While chart patterns are powerful tools for finding good entry and exit points (buy and sell prices), relying solely on them to conduct trades is not advisable. Many other factors have to be taken into consideration, not to mention that misinterpretation is always a risk.
Chart Pattern Essentials
Three main categories of chart patterns are:
- Continuation chart patterns
- Reversal chart patterns
- Bilateral chart patterns
Chart patterns can be either bullish or bearish.
- When identifying chart patterns, we observe their shape and accompanying trading volume.
- To safely trade a chart pattern, it has to be completed and confirmed.
- Chart patterns formed in longer time frames are more reliable than those formed in shorter time frames.
Categories of chart patterns
Chart patterns can be divided into three main categories: continuation, reversal and bilateral. Continuation chart patterns indicate that a market trend, either bullish or bearish, is likely to continue. Reversal chart patterns signify a trend reversal from bullish to bearish or vice versa. Bilateral patterns are indecisive patterns and do not point to a definite direction.
Identifying chart patterns
When identifying patterns, the most important thing to look for is their shape. While patterns are forming, price should respect important resistance and support levels, trendlines and channels, which are unique for each pattern and lead to its formation. We will cover this in greater depth in the articles on continuation chart patterns, reversal chart patterns and bilateral chart patterns.
There are aspects other than shape which are also important to keep an eye on when identifying chart patterns. Often, we must acknowledge the highs and the lows on the chart to identify a certain pattern. The meaning of highs and lows are explained below.
A high is a chart’s high point (top), while a low is a chart’s low point (bottom).
A higher high is a high which exceeds the chart’s previous high.
A lower high is a high which does not exceed the chart’s previous high.
A lower low is a low which exceeds the chart’s previous low.
A higher low is a low which does not exceed the chart’s previous low.
Observing trading volume is also very important at certain parts of patterns, as it can confirm or disprove its validity. If the trading volume is high when a price makes a significant move, this confirms its strength. If the volume is low as the price makes a big move, this indicates weakness in the price change, thus the price is likely to be rejected soon after the change.
Chart patterns and time intervals
Regardless of their geometric shape, all chart patterns have a few things in common. For one, a pattern can appear within another pattern. For instance, if you take a look at a one-day-interval chart, you might find a bull flag chart pattern signifying uptrend continuation. Then, if you change the time interval from one day to one hour, you might find a double top pattern, which signals a bearish reversal.
Furthermore, patterns formed in larger time frames normally turn out to be more reliable and carry more weight. In our case, the double top pattern formed on an hourly chart is not as reliable as a bull flag pattern found on a daily chart. In other words – longer time frame patterns are believed to be better indicators than shorter time frame patterns.
Completion and confirmation of chart patterns
To effectively trade any chart pattern, its formation has to be completed and then confirmed. A pattern is considered complete after its shape is fully visible on the chart and it is considered confirmed after the price “breaks out” of the pattern in the direction which aligns with its original prediction. Making a trade before a pattern’s confirmation is risky, as the pattern can easily be invalidated.
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Now that you are familiar with the basics of chart patterns, you can proceed to learning about particular patterns. Some predict that a market trend will continue (these are the so-called “continuation chart patterns”), while others predict a trend will reverse (they are referred to as “reversal chart patterns”). A third, and most ambiguous, group contains the patterns that predict the price could go either way (“bilateral chart patterns”). Check our articles to learn more.
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