As a certified practitioner of technical analysis for the last 20 years, I can provide you a unique way of truly understanding stock chart patterns. I have written a book and produced countless hours of video and podcasts dedicated to the subject of the technical analysis of the stock markets. If you like this lesson, please share and comment.
What is a Stock Chart Pattern?
A stock chart pattern is a way to interpret the supply and demand action of the buyers and sellers of stocks in the market to determine if the trend will continue or reverse. Each trend is either up, down or sideways. You can determine the shape of a chart pattern by drawing support or resistance lines on the chart’s price pattern.
The above paragraph is the critical key to understanding all stock chart patterns, trends continuing or reversing, the trend being up or down, and support and resistance lines. Read on to learn more.
3 Different Stock Chart Trend Types
- Uptrend: The stock price or index is moving up, making new highs or higher highs
- Downtrend: The stock price or index is moving downwards making lower lows
- Sideways consolidation: The stock price is neither making significant new highs nor new lows
- Related Article: Read more about stock trend types.
2 Types of Chart Patterns
- Continuation Pattern: These patterns indicate that the stock price will continue in the same direction, either up or down.
- Reversal Pattern The reversal pattern indicates that the stock price with stop moving on its current trajectory and begin moving in the opposite direction.
2 Types of Trendline
- Support Line: The support line is drawn connecting all the stock price lows. When there is a break down through the support line you can expect the stock price to move down.
- Resistance Line: The resistance line is drawn connecting all the stock price highs. When there is a break up through the support line you can expect the stock price to move up.
It may sound complicated now, but in a later section, this is all explained.
What is a Continuation Pattern?
Continuation patterns occur during a stock price move and are visual representations of consolidation or periods of rest before the price continues its current trend, be that upwards or downwards. This means if you see a continuation pattern, you should expect the stock price to continue it the direction it had prior to the pattern forming.
All of these triangles are essentially continuation patterns. They should give you some confidence that the trend will continue. Always be aware that if the price breaks out in the wrong direction due to a shock (e.g. bad earnings or bad news) you should be prepared to act.
Image courtesy of Liberated Stock Trader PRO Training. All rights reserved
Flag Chart Pattern
The Flag stock chart pattern starts with an uptrend in price and then is met by resistance from buyers to this new price high.
As the stock price moves down the buyers are buying at new lows, displaying confidence that the stock price will move up. When the price breaks through the upper parts of the flag pattern, that is the time to buy.
The Pennant stock chart pattern shows that during an uptrend the stock price meets resistance and the uptrend temporarily halt. Here you see lower highs, but also a horizontal support line.
This indicates that the sellers are unwilling to sell for less than this price, which then builds momentum for a break out through the support line on to new highs for the stock price.
Ascending Triangle Pattern
The Ascending Triangle looks like the opposite of a Pennant, but the outcome is the same.
This time the buyers are happy to buy at the price of the upper horizontal resistance line, but the sellers are unwilling to sell at new lows.
This drives supply and demand through the upper resistance line and on to new stock price highs.
Descending Triangle Pattern
The Descending Triangle shows a very different picture. As the price moves down, the sellers believe the price is undervalued and refuse to sell at this new low price.
However, the number and willingness of the buyers are also drying up, meaning that ultimately without demand from buyers the stock price is destined to continue falling.
A very common continuation pattern is the Rectangle, or more commonly known as a” “channel” or “trading range.” The price should normally break out in the same direction as the previous trend.
The Rectangle means that there is a period in which the buyers and sellers, or supply and demand are at equilibrium, this means sideways consolidation.
Often it is considered a resting or cooling down period, and the majority of technical analysts expect a breakthrough of the resistance or support line to mean a continuation of the uptrend.
But beware, if the break of the consolidation pattern is in the opposite direction, this means a reversal pattern.
Falling Wedge Chart Pattern
Falling Wedges have a very different character to triangles in the fact that they point in the exact same direction to the breakout. When the pattern of the Wedge points down it means the stock price should theoretically continue moving upwards.
In the image below we can see that the falling wedges signify an upward breakout.
What is a Reversal Chart Pattern?
A price reversal pattern depicts the battle between the buyers and sellers, or supply and demand in a market. Each reversal pattern indicates that the price of the stock, commodity or foreign exchange currency is about to start moving in the opposite direction due to the change in sentiment between the market participants.
Head & Shoulders Pattern
The king of the reversal patterns is the most predictive of all stock chart patterns, it is the Head and Shoulders. The problem is most people do not know how a head and shoulder pattern actually works. Read on to find out more.
What does a Head and Shoulder Pattern look like? The importance of the head and shoulders pattern should not be under-estimated. One of the most reliable patterns in technical analysis yet one of the most misunderstood.
