Since the dawn of capitalism, people have been trying to find new ways to predict what is about to happen next. Some methods seem to work fairly well for a season and then suddenly they appear to just stop working. Chart patterns are not one of these methods.
Chart patterns are one of the few anticipation methods that has stood the test of time. In western trading, we know chart patterns go back at least to the 1920’s and 30’s. If you go to the other side of the world, however, in Japanese trading we have history going as far back as the 1700’s that shows a very active and well-codified use of chart patterns.
Regardless of your cultural background, one thing we know for sure about chart patterns: They work.
As with all technical tools that “work”, inevitably various groups of followers will jump on board using the tools and before long, the original skills and techniques have become distorted and lost in the retelling.
Perhaps one of the most difficult aspects of learning chart patterns is the reality that there are so many “versions” of what is supposedly truth on the matter. If you read one blog it will tell you that such and such is a head and shoulders pattern, then if you read another blog it will tell you why the first blog you read was completely wrong.
In this post and series of articles, I’m going to share the more traditional view of chart patterns. I’m going to share the art form in the way that I learned it. Along the way, I will add some of my own commentary and distinctions from personal use, but for the most part, my intention is to stay true to the original usage of the patterns.
This should encourage you. When you approach chart patterns the way they were originally used, I expect you will find they work much better, much more consistently, and as a result, you will have the opportunity to make much bigger profits when trading patterns!
So what are chart patterns?
Chart patterns are patterns of price behavior that appear on a price chart. They are the result of the mass of traders trying to decide what is the next direction for a stock.
These are the type of questions traders are asking. Even if it is on a subconscious level, every trader wants to have even more confidence they are making the right decisions.
Chart patterns occur when the masses start to ask the same questions at the same time. It causes a pause in the trend. Rather than the trend going straight up, it takes a break before continuing. Or perhaps instead of continuing the trend reverses.
Chart patterns can be a very advantageous study to understand because when you do understand them, your ability to recognize and avoid dangerous situations goes up exponentially. Also, by recognizing chart patterns you can better take advantage of many good situations.
The history of chart patterns goes back hundreds of years. As far back as the 1700’s the great Japanese trader Sokyu Honma had already developed trading systems built around chart patterns.
One of the benefits of living in the 21st century is the reality that today we have powerful charting softwares that can draw charts instantaneously. Not only will they draw charts, but we can switch to see a different time frame in seconds.
No other time in history has presented so many amazing tools for the study of chart patterns and technical analysis. As traders, we owe it to ourselves to take the time to learn these tools and techniques.
Because at the end of the day, the goal of every trader is to make money. Never before have we had such a great opportunity to work with such powerful tools and combine it with the rich history of quality technical analysis.
Chart patterns are just one of the components that make this study so valuable
There are three broad categories of chart patterns. They are:
As I develop this series on chart patterns we will look at each of these classifications in more detail and you will learn several patterns that work well for each function. However, for the function of this article, let’s take a general overview of each of these pattern classifications.
As the name suggests, reversal patterns reveal that a trade is about to reverse direction. In other words, the previous trend is coming to an end and a new trend in the opposite direction is setting up.
There are a couple of important things to recognize about reversal patterns:
Reversal patterns are terminal.
One important thing to remember is reversal patterns terminate the previous trend. They bring that trend to an end. Once the reversal pattern has setup and confirms, the odds have increased substantially (well over 50%) that the preceding trend is done for a while.
This is powerful insight. How many traders have fallen victim to a reversing trade simply because they didn’t recognize the pattern? All over the financial news outlets we hear “buy on the dips”, and as a result, many traders buy when a stock goes down thinking they are buying on the dips.
There’s a time to buy on the dips, and there’s a time to run from the dip! Reversal patterns help us identify those times. If you see a stock on a strong pull back and think “I should buy the dip”, but you also see a strong reversal pattern (like a double top or head & shoulders), that is a perfect warning to prevent you from making a huge financial mistake.
The bottom line about this subject is simple: Reversal patterns reverse the trend.
It is also important to recognize that reversal patterns reverse the primary trend. That’s the big picture trend.
Very often I have a student in a class trying to convince me that a certain reversal pattern has occurred. However, upon looking at the chart, it is evident that this trend is very young. A reversal pattern at that level would not likely play out as a reversal.
You want to identify reversal patterns that are terminating the primary trend. This is where you will find the best, most profitable signals to trade.
The next classification of patterns is consolidation patterns. Consolidation patterns can be frustrating to trade, particularly while they are early on in their development.
A consolidation pattern simply reveals that the traders who had been driving the previous trend have come to a resting point. The market is “consolidating” the buyers and sellers and either the trend will reverse soon, or it will continue, but right now it’s taking a break and everyone is taking account of where things are preparing for the next move.
The downside of consolidation patterns is the fact that they can take a long time to develop. For example, in this chart below you can see a consolidation on the Dow Jones Industrial average that took place over almost 2 years! That can be very annoying!
The good thing about consolidation patterns is this: If you can be patient, when they do break out, more often than not, they turn into a strong new trend. And that’s a great trading opportunity!
In a later post, we’ll look at the different types of consolidation patterns so you can identify them early and make a profit from them.
Continuation patterns are the third classification of patterns. These are patterns that show a trend is continuing a trend. This is when you would want to “buy the dip”.
Continuation patterns are popular patterns, particularly among longer-term traders who are trying to time a new entry into a long term trend.
Unfortunately, like most of the patterns, continuation patterns are often misnamed, not properly understood, and as a result, they are misused.
As we build further in this series, I will share the specifics related to continuation patterns. You’ll learn what to look for, as well as what additional details characterize continuation patterns.
Chart patterns work because people are predictable. This is one of the core tenants of Technical analysis.
People are the main driving force behind buying and selling behavior. It really doesn’t matter what the “statistics” suggest a stock should be worth. What matters is how the people trading that stock "feel" about it.
If they are optimistic, they will buy.
If they are pessimistic, they will sell.
Chart patterns reflect that human sentiment that we see in the trades. When you learn to interpret chart patterns, you are learning to read human behavior as it appears in the stock price.
I’m certain as you learn more you will quickly discover chart patterns are a valuable tool to add to your skills as a trader. Not only do they give you a pattern to trade for profits, they give you powerful insights that no other trading technique will provide.
When you pair them up with basic technical analysis and other pattern studies like Candlestick patterns, Chart patterns are a priceless analysis technique you will certainly want to master.