoulder. The measured move for a head and shoulders pattern is the distance between the neckline and the top of the head.