Technical analysis is the study of prices and volumes, in an attempt to identify commonly occurring patterns. These patterns are of interest to many traders because they often have predictive value. In other words, history rarely repeats itself but it does look rather similar.
The chart patterns discussed in this article are drawn from this chart patterns pdf, a free ebook that reviews classical chart patterns. It also includes links to technical analysis tools you could use to identify these patterns directly within your broker’s trading platform. These include both Trading Central and TradingView.
Head and Shoulders
The Head and Shoulders pattern is one of the best known reversal patterns. Studies have shown that 90% of the time, this pattern is followed by a breakdown in price. This pattern is related to the Inverse Head and Shoulders pattern, which acts as a mirror image, pointing to future price gains.
In practice, price action starts by drawing the left shoulder, before forming a first low which acts as one of the neckline’s touchpoints. The price then rises further to form the head of the pattern, higher than the shoulder’s top. Finally, price forms a lower high, which represents the right shoulder before falling back down to the neckline.
This pattern’s price target is measured by the height of the head from the neckline. Conversely, the chart pattern is therefore invalidated when the price breaks the head of the pattern.
This chart pattern is characterised by two parallel trend lines which generally slant in the opposite direction to the current trend and thus mark a break in the current trend. The channel formed will be bullish if the current trend is bearish and vice versa. For this figure to be complete, the price must touch the upper limit of the channel at least twice, and the lower limit of the channel at least twice.
In the majority of cases, a drop in volume is observed during the formation of this flag, followed by a recovery in volumes when the channel is broken. The pattern is invalidated when the price closes outside the channel in the opposite direction to the current trend!
Rectangle (trading range)
This pattern forms a sideways price consolidation within a market trend. That is to say that the prices fluctuate between horizontal support and resistance lines, for weeks and sometimes months. Ultimately, the exit from this rectangle is in the direction of the trend.
This range chart pattern is popular with traders because it’s an easy one to trade. For example, you could sell at resistance and buy at support; and repeat this strategy multiple times as the price moves back and forth in a channel.
The pattern is invalidated when the price closes outside the rectangle, but in the opposite direction to the current trend!
Cup and Handle
Last but not least, a Cup and Handle pattern is characterised by a strong advance followed by two tests of a support or resistance level, which form a U-shape, also known as a “Cup”.
You can then expect a “handle” to form to the right of the “Cup”, in the form of a small indentation resembling a feathered figure. Once the handle is formed and acts as support, the stock is ready to resume its upward trend and make new highs.
This pattern is invalidated when the price breaks the bottom of the Cup with Handle, as shown in this FT.com article. That’s why it’s important to use risk mitigation tools (like a stop-loss) to protect yourself when a chart pattern breaks down.