Here we discuss the famous head and shoulders price pattern. Understood to be one of the most predictive patterns the Head and Shoulders pattern has some unique characteristics.
However, you do need to know what you are looking for.
Head & Shoulders Pattern Example.
- Two shoulders.
- A high point, the head, in between the shoulders.
- The volume should confirm the pattern.
So what lessons can we learn from the chart?
- This is the left shoulder
- This is the head
- This is the right shoulder
- This is the neckline, using a trend-line connect the low from both sides of the head through the outer price limes.
- The left shoulder was formed on increasing volume. This is to be expected.
- In the forming of the head, we see a significant decrease in volume.
- In the right shoulder, we see also decreasing volume
- The price failed to exceed the previous peek
All of the above conditions of the Head & Shoulders pattern here are consistent with textbook descriptions. See the classic book Technical Analysis of the Financial Markets by John J Murphy as a reference.
The Head and Shoulders pattern is said to be confirmed on a break of the neckline, this is about to occur or has occurred in the final price bar in July.
Cup and Handle Pattern
The Cup and Handle pattern depicts a scenario whereby the buyers and sellers reach a long slow decision point.
The stock price slowly stops moving and gradually starts to make higher lows and higher highs. Just as it looks like price is going to break upwards the price moves back down, but it is only getting prepared for a stellar breakout upwards.
Megaphone Chart Pattern
Here we have a Megaphone Top. This is a rare pattern that occurs usually at major tops. You can see that the swings get larger at each bounce, suggesting uncertainty and volatility until finally, the price breaks out downward on increased volume.
Rising Wedge Chart Pattern
Rising Wedges have a very different character to triangles in the fact that they point in the exact opposite direction to the breakout. Both of the edges of the wedge point in the same direction, either upwards or downwards. In the image below we can see that the Rising Wedges signify a downward price breakout.
Reversal Pattern Accuracy
Price patterns and trend lines share the same characteristics. The longer they are, the more important they are. The more a price pattern touches a trend line and reverses, the more important that line is. In Figure 41 we see that the accuracy of a Triple Top is more than that of a Single Top. Why? Because price touches the Resistance level more times.
The following diagram shows us the most common reversal patterns and their relative probability of accuracy.
Reversal Patterns Accuracy Matrix
Gap Patterns In Stock Charts
Another very important pattern that signals continuation is the “gap.” A gap occurs when the price of a stock during a given period is significantly higher or lower than the price range of that stock for the previous period. The price did not overlap at all over the two periods.
This leaves what is known as a “gap” in the price chart. A “gap up” in the stock price is a show of strength. This tells us that the demand for the stock was so strong on the open that it jumped many points higher. The opposite is true for a “gap down.” This signifies weakness as the stock gaps down usually due to aggressive selling.
The Breakaway Gap
The Breakaway Gap usually occurs when a stock is moving in a normal way through a price range or channel, then the demand for the stock suddenly explodes and the stock “gaps out” of the current trend. This is a sign of strength and a very bullish sign with a “gap up.” A breakaway gap to the downside is a sure sign of weakness.
The Continuation Gap
The Continuation Gap is another sign of strength showing that demand is still strong and the trend will continue, this often confirms the initial “breakaway gap.”
The Exhaustion Gap
The Exhaustion Gap can be the second or third gap and occurs during a very strong upsurge in price. This is a warning, as it might signify that the stock has over extended itself and may be due a change in trend or a pull back. The opposite is true for an exhaustion gap on the downside which might signal a bottom is near.
The Island Gap
The Island Gap occurs when demand is so high that price and the market participants drive the price up to unacceptable levels and the demand dries up rapidly. This sudden oversupply causes the stock to plummet as all demand is satiated. Of course, too much supply with no demand causes falling prices.
Quick Tip: Gaps are important signs of serious shifts in supply and demand. If surges in demand outstrip the supply, prices rise to convince people on the sidelines to sell. Downside gaps indicate supply is outstripping demand, causing prices to fall.
This might seem all very theoretical, so here are gaps in action.
Example of Stock Chart Gap Patterns
Here we can see clearly how gaps can occur in stocks. STEC provides a perfect example of how understanding gaps is critical to trading success.
How to Draw Trendlines on Stock Charts
Drawing a trendline on a stock chart is simply connecting with one line all the price lows, and with another line connecting all the price highs.
What is a Stock Price Trend?
If someone asked you today if the stock market in an uptrend, downtrend or a lateral consolidation, what would you answer?
Knowing the answer to this key question is important for the stock market or even an individual stock. Why?
