By Darrell Hale
Technical Analysis is one of the oldest tools for making trading decisions. At its core, it’s simply analyzing the price and volume of the instrument you are trading. There are many ways to get there (Moving Averages, Relative Strength, Oscillators, etc…). In this article we will focus on chart patterns, specifically, the top ten patterns used by technical traders. Let’s get started.
Bearish Head and Shoulders Pattern
The head and shoulders is probably the most popular pattern used by technical traders. It is easy to spot and sends a very powerful trend-reversal signal. It is comprised of two shoulders and a head. The first shoulder is created by a rise in the security and a subsequent decline, forming a peak. At the base of the peak, price consolidates and rallies again, but his time rising above the former peak and again declines. At this point you can see the left shoulder and the head.
When price rises for a third time, it doesn’t quite make it to the second peak (“the head”). This forms the right shoulder, and there is usually a sell off at this point. Why? Those who sold around the “head” are still in control and rallies are being thwarted by heavy selling. This can be a strong signal that the current up trend is in trouble. This can lay the foundation for a low risk entry trade.
The above example demonstrates the head and shoulders as an uptrend reversal pattern. What about a downtrend reversal? That is called the “Reverse Head and Shoulders”. It is exactly the same principle, but used in a downtrend. If you want to know what it looks like, take a head and shoulders pattern and turn it upside down.
Bullish Doji Pattern
The Doji is another very popular and interesting pattern that tells a story. The security opens and trades above and below the opening price all day, only to close right at or very near the opening price. This gives us one very important piece of information. There is indecision. Neither buyers nor sellers are in control. This helps us because in a down trend, sellers are in control. If, after a downtrend you see a doji that could signal a shift in sentiment, or at the very least halt the selling. The reverse is true for an uptrend. When this pattern forms, it is best to have a “wait and see” mentality. The next bar that forms can either confirm the change in trend or continue in that direction.
This pattern is also used as a trend reversal pattern. It consists of two candles. The first candle is characterized by a very narrow trading range and closes down. Because it closed down, the sellers are still in control, but not as aggressive since the range is tight. They are wavering a bit. The next candle is a wide range trading day that engulfs the body of the previous candle and closes at, or near the top of the range. Aggressive buyers have stepped in to take control and signal a change in sentiment of the security. It is best not to fight this move as it could mean the end of the downtrend and the beginning of a strong up trend. The reverse is true for a bearish engulfing pattern.
When a trader sees prices consolidating for an extended period of time, a breakout could be eminent. Breakouts appear as tight trading ranges, with a spike outside of this range, continuing in the direction of the breakout.
Bullish Hammer Pattern
Unlike other patterns where, it takes some time to develop (maybe several days or so); the hammer gives us important information on the same day. The security opens and sellers immediately step in and send it lower. There is usually price consolidation after such a move. At some point during the trading day, buyers have stepped in and created enough demand to close at the top of the range. This kind of trading can easily happen when there is some new fundamental information that has entered the marketplace that can cause an immediate shift in market sentiment. The reverse is true for bearish hammer patterns.
Bullish Piercing Pattern
The piercing pattern can be scary. It can be extremely unforgiving if you are caught on the wrong side of it. This is a reversal pattern where on the first candle you see a wide range that close near the bottom of the range. Sellers are in control, right? But on the second candle you see another wide range but this range “pierces” the previous candle and closes near the top of the range. This is powerful because the sellers, who had a profit, may panic and start covering losses. This can cause a massive increase in price as short covering ensues.
Bull flags are usually categorized as continuation patterns in an uptrend. They are typically seen after a sharp move upward. After this move, the market consolidates and trades down a bit, against the trend, but never really threatening the overall uptrend. You can look at bull flags as a series of “pull backs”. The pull backs form the flag and the sharp move forms the pole. Usually price breaks out of the flag pattern and continues in the direction of the trend.
The Double Bottom
The double bottom is a very popular pattern to the technical trader simply because it is straightforward. Price trades down to an area where buyers step in and bid prices back up. This causes a rally, forming the first bottom. After demand fades, price trades back down to the previous bottom and buyers step in again, at the exact same spot. What the market is telling us is that, buyers are willing to “defend” this area. Those who got long previously, can add to their positions. Buyers who missed the move have another shot at getting in. This are will serve as a key support zone if it holds up.
After spotting an uptrend, a trader may look to enter the market on a pullback. This happens when price sells off in the midst of an uptrend. This can provide a great opportunity to enter the market at a cheaper price, in the direction of the trend.
The Triple Bottom
This can be described as the double bottom “on steroids.” It also serves as a powerful support zone. Even more so, as buyers are willing to step in a third time and bid prices back up. The more times price touches this zone, the more significant the pattern becomes.
The technical trader can have a variety of chart patterns to choose from. This article highlights 10 of them. When used in conjunction with other techniques, these patterns can produce powerful signals.