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Chart Patterns Tutorial

Traders have debated the merits of

“technical analysis” versus “fundamental analysis” for years. In

reality, most traders probably do not make such a rigid distinction

between these two approaches to market analysis and use some of both

in making their decisions.

Fundamental analysis studies factors

such as supply, demand, weather, political developments, economic

reports and the like to come up with their forecast for potential

price direction. But many traders do not have access to all of the

vast amount of fundamental information available nor do they have

the ability to interpret the significance of much of this

information on the market they are trading. Conclusions from

fundamentals tend to be quite subjective.

Instead of trading to digest all of

this fundamental information and convert it into an opinion on

prices, those who use technical analysis believe that everything

that is to be known about a market is incorporated into one thing,

price, and look only at data generated by the action of the market

itself. The technical trader’s main resource is a price chart, which

shows visually what has happened to prices historically and, based

on past market action, what is likely to happen when the same

conditions arise in the present.

Even the staunchest advocate of market

fundamentals is likely to refer to a price chart before making a

trade, if for no other reason than to get some perspective on how

current prices fit into a market’s price history. By the same token,

even the most dedicated follower of technical analysis is likely to

keep in mind the importance of key fundamentals such as natural

disasters, political upheavals, major economic reports, etc.

This trading tutorial focuses on the

basics of technical analysis, which involves several underlying

assumptions:

• All

  fundamentals or any other inputs known to the market are

  reflected in price.

   

• History repeats

  itself so that a study of what prices did in the past can

  provide clues about what they will do in the future.

   

• Prices tend to

  move in trends – up, down or sideways – and changes in existing

  trends provide potential trading signals.

Technical analysis can be rather simple or quite

complex, depending on the capabilities you have to manipulate the

market data. The "primary" trading

tools include basic chart patterns, such as triangles, double tops

and bottoms, head-and-shoulders, flags, pennants and, of course, one

of the most basic, yet most powerful, trading tools, the trend line.

As long as you have the relevant price data, these basic tools do

not even require a computer although a computer does make analysis

much faster and easier.

Charts for

traders

Over the years traders have developed a number

of different types of charts in an effort to get a better view of

price action. Old chart techniques are resurrected and new chart

ideas devised, but the following types of charts continue to be the

most widely used.

Close-only

charts – As its name suggests, only the close for a time

period is plotted, and a line connects the dots of these closes.

These work best for an overview, especially over a long period of

time.

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Source: VantagePoint Intermarket

Analysis Software

Bar or line

chart – Perhaps the most popular type of chart, the bar

chart adds new information for the trader, showing the high and low

prices for a time period in addition to a horizontal notch on the

right side of the vertical bar indicating the close. Many chart

services also show the opening price with a horizontal notch on the

left side of the vertical price bar.

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Source: VantagePoint Intermarket

Analysis Software

Candlestick

chart – This concept was introduced to western traders in

the late 1980s and adds yet another dimension to the standard

open-high-low-close price data to make the price action during a

period more visual at a glance. The open and close have the most

significance with the difference between the two making up the

“body” of the candle. If the close is higher than the open, the body

is usually shown as clear or white and indicates the market gained

strength during the period – the bulls won the day. If the close is

lower than the open, the body is usually black or dark and indicates

the market lost strength during the period – the bears won the day.

Price action outside the range of the body is shown as “tails” or

“shadows” and gives further clues about price movement during the

time period specified.

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Source:

VantagePoint Intermarket Analysis Software

The

Basic

Tool: Trend lines

No matter what chart type you use, the first

thing you should try to determine as a trader is the trend of

market. You can use all kinds of clever ideas and sophisticated

techniques to arrive at your trading decisions, but a basic building

block of whatever trading style you use should be trend analysis.

Here is what respected technical analyst John

J. Murphy says about trend lines in his excellent book, Technical

Analysis of the Futures Markets: "The importance of trading in

the direction of the major trend cannot be overstated. The danger in

placing too much importance on oscillators, by themselves, is the

temptation to use divergence as an excuse to initiate trades

contrary to the general trend. This action generally proves a costly

and painful exercise. The oscillator, as useful as it is, is just

one tool among many others and must always be used as an aid, not a

substitute, for basic trend analysis."