If you buy a stock (go long) in an uptrend you are more likely to make money on it. There is a simple way to see for yourself if the market is heading upwards or downwards.
First, let’s examine what types of trend exist:
Types of stock price trend
- Uptrend: The stock or index is moving up, making new highs or higher highs
- Downtrend: The stock or index is moving downwards making lower lows
- Sideways consolidation: neither making significant new highs or new lows
There are also time-frames to consider in evaluating a trend, for this we will refer to Charles Dow’s classification in Dow Theory.
Types of Stock Trend Time-Frames
Charles Dow could be considered the godfather of technical analysis, as he pioneered the definition of stock price trends, he says:
- Short Term Trends span from days to weeks
- Medium Term Trends span from weeks to months
- Long Term Trends span from months to years
By combining the above terms, you can be specific about the market trend. For example, you could say the market is in a short-term up-trend, but a long-term down-trend. But isn’t that contradictory, the market being in both an uptrend and a downtrend at the same time?
Not really it makes perfect sense.
The Following Examples are an excerpt from the Liberated Stock Trader Academy Book and Training Course. Chapter 7, Section 2.
Drawing trendlines is one of the most important skills of technical analysts, trend lines represent important areas of support and resistance. Once you have this skill, charts come to life and start to signal their message to you.
Drawing your First Trendlines
How to Draw an Uptrend
- To evaluate an upward trend draw a line joining the highest highs
- For the floor of the uptrend draw a line connecting the lowest lows. The price here bounces 3 times off the bottom line but then proceeds higher.
- A trend line is drawn to show that price has moved strongly past the previous high this is a BUY Signal at $35.50.
- Finally, the price is exhausted and falls through the bottom resistance line at $51. This break of the upward support line is a sell signal.
Quick Tip: The more bounces off a trend line the stronger the trend.
Buying and selling based on the trend lines are shown here would have bagged you a 49% win. Alas, life is never that easy and showing this in retrospect does mean we have the benefit of hindsight.
How to Draw Support & Resistance Trendlines
It is very important you practice drawing trend line as much as possible, after a while you will get used to it and it will become second nature.
Here is another example of how to draw trend lines. This is a chart of Ticker: AAPL Apple Inc. it shows how to draw trend lines in a downward price move and an upward price move.
Notice that the trend line above the price is called resistance and the trend line below price is called support. When price breaks up through resistance it moves higher, this could potentially be a buy signal. When the price breaks down through the support trend line it moves lower, this could potentially be a sell signal.
Quick Tip: The longer the trend line is in place or acts as support or resistance, the stronger the trend and the bigger the move when the trend line is broken.
Look again at the chart of Apple Inc. See how Apple was in a sideways consolidation from 2001 through to 2004. When it eventually broke out of that channel upwards through resistance the stock took off making over 1600% gain.
Chapter 7 of the PRO Training delves deeper into the technical analysis to enable you to make Buy and Sell decisions using trend lines, spot the most important patterns and trends, discusses the importance of Price Gaps, Triangles, and Wedges.
Drawing Trend Lines to Recognise Stock Chart Patterns
If you cannot draw a Trend-line you should not invest in the stock market!
In this example, we will examine how to look at price movement and use it to evaluate the stock.
Price is known as the most important indicator and so it should be when it boils down to it the most important thing is the price.
Here we can see a chart of Broadcom (BRCM), one of the darlings of the tech bubble in 2000.
Where will you draw the trend lines?
Take a moment to think about where you would draw the trend lines before you scroll down to the chart where I have drawn them.
Support, Resistance & Double Bottom Pattern Trendlines
A chart can really come alive when we add trend lines. The graphic below shows BRCM, with trend lines, superimposed.
- Starting from left to right we see from mid-April to July, the stock starts to move in a sideways pattern, known as “Channeling”.
- The two red lines show the “trading range”; this is the range between which the stock price fluctuates.
- The upper line is known as the Ceiling or the “Line Of Resistance”, and the lower the Floor or “Support”. Both lines show where the number of sellers equals that of buyers.
- When the stock price falls through the support line it means the trend has changed, and new market impetus has affected the stock. If you owned this stock in April and enjoyed the corresponding price rise this break would be a strong “Sell Signal” to the trained eye.
- The stock consequently dropped in 2 days but also had the good courtesy to rise again over the following month to give anyone slow on the uptake another chance to Sell. It broke through the previous support line but was not strong enough to make it to the upper ceiling of the channel. If you had not got out this time you would have suffered a punishing 50% loss. Enough to make a grown man weep!
- The next significant point to note is in mid-October when the stock bounces at about $13, clearly oversold and proceeds to make a very nice looking “Double Bottom” or “W” bottom.
