Chapter 4-3 Common Chart Patterns
The Flag Pattern is the most basic form of a continuation pattern, which occurs when there is a vertical, or parabolic, move in price followed by a tight consolidation as buyers take profits. The breakout/breakdown should occur on above average volume, with the consolidation occurring on decreasing volume. An ideal Flag Pattern would have a perfectly horizontal base, although it is much more likely for the base to slope directionally. As with all continuation patterns there can be false breakouts/breakdowns. Unlike other continuation patterns, if a Flag has a clearly defined base this can be used to build a position before the breakout occurs.
Trade: As with Triangles and Pennants, the trade is a breakout/breakdown from a period of consolidation. The difference with a Flag is that the trade can be entered prior to the breakout. For example, if a stock makes a vertical move up followed by a consolidation (Bull Flag), with a clearly defined price serving as a bottom for the consolidation, you can offer shares above this price and place a stop directly below the bottom of the flag, creating an excellent reward to risk opportunity.
Symmetrical Triangle Pattern
Symmetrical Triangle Patterns are continuation patterns, similar to a Flags and Pennants, which occur after a large move in price. Afterwards, the stock will begin to consolidate in a triangle, usually with decreasing volume. When price breaks the triangle it should be on a high volume spike (confirmation) and in the same direction as the previous trend. The breakout itself has potential to move the entire range of the triangle (from highest to lowest points).
Trade: Because there is no clearly defined base in a triangle it is prudent to wait for a confirmed continuation breakout on a high volume bar, as there can be numerous false breakouts in either direction, although they should occur on light volume. On a bullish Symmetrical Triangle the breakout should be through the upper trendline of the triangle, and a bearish breakdown should be through the lower trendline. Breakouts/breakdowns should both be on increased or heavy volume.
A continuation pattern, Pennants are similar to Symmetrical Triangles and Flag Patterns. The Pennant Pattern is essentially identical to a Symmetrical Triangle, the only notable difference being the much shorter duration of the consolidation. In a Pennant the triangle may also be less visually definable than in a Symmetrical Triangle. However, as with the Symmetrical Triangle, the consolidation should occur on decreasing volume relative to the volume during the initial trend and the breakout/breakdown should occur on a heavy volume bar.
Trade: It is typically best to wait for the confirmed breakout/breakdown on high volume and in the direction of the previous trend, as there is always the risk of a false breakout/breakdown.
A Wedge combines the consolidating price and volume of a Symmetrical Triangle with the sloping trend of a Flag Pattern. Although it resembles a Symmetrical Triangle, it can be a continuation or reversal pattern. A Rising Wedge is bearish while a Falling Wedge is bullish, regardless of the previous trend. As with Triangle and Pennant patterns, volume should decline during Wedge formation and spike when the formation is broken.
Trade: Since it is impractical to build a position while the wedge is forming because of a poor reward to risk setup, traders should wait for a confirmed breakout in the opposite direction of the Wedge itself. As with a Symmetrical Triangle, the breakout/breakdown should be accompanied by a surge in volume.
Head and Shoulders Pattern
A Head and Shoulders Pattern is a bearish reversal pattern, most often occurring during an uptrend. An Inverted Head and Shoulders is a bullish reversal pattern, which is most reliable if it occurs during a downtrend. A classic example of a Head and Shoulders would begin with an uptrend occurring on above average volume followed by a correction, the low of which forms the neckline; this being the left shoulder. After forming the neckline price will reverse and make new highs on lower volume. The reversal of this move should test the neckline forming the head of the pattern. The right shoulder must be a lower high than the head, but not necessarily lower than the left shoulder. The reversal of this final downtrend must break the neckline, forcing any remaining buyers to cover, often indicated by a surge in volume.
Trade: Traders should not be preemptive and wait for the pattern to form before entering. If scalping, the right shoulder is possible to trade as you can buy off of the neckline with minimal risk. However, the optimal trade is the breakout/breakdown through the neckline with volume confirmation.
A Double Top is a bearish reversal pattern occurring only at the end of an extended uptrend, while a Double Bottom is a bullish reversal pattern occurring after an extended price decline. Of key importance is that the second top does not make higher highs (in the case of a Double Top), or in the case of a Double Bottom, that the second bottom does not make lower lows. In a Double Top the low of the first price correction (first top) serves as the confirmation level, with a breakdown through this price signaling confirmation of the pattern.
Trade: It is possible to scalp the move from the second top/bottom to the confirmation level; although your entry (and risk) will be arbitrary since your exit is known. This is accomplished by entering near the low of the first bottom as it starts to reverse, with a limit order in range of the confirmation level and a tight stop at new lows. The breakout/breakdown is the better reward to risk setup and should be confirmed by a volume spike.
In a Parabolic Uptrend price will increase with at a very rapid pace as buyers’ fuel momentum with almost no visible selling. These moves are usually event-driven (news, earnings, economic data, etc.), and are much more volatile than normal. Volume during the move itself should be noticeably above average and begin to fade as the move nears its conclusion. Note that the price can continue to rise even as volume subsides. The reversal itself (in both a Parabolic Uptrend and a Parabolic Downtrend) should occur on rising volume. A declining price indicates selling pressure in a Parabolic Uptrend, while a rising price signifies short covering pressure in a Parabolic Downtrend.
Trade: Parabolic Reversals are the most risky patterns to trade as entries are arbitrary and the logical exits (new highs in an uptrend, new lows in a downtrend) can be breached by erratic price action. However, due to the extent of the move itself reversals can be extremely profitable. It is very important to wait for the volume and price to confirm a reversal, as it is very easy to enter the trade too early, thus putting you at great risk.
It is essential to adhere to your predetermined exits upon participating in a trade, regardless of the indication of a chart pattern. A successful trader never solely relies on one single indicator. While indentifying a formation on a chart can be useful, to truly reach consistent success it is important to couple favorable chart patterns with other indicators. When multiple indicators all point to a similar conclusion probability dramatically increases.