We know that markets move in trends with peaks and troughs in their price movements. the next step is to use these price actions to give clues as to how the market may move in the future.
This is done by identifying recognisable patterns within the price movements, which can then be used to generate price objectives for potential future moves. Note that, for any pattern to be valid, a prior directional trend must be in place.
Price patterns can be divided into two categories:
- Continuation patterns
- Reversal patterns
Continuation patterns tell us that a sideways movement on a chart may be just a pause in the overall trend, after which the market will continue to move in the same direction as before. The main advantage of identifying a pattern is that we can use it to define minimum price objectives at a fairly early stage to give us time to profit from the expected future move.
There are three types of triangle; symetrical, ascending and descending. They appear here under the title ‘continuation patterns’ but they can be notoriously badly behaved and can sometimes be seen as reversal patterns. This is not a problem because they must never be traded until after the breakout has happened.
A triangle is formed by two converging lines. We know already that it takes two points to draw a trend line, but a third point to confirm it. The lines drawn on triangles are not true trend lines and do not require three touches but the more touches on each line the stronger the pattern. There are a number of rules to follow when dealing with triangles.
- The vertical height of the triangle, x, projected down from point A to the lower trend line is called the ‘base’. In a downtrend, the point A would obviously be on the lower line, but the calculation of the base is the same. Some analysts select a more conservative measurement for the base, by measuring vertically up from point B.
- The price should break out around two thirds of the way through the pattern, but certainly between a half and three-quarters of the way along from the base to the apex (G). A breakout before halfway means that the triangle has barely had time to take shape and should not be trusted. If the price is still within the triangle beyond the three-quarters point, then there is more likelihood that the price will simply continue to drift sideways and lose its shape, nullifying the measuring properties of the pattern.
- Regarding measuring implications, the minimum price objective for a triangle is the vertical height of the base, x, projected vertically from the breakout point in the direction of the break. However, a more conservative MPO would be found by projecting the height between B and the upper line from the breakout.
- Triangles are generally medium to long-term patterns, typically lasting for 1-3 months (although they can occur over longer or shorter time periods).
- A symmetrical triangle is created when the sideways price movement narrows to form a triangle pattern.
- Guide lines can be drawn to converge in the future, with one of them sloping upward and one down.
- Of the three types of triangle mentioned here, this is the most likely to breakout on the wrong side, as the buyers and sellers are both prepared to accept a worse price as the pattern evolves.
- Ascending triangles are, more often than not, bullish patterns.
- They have a horizontal upper line and an up-sloping lower line.
- The up sloping line is created by dealers being prepared to pay a slightly higher price each time the price declines (i.e. buying pressure is increasing)
- The flat upper line is telling us that the sellers are prepared to wait for the price to rise before selling (i.e. selling price is not increasing).
- With buying pressure increasing and selling pressure remaining constant, it therefore makes sense for the price to breakout on the upside.
- A return move back is also quite common before the price moves off towards the minimum price objective.
- Descending triangles are the exact opposite of ascending triangles, and are therefore mostly bearish.
- The measuring implications are the same as for the others, as are the duration (generally 1-3 months) and time limits for the breakout (one-half to three-quarters of the way from the base to the apex.
Flags and Pennants
Flags and pennants are generally short-term patterns, lasting for anything from a few minutes to a few days (maximum 2 weeks). They are formed when a very sharp advance (or decline) stops to consolidate before continuing its move with a further sharp advance (or decline).
Both patterns have the same price implications despite their different shapes. The initial move should be projected vertically from the breakout point of the flag or pennant to give a minimum price objective.
Note that these patterns may occasionally repeat themselves within the same fast move, in which case, each occurence of the pattern will generally be separated by similar vertical distance.
Reversal patterns illustrate a sentiment shift, from bullish to bearish or vice versa. They tell us that a pause in a prevailing trend is actually the end of the trend and that prices will start to move in the opposite direction
Head and Shoulders
- A head and shoulders top is made up of left and right shoulders (A and E), and a head (C) being higher than the shoulder.
- The ‘neckline’ is drawn through the two reaction lows (B and D) and the pattern can only be confirmed as a head and shoulders after a break below the neckline.
- Quite often the price will return to test the neckline but for the patterns to be valid it should not re-cross this line.
- The minimum price objective is then the vertical distance (x) from the top of the head to the neckline, projected downward from the point at which the neckline was broken.
This pattern can also be seen inverted at the end of a downtrend, in this case it is called an inverse head and shoulder pattern.
Double Tops and Bottoms
A double top has two peaks (A and C) at roughly the same level, with a reaction low (B). If C is slightly lower than A then that is not a problem, it becomes an issue if C is slightly higher than A, in that case it has made a higher high.
As with the head and shoulders, the price objective is the vertical distance (X) projected downwards from the breakout point.
This pattern can also be seen inverted at market bottoms.
Triple Tops and Bottoms
These are rarely seen. A triple top has 3 peaks at roughly the same level with two reaction lows. As with a head and shoulders and double tops and bottoms, a prior uptrend is essential. Triple tops have the same price objective calculations and often have a return move.
These can also be seen inverted at the bottom of a trend and are called triple bottoms.
Something you should be wary of when identifying a triple top or bottom is that the market is essentially ranging, so unless it does not follow the pattern almost exactly, the chances are is that the market has started going sideways.
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