One of the more useful features of chart analysis is the presence of price patterns, which can be classified into different categories and which have predictive value.These patterns reveal the ongoing struggle between the
forces of supply and demand, as seen in the relationship between the various support and resistance levels, and allow the chart reader to gauge which side is winning. Price patterns are broken down into two groups—reversal and continuation patterns. Reversal patterns usually indicate that a trend reversal is taking place. Continuation patterns usually represent temporary pauses in the existing trend.Continuation patterns take less time to form than reversal patterns and usually result in resumption of the original trend.
REVERSAL PATTERNS
The Head and Shoulders
The head and shoulders is the best known and probably the most reliable of the reversal patterns.A head and shoulders top is characterized by three prominent market peaks.The middle peak, or the head, is higher than the two surrounding peaks (the shoulders). A trendline (the neckline) is drawn below the two intervening reaction lows.A close below the neckline completes the pattern and signals an important market reversal (See
Figure 5-1).
Price objectives or targets can be determined by measuring the shapes of the various price patterns.The measuring technique in a topping pattern is to measure the vertical distance from the top of the head to the neckline and to project the distance downward from the point where the neckline is broken.The head and shoulders bottom is the same as the top except that it is turned upside down.
Double and Triple Tops and Bottoms
Another one of the reversal patterns, the triple top or bottom, is a variation of the head and shoulders.The only difference is that the three peaks or troughs in this pattern occur at about the same level. Triple tops or bottoms and the head and shoulders reversal pattern are interpreted in similar fashion and mean essentially the same thing.
Double tops and bottoms (also called M’s and W’s because of their shape) show two prominent peaks or troughs instead of three. A double top is identified by two prominent peaks. The inability of the second peak to move above the first peak is the first sign of weakness. When prices then decline and move under the middle trough, the double top is completed.The measuring technique for the double top is also based on the height of the pattern. The height of the pattern is measured and projected downward from the point where the
trough is broken. The double bottom is the mirror image of the top (See Figures 5-2 and 5-3).
Saucers and Spikes
These two patterns aren’t as common, but are seen enough to warrant discussion.The spike top (also called a V-reversal) pictures a sudden change in trend. What distinguishes the spike from the other reversal patterns is the absence of a transition period,which is sideways price action on the chart constituting topping or bottoming activity. This type of pattern marks a dramatic change in trend with little or no warning (See Figure 5-4).
The saucer, by contrast, reveals an unusually slow shift in trend.Most often seen at bottoms,the saucer pattern represents a slow and more gradual change in trend from down to up.The chart picture resembles a saucer or rounding bottom—hence its name (See Figure 5-5).
CONTINUATION PATTERNS
Triangles
Instead of warning of market reversals, continuation patterns are usually resolved in the direction of the original trend.Triangles are among the most reliable of the continuation patterns. There are three types of triangles that have forecasting value—symmetrical, ascending and descending triangles.Although these patterns sometimes mark price reversals, they usually just represent pauses in the prevailing trend.The symmetrical triangle (also called the coil) is distinguished by sideways activity with prices fluctuating between two converging trendlines.The upper line is declining and the lower line is rising. Such a pattern describes a situation where buying and selling pressure are in balance. Somewhere between the half-way and the three-quarters point in the pattern, measured in calendar time from the left of the pattern to the point where the two lines meet at the right (the apex), the pattern should be resolved by a breakout. In other words, prices will close beyond one of the two converging trendlines (See Figure 5-6).
The ascending triangle has a flat upper line and a rising lower line. Since buyers are more aggressive than sellers, this is usually a bullish pattern (See Figure 5-7).
The descending triangle has a declining upper line and a flat lower line. Since sellers are more aggressive than buyers, this is usually a bearish pattern. The measuring technique for all three triangles is the same.Measure the height of the triangle at the widest point to the left of the pattern and measure that vertical distance from the point where either trendline is broken. While the ascending and descending triangles have a built-in bias,the symmetrical triangle is inherently neutral. Since it is usually a continuation pattern,however, the symmetrical triangle does have forecasting value and implies that the prior trend will be resumed.
Flags and Pennants
These two short-term continuation patterns mark brief pauses, or resting periods, during dynamic market trends. Both are usually preceded by a steep price move (called the pole). In an uptrend, the steep advance pauses to catch its breath and moves sideways for two or three weeks.Then the uptrend continues on its way.The names aptly describe their appearance. The pennant is usually horizontal with two converging trend- lines (like a small symmetrical triangle). The flag resembles a parallelogram that tends to slope against the trend. In an uptrend, therefore, the bull flag has a downward slope; in a downtrend, the bear flag slopes upward. Both patterns are said to “fly at half mast,”meaning that they often occur near the middle of the trend,marking the halfway point in the market move (See Figures 5-8 and 5-9).
In addition to price patterns, there are several other formations that show up on the price charts and that provide the chartist with valuable insights. Among those formations are price gaps, key reversal days, and percentage retracements.
