Technical Analysis Tutorial: A Practical Guide

Technical Analysis: Chart Patterns

While trending, the market usually create chart patterns. Those chart patterns can provide indications whether the trend will continue or reverse.

A chart pattern or formation is simply a configuration of the price action. Many of these configurations can be bounded by trend lines. 

For example, the triangle pattern in the chart below is bounded by two opposing trend lines. The falling trend line is constructed by connecting the swing highs and the rising trend line by connecting the swing lows.

Remember: All patterns must be a preceded by either an advance or decline. I.e. if the triangle pattern shown above was not preceded by a directional trend, that would suggest it’s not a valid pattern.

The entry to the pattern from the preceding trend is called the “Entry” of the pattern. All patterns have entries and exits. The entry is the direction before the pattern and the exit the direction of the breakout of the pattern.

Note:  We will be using the terms support and resistance, upper and lower bound, and upward and downward trend lines interchangeably in this section. So don’t be confused, they all have the same meaning.

There are plenty of chart patterns, dozens. However, in this technical analysis tutorial we will mention the most important and reliable ones.

Double Top and Double Bottom

The simplest chart patterns are the double top and bottom patterns.

The double top pattern consists of two peaks separated by a trough. Both peaks must happen roughly near the same price (less than 5% percent difference).

The double top pattern must be preceded by an advance or an uptrend. Otherwise it is not a double top, it is just a sideways market.

The pattern completes on a breakout below the middle trough.  And suggest a trend reversal or at least a deep retracement of the prior trend.

A downside potential target of the breakout is identified by measuring the distance from the highest peak to the trough between the two peaks. Then projecting this distance from the point of breakout (This is called the Measured Rule). A safer target would be 75% of the this distance.

The double bottom pattern is the exact opposite of the double top.

Triple Top and Bottom

Triple top is like a double top, but it consists of three peaks instead of two. And two troughs instead of one.

Like the double top, the triple top peaks must be within the same price range with a maximum of 5 percent difference.

The pattern completes on a break below the trend line that connects the first trough with the second trough. And suggests a trend reversal or at least a deep retracement of the prior trend.

The downside potential target of the breakout is identified by projecting the the distance from the highest peak to the trough from the point of breakout.

Chart examples:

Rectangle

A Rectangle is simply a sideways movement that consists of multiple peaks and throughs, that is contained above a horizontal support and below a horizontal resistance. Each peak must touch the resistance level at least twice and each trough must touch the support twice.

In other words, connecting the swing highs we will get a horizontal line and connecting the swing lows we will get a horizontal line. Both lines are parallel.

Unlike double and triple top/bottom patterns, the price may fail to reach the resistance or support area, it may fail short ahead of it. And this might be an indication of the direction of the eventual breakout. 

The target of a breakout of a rectangle whether up or down, is identified by measuring the distance between the resistance and support lines, then projecting this distance from the point of breakout.

Remember: The rectangle can be a reversal or a continuation pattern depending on the direction of the entry (prior trend) and the exit(breakout).

i.e. if the price was in an uptrend then paused and formed a rectangle formation, then a breakout completed to the upside, that would suggest the continuation of the uptrend.

Oppositely, if a downside breakout of the rectangle occurs, that suggests the uptrend might be reversing.

Charts example:

Triangles

The rectangle pattern is bound by two parallel trend lines forming a rectangle shape. What if the trend lines are not parallel?

Symmetrical Triangle

If the result of connecting the swing highs is a downward sloping trend line. And the result of connecting the lows is an upward sloping trend line. The formation constructed will be a symmetrical triangle.

The triangle’s upper bound is a downward slopping trend line, and the lower bound is upward sloping trend line. The two trend lines are opposing.

Both trend lines must have the similar (or close) angle. The price must touch each trend line at least twice and the area within the triangle must be covered with the price action.

Remember: The point where the two trend lines meet is called the apex. The price must breakout before reaching the apex. Otherwise, the triangle will be no longer valid. The optimal breakout area is within the last quarter of the triangle.

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

Chart example:

The triangle can be a reversal or a continuation pattern, depending on the direction of the entry(prior trend) and the exit(breakout).

Ascending and Descending Triangles

The ascending triangle consists of a horizontal trend line resistance and an upward sloping trend line support.

For all triangles, the price must breakout before reaching the apex. Otherwise, the triangle is no longer valid. The optimal breakout area is within the last quarter of the triangle.

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

The ascending triangle is mostly a bullish continuation pattern. But it can be a reversal or a continuation pattern depending on the direction of the entry(prior trend) and the exit(breakout).