The definition of a trend is pretty simple. An

uptrend is a series of higher highs and higher lows. A downtrend is

a series of lower highs and lower lows.

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Source:

VantagePoint Intermarket Analysis Software

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Source:

VantagePoint Intermarket Analysis Software

Like much of technical analysis, however,

drawing trend lines is more art than science. When drawing an

uptrend line, you draw a straight line up to the right along

successive "reaction" lows (see chart below). During a downtrend, a

line is drawn to the right along successive rally peaks (see chart

below). It's important to note that the more times the trend line

touches rally peaks or reaction lows, the more powerful and more

valid the trend line becomes.

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Source:

VantagePoint Intermarket Analysis Software

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Source:

VantagePoint Intermarket Analysis Software

As mentioned in the basic rules of technical

analysis, a trend in motion tends to stay in motion. Of course, at

some point any trend will end. One rule for negating trend lines is

that prices must penetrate the trend line resistance or support

level and then show evidence of follow-through strength or weakness

during the next trading session. However, if prices make a big push

above or below the trend line, then that trend line is negated

without needing follow-through confirmation.

In some cases, you can draw a line parallel to

the uptrend or downtrend line to form a trading channel, providing

some boundaries within which the trend unfolds. In an uptrending

move, the straight line across the reaction lows reveals the trend,

and a parallel line across the highs defines the channel. In a

downtrending market, the straight line across the highs determines

the trend and a channel line is drawn across the lows.

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Source:

VantagePoint Intermarket Analysis Software

Channels make the trend clearer, and breakouts

in either direction can provide signals to initiate or exit

positions.

Prices do not always move up or down but spend

much of their time chopping back and forth. One example of a channel

is the formation that develops during a sideways trading range or a

basing pattern when prices hold in a generally narrow band at lower

price levels for a period of time. The longer the sideways basing

action, the more powerful the upside breakout from the trading range

is likely to be.

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Source:

VantagePoint Intermarket Analysis Software

Basic Chart

Patterns: Continuation

A market trend tends to persist, as we

mentioned in the previous section. As long as price action continues

to respect a trend by bouncing off a trend line, the trend line is

perhaps the most powerful continuation pattern. But other price

movements also suggest that the trend in place is likely to

continue.

Bullish flags - Bullish flag patterns occur when a market makes

a very strong uptrend in prices, followed by a pause or sideways to

lower trading for a few price bars, and then the market resumes a

strong price uptrend. The countertrend move against the main trend

usually lasts just a few days. Sometimes the initial surge off a

bottom looks like a flagpole and can be used as a measurement

device, adding the length of the flagpole to the point where prices

break out above the flag to project a price target.

Markets typically fluctuate between periods of

high volatility and periods of low volatility, and that is how flag

patterns are formed as the market seems to take a breather to

reassess the situation before resuming its upward climb.

src="http://tradingeducation.com/chart_patterns_tutorial3_files/image002.jpg" v:shapes="_x0000_s1028">

Source:

VantagePoint Intermarket Analysis Software

Bearish flags

- Bearish flag patterns are formed when a market

makes a strong price downtrend followed by a pause or sideways to

higher trading for a few price bars, and then a resumption of the

strong price downtrend. As with a bullish flag, the congestion area

that forms is a period when the market consolidates and reassesses

what it has done before returning to its downward trek.

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Source:

VantagePoint Intermarket Analysis Software

Symmetrical

triangles or pennants - Several types of triangle-shaped patterns are

continuation patterns. Price action seems to tighten into a coil,

with highs and lows producing smaller ranges as prices move toward

the apex of the triangle. Technical odds favor a price breakout from

the triangle pattern in the direction of the most recent dominant

price trend – in the chart example above, down.