- Chartists the world over recognize the double bottom and those that like to buy on Bottoms would have done. This clearly happened as the stock moved up 38% in 3 weeks.
Video: How To Draw Trendlines
Watch The Video Overview
Please excuse the sound quality -- it was a live broadcast.
Using Trend-lines to make Buy and Sell Decisions
So we have seen the Sideways Channel and the W bottom. But how do we know when a stock is going to take off?
The truth is we never really know.
All we can do is make judgments based on what we see. Do not forget we are only buying Stocks of companies that have
- Excellent Earnings per Share
- Strong acceleration in the growth of Earning per Share
- Excellent Revenue growth
So we are in essence giving ourselves a great head start and reducing our overall risk.
4 Step Guide to Using Trend Lines for Buy & Sell Decisions
4 Steps to Draw the Trend Lines on the Chart
- To evaluate an upward trend draw a line joining the highest highs
- For the floor of the uptrend draw a line connecting the lowest lows. The price here bounces 3 times of the bottom trendline but then proceeds higher. The more bounces off a trend line the stronger the trend.
- A trend line is drawn to show that price has moved strongly past the previous high, this is a BUY Signal at $35.50.
- Finally, the price is exhausted and falls through the bottom resistance line at $53.
Buying and selling based on the trend lines, here, would have netted you a tasty 49%.
Alas, life is never that easy, and showing this in retrospect does mean we have the benefit of hindsight. This is why the finest minds of Wall St. have a whole host of other technical indicators that accompany price to enable you to assess trend quality. These will be discussed in other chapters.
Candlestick Chart Patterns
Used widely in Japan and gaining a strong foothold in the rest of the world the Japanese Candlestick chart gives an excellent insight into current and future price movement. Named Candlesticks because they look like candlesticks with a wick and the main body.
Candlesticks give an excellent view of the Open, High, Low and close of the price. Pictorially illuminating and easy to see trends. There is a full reference below of 1 bar to 4 bar patterns which help us to make judgments on the future direction of price. They connect psychology with the price pattern.
Although Candlesticks have many advantages, they can seem like information overload to the beginner. There are also many Candlestick patterns to learn.
As we are concerned with spotting changes in price moves we will focus on the Reversal Patterns. This section is the Bullish Reversal Pattern meaning when a price is moving down and you see this sign, the price may change direction and start moving up in the short term. These are the most common patterns, not an exhaustive list but it will give you an idea of what is common in all patterns.
The Hammer can be either filled or hollow, the Japanese say the price is hammering out a bottom. What is important here is that at the end of a down move, the buyers and sellers test out an extreme low (the long shadow) however by the closing bell the price has returned higher.
The lows were tested but price found no comfort there, there were enough buyers at this level to move the price back up.
Inverted Hammer Chart Pattern
The Inverted Hammer shows that at the end of a downward move the stock gaps significantly down there is much movement throughout the day moving back to fill the gap but the price settles lower for the day. This shows significant price action and that buyers are showing a strong interest in the stock at these levels.
Bullish Engulfing Chart Pattern
Here we have a negative spinning top or a short day during a downtrend, then followed by a long day of real power the long white body tells you something significant has changed and so has the sentiment, a clear trend reversal.
Bullish Harami Chart Pattern
During a downtrend, we experience a very negative “Long Day” followed by a short positive day. This indicates the market participants have found a level they are happy with. Candlesticks are most useful when predicting a change in trend, this might be from an “up” to a “down” trend or from a “down” trend to a “sideways” trend. In the case of this Harami, the change in trend may be from downwards to sideways.
Piercing Line Chart Pattern
This shows a day of real strength following a very negative day. The White candle gaps down on open but the buyers show real demand throughout the day to retrace more than 50% of the previous day’s losses.
Automated Stock Chart Pattern Recognition
Understanding and recognizing all of these chart patterns can be challenging and time-consuming, fortunately, our partner TrendSpider has a fully automated solution to do this work for you. Read the TrendSpider Review here, or visit TrendSpider now to take advantage of their award-winning software.
Automated Stock Price Trend Recognition
There is only one software vendor currently using artificial intelligence to automate the identification and plotting of trend lines. TrendSpider can detect trendlines on multiple time-frames from minutes to weeks and plot them all on a single stock chart. Check out our awards winner for stock charting innovation, TrendSpider.
Stock Chart Patterns Summary
This is truly a huge article covering everything you will need to know about stock chart patterns and supply and demand. The problem is, reading about it on a screen and understanding how to apply these principles in real-world technical analysis of stock trends is difficult. This is why I have created the Liberated Stock Trader Pro Training to help guide you through this maze and help you truly understand with 16 hours of detailed video training and a print book.
To your success.
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