Descending Triangle

The descending triangle consists of a horizontal trend line support and a downward sloping trend line.

The point where the two trend lines meet is called the apex. The price must breakout before reaching the apex. Otherwise, the triangle is no longer valid. The optimal breakout area is within the last quarter of the triangle.

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

The descending triangle is mostly a bearish continuation pattern. But it can be a reversal or a continuation pattern depending on the direction of the entry (prior trend) and the exit(breakout).

Flag and Pennant

A flag pattern is very similar to a channel, but it has a smaller size as it forms in short period of time. Also, the pennant is similar to a symmetrical triangle, but smaller in size and shorter in time. Both patterns are continuation patterns.

Both patterns are small corrective moves within a strong trend.

Both patterns can be bullish or bearish. Bullish flag and pennant form in the context of an uptrend. While bearish flag and pennant form in the context of a down trend.

Remember: Usually, trends pause for corrections that take the shape of flag or pennant. If you spot one, expect the price to resume the trend after a breakout of the flag or pennant.

The target of the breakout is identified by measuring the distance between the the start of the wave preceded the pattern to the first high of the pattern. Then, projecting this distance from the breakout point.

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Wedges

A wedge is a form of a triangle pattern, where the two-trend line are heading in the same direction but with different slopes.

Wedges come in several shapes, here are the main wedge patterns.

Rising Wedge

The rising wedge forms when both trend lines are upwards, and the lower bound trend line is steeper the upper bound trend line.

Rising Wedge in an Uptrend

The rising wedge formation usually happens at a late stage of an uptrend and is followed by a breakout of the wedge to the downside, signaling an end of the uptrend or at least a deep downside correction.

Sometimes, a break out of a rising wedge to the upside can happen. However, it is usually a signal of unhealthy acceleration of the uptrend and could be short-lived.

Rising Wedge in a Downtrend

In a downtrend, upside corrections can take the shape of the rising wedge. The breakout of the rising wedge to the downside signals the end of correction and resumption of the overall downtrend.

Falling Wedge

In a falling wedge, both trend lines are downward. But the upper bound trend line is steeper the upper lower bound trend line.

Just like the rising wedge, falling wedge can form in an up or down trend.

The breakout in a falling wedge is usually to the upside, but in some occasions it breaks to the downside.

Rising Broadening Wedges

A rising broadening wedge has two trend line pointing upwards. The lower bound trend line has a smaller slope than the upper bound trend line.

The breakout in rising broadening wedge usually occurs to the downside but sometimes the price can break to the upside.

Falling Broadening Wedges

A falling broadening wedge has the two trend lines point downward. The lower bound trend line has a larger slope than the upper bound trend line.

The breakout in falling broadening wedge is usually to the upside, but sometimes it breaks to the downside.

There is no specific rule for measuring targets for wedges patterns.  Other technical analysis techniques should be used to forecast price target.

Head and Shoulders Patterns

The pattern is considered a reversal pattern, it can be bullish reversal (head and shoulders top) or bearish reversal (head and shoulders bottom).

Head and shoulder top pattern consists of three swing highs. The middle(second) high is higher than the first one, and the third high is lower than the second one and near the price of the first peak.

The first and third peaks are called shoulders, while the middle peak is the head.

The pattern completes when the price breakout of the trend line that connects the swing lows between the peaks. This line is called the neckline of the pattern.

Remember: The neckline can be horizontal, upward or downward sloping.

The target of the pattern is measured by projecting the distance between the neckline and the head of the pattern, from the point of breakout of the neckline.

A head and shoulders bottom is a bullish reversal pattern. It is the exact opposite of head and shoulders top.

In both top and bottom head and shoulder patterns, if the pattern has a symmetry in both side of the head, the pattern is considered more reliable.

There is a variation of the head and shoulders patterns, where more than two shoulders are formed. This is called a complex head and shoulders pattern. It has the same implications of the normal head and shoulders pattern.

Cup and Handle Top and Bottom

A cup and handle pattern is rounding patterns that is formed when the price reverses direction gradually and in a slow manner. The reversal forms a curve like shape. The price then enters a small and short pullback, before resuming the upward reversal.

The high of the retracement is called a lip. The lip is the key breakout level to watch. As the pattern is confirmed when the price breaks back above the lip.

Target of the pattern is identified by measuring the distance between the lowest low in the pattern towards the lip level. Then projected from the breakout level (lip level).

If you are interested in exploring more about chart patterns, you can check the encyclopedia of chart pattern book by Bulkowski , or visit his website.