Using Chart Patterns to Become a Better Trader

Reading chart patterns is one of the cornerstones of technical trading. Expert technical traders can take one look at a chart and give you a complete analysis based on the formations that they see.

Today, courtesy of TraderPlanet, we're sharing some of the basic chart patterns and their meanings so that you can implement them into your trading strategy.

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Basic Chart Patterns: Reversals

Like their name implies, these patterns suggest that one trend is ending and the market is ready to begin another trend in the opposite direction or, perhaps more likely, move sideways for a while. As with continuation patterns, a trendline is the basic pattern to watch. If prices break through a trendline and then follow through in the same direction, this is the best evidence of a trend reversal. Keep in mind that all chart patterns apply to all trading time frames – daily, weekly, monthly, yearly, hourly or even minute-by-minute bar charts.

Double tops - This phenomenon occurs when prices reach a fresh high, back off from that high, re-test the high and back off again. The longer the time between the “twin peaks” of the highs, the more powerful the chart signal is likely to be. Variations of this pattern that look somewhat similar are called “M” tops or 1-2-3 swing tops, but the second high is usually lower than the first high for these patterns. In all of these cases, the key points are the highs, which mark a barrier that becomes strong resistance, and the interim low. If prices drop below that low, the top is confirmed, and it is signal to sell.

Double bottoms - The principle of this pattern is the same as the double-top reversal, except reversed. Similar patterns are the “W” bottom or 1-2-3 swing bottom. In all of these patterns, prices reach a fresh low, rebound a bit, drop back to re-test the low and then move back higher. When prices exceed the interim high, a bottom is confirmed, and the market is providing a signal to buy.

Head-and-shoulders top reversal - This classic trend reversal pattern occurs when the market makes a new high (left shoulder), drops back, runs up to a higher high (head), drops back again, rallies to a high that is at about the same level as the left shoulder high (right shoulder) and then declines again. The key point is the “neckline” or the horizontal line that connects the two interim lows on the chart.

When prices drop below the neckline, that signals the completion of the top and the potential beginning of a downtrend although, in many cases, prices tend to react back to the trendline so the break does not produce a downtrend immediately. Sometimes the neckline break occurs as a gap or with a strong move down, reinforcing the price reversal.

The head-and-shoulders is one of several chart patterns that can be used to project a price target. Analysts measure the distance from the top of the head to the neckline and then subtract that distance from the neckline break to calculate how low prices might go.

Head-and-shoulders bottom reversal - Just as the double bottom mirrors the double top, the head-and-shoulders bottom is like the head-and-shoulders top but in reverse. That is, prices slide to a low (left shoulder), rally, then fall back to a lower low (head), move back up, then sink again to a low at approximately the same level as the left shoulder low (right shoulder).

The neckline again is an important point. When prices break through the neckline, the reversal pattern is complete and a potential uptrend may begin. As with the head-and-shoulders top, there is likely to be some trading back and forth on either side of the neckline as the market makes its decision on which way to go, and the distance between the neckline and the head can be used to project how high prices might go.

Falling wedge - This pattern occurs when the market is in an overall price downtrend and the highs are declining faster than the lows, forming a wedge shape. Sellers are able to push prices lower but there is enough buying support to keep the market from tumbling. Eventually, the force of selling begins to dry up and can’t take prices lower, and the market starts to rebound as buying power exceeds selling power. These patterns are usually bullish and do portend a change in trend.

Rising wedge - This pattern is the reversal of the falling wedge and occurs when the market is in an overall price uptrend s. Buyers keep pushing the lows of the day up, but there is enough selling to keep the market from taking off higher. Eventually, buying dries up and the sellers take over, pushing prices below the short-term wedge uptrend line. These patterns are usually bearish and do portend a change in trend.

Diamond pattern - This is a relatively rare pattern that usually occurs at market tops. Volatility increases at higher price levels, producing wider range days to form the widest part of the diamond. Then volatility decreases on the right side of the high and the price bars get smaller as they move into a triangle-like pattern to complete the diamond formation. This low-volatility, high-volatility, low-volatility combination usually resolves itself with a turn to the downside.

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