Descending

triangle - Adding to the succession of patterns suggesting

a continuation of the downtrend on the chart above is the descending

triangle. The market is able to find buying support at about the

same general level for several days in a row, but the highs for the

day get progressively lower as prices move toward the apex of the

triangle. As with other triangles, when buyers decide they can no

longer hold the price at the level on the horizontal side of the

triangle and the breakout eventually occurs, prices are expected to

move in the direction of the dominant trend.

Ascending

triangle - The ascending triangle reverses the appearance

of the descending triangle. Sellers keep the lid on price movement

at the horizontal side of the triangle but buyers keep pressing the

market higher, causing the lows to be higher each day until the

breakout above the horizontal line occurs. As the chart indicates,

it may take a few more days of trading as buyers and sellers retest

the breakout. As with other triangles, the expected move after the

breakout is in the direction of the dominant trend.

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Source:

VantagePoint Intermarket Analysis Software

Cup and

saucer - Some analysts call this formation a cup and

handle, but the type of trading activity is the same. A market makes

a gradual descent, trades at a lower level for a while and then

makes a gradual ascent to form a rounding bottom – the saucer or the

cup, depending on the name you give this formation. After prices

reach the lip on the right side of the saucer (or cup), the market

runs into resistance from the lip on the left side and sets back for

a short time before moving back up to the lip level, forming the cup

(or handle). When prices do pick up enough momentum to break above

the lip level, they often do so with rather vigorous market action

on higher volume, sometimes leaving a gap at the start of what

becomes an extended uptrend.

src="http://tradingeducation.com/chart_patterns_tutorial3_files/image008.jpg" v:shapes="_x0000_s1025">

Source:

VantagePoint Intermarket Analysis Software

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.

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Source:

VantagePoint Intermarket Analysis Software

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.

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Source:

VantagePoint Intermarket Analysis Software

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.

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Source:

VantagePoint Intermarket Analysis Software

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.

src="http://tradingeducation.com/chart_patterns_tutorial4_files/image008.jpg" v:shapes="_x0000_s1028">

Source:

VantagePoint Intermarket Analysis Software

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.

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Source:

VantagePoint Intermarket Analysis Software

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 uptred line. These patterns are usually bearish and

do portend a change in trend.

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Source:

VantagePoint Intermarket Analysis Software

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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Source:

VantagePoint Intermarket Analysis Software

More Chart

Basics

Several other concepts need to be mentioned in

any discussion of basic chart patterns because they are an integral

part of any technical analysis toolbox.

Support and resistance

- As has been mentioned previously in this

tutorial, technical analysis begins with the trend line. The trend

line is also the first point of support and resistance. Projecting a

trend lines to determine future support and resistance areas is

extremely effective. As the charts in the trend line discussion

illustrated, a trend line along the lows in an uptrend or across the

highs in a downtrend is a key barrier for prices to cross if the

market is to change trend direction.

But trend lines aren’t the only source of

support and resistance. One of the favorite methods for determining

support and resistance levels is to look at a bar chart and its past

price history and then see at what price levels the highs, lows and

closes seem to be touching the most. This method of determining

support and resistance levels works on any bar chart timeframe –

hourly, daily, weekly or monthly. Many times a bunch of highs or

lows will be concentrated in a small price area but not at one

specific price. Instead, you have a support or resistance "zone"

that should be rather narrow to be effective.

Major price tops and bottoms are also major

resistance and support levels. Unfilled price gaps on charts also

qualify as very good support and resistance levels. Moving averages,

especially longer-term ones, can also provide support or resistance.

Still another way that support and resistance levels can be

identified is through geometric angles from a certain key price

point, a concept most often associated with W.D. Gann, a legendary

stock and commodity trader who died in 1955.

Finally, support and resistance levels can be

determined by "psychological" price levels. These are usually round

numbers that are very significant in a market. For example, in crude

oil, a psychological price level might be $60 per barrel. For

soybeans, that might be $5 or $6 per bushel or in cotton, 50 cents a

pound. These levels mark clear step-up or step-down prices where the

market often pauses to reassess the situation.

Many chart patterns develop as a result of

price action at support and resistance areas. For example, a double

bottom may form because prices find support from an earlier bottom,

or a triangle may form as prices are unable to overcome short-term

trend line support or resistance until a breakout eventually does

occur.

One important point to note about support and

resistance is that when a key support level or zone is penetrated on

the downside, that level or zone will likely become key resistance.

Likewise, a key resistance level or zone that is penetrated on the

upside will then likely become a key support level or zone.

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Source:

VantagePoint Intermarket Analysis Software

Retracements - Another way to discover support or resistance

areas is by looking at "retracements" of a significant price move –

price moves that are counter to an existing price trend. These moves

are also called "corrections." Once a market has broken through a

trend line, the first thing many traders want to know is how far

this new move or correction will extend.

Based on studies of past price history, a

popular retracement is 50% of the previous trend. For example, let's

say a market is in a solid uptrend that began at 100 and rallies to

200. Then comes the correction, a common occurrence as markets

seldom make one-way moves. How far will prices back off?  Analysts

who rely on retracements would put a target at 150 or 50% of the

move from 100 to 200 and expect prices to bounce back up and resume

the uptrend after reaching or nearing that price level. A correction

retracement less than 50% indicates a stronger market, a retracement

of more than 50% a weaker market.

The 50% mark isn’t the only popular retracement

level. Some analysts use the 33% and 67% levels as support or

resistance. Followers of Fibonacci numbers use 0.382% and 0.618% of

a prior move as key support and resistance levels.

No matter what you use as an expected

retracement target, it gains heightened validity if it coincides

with some other important form of support or resistance such as a

trend line, previous high or low or a gap.

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Source:

VantagePoint Intermarket Analysis Software

Gaps - Gaps are areas on a price chart where no

trading occurs. The last bar's low is higher than the previous bar's

high for a gap-higher move. The last bar's high is lower than the

previous bar's low to form a gap-lower move. For example, if a

market closes at 100 in one session and then opens at 105 in the

next section, a 5-point gap would be evident on a chart.

With electronic trading 24 hours a day, gaps

are less likely to appear as the market moves fluidly from one price

to the next. However, for those markets that have only day sessions,

which includes most physical commodities as well as stocks, gaps may

show up because of some overnight news or development that causes a

sudden shift in prices. Price gaps typicallly indicate a strong

market move, and many times the gaps will then serve as important

support or resistance levels on the chart.

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VantagePoint Intermarket Analysis Software

Gaps cannot be characterized as reversal or

continuation signals as different gaps mean different things – and

sometimes have little impact at all. There are three main types of

gaps:

• Breakaway gap. These occur at the beginning of a move

  as prices reject the previous tend and suddenly reverse course or at

  the breakout point of a chart formation such as a trend line or a

  triangle. The breakaway may be due to new conditions that have

  become known to traders or because pent-up buying or selling erupts

  in a strong move.

   

• Measuring gap. As the market moves up or down, it may

  suddenly leave a gap higher or lower on some new development. Some

  analysts view such gaps as the halfway point to an ultimate price

  objective. It obviously is impossible to know that for sure until a

  move is complete so these gaps are a little tricky to use in

  analysis. However, you may be able to combine a gap projection with

  a well-defined support or resistance area such as a previous high or

  low to arrive at a potential price target.

   

• Exhaustion gap. This gap appears at the end of an

  extended move and reflects a last burst of buying in an uptrend or

  selling in a downtrend. Once this exuberant buying or selling has

  occurred, there are no new buyers or sellers to maintain the trend –

  the force that was driving the trend has been exhausted. As a

  result, the turn in the trend can produce some dramatic moves in the

  opposite direction as the late buyers or sellers scramble to unload

  their losing positions. This is the type of situation that sometimes

  produces island tops or island bottoms on a price chart. One day or

  several days of price action may be isolated by an exhaustion gap

  and then a breakaway gap during the market’s sudden turnabout.

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Source:

VantagePoint Intermarket Analysis Software

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VantagePoint Intermarket Analysis Software

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