Getting Started in Chart Patterns

1. Chart Patterns: Footprints of Market Psychology

Chart patterns are the footprints of the smart money, but the dumb money is mixed in as well.

Recurring Formations. Chart patterns are recurring formations that appear on price charts, reflecting the collective trading behavior of professionals, companies, and individual investors. These patterns are not random; they are the visual representation of the tug-of-war between fear and greed in the market.

Psychological Insights. By studying chart patterns, traders can gain insights into the underlying psychology of the market. For example, a double top pattern suggests that sellers are gaining control, while a double bottom indicates that buyers are stepping in. Recognizing these patterns can help traders anticipate future price movements.

Beyond Smart Money. While chart patterns were once thought to be the exclusive domain of "smart money," the reality is that both informed and uninformed traders contribute to their formation. This means that anyone can learn to identify and profit from these patterns, regardless of their level of experience.

2. Trendlines: Guiding Lines of Price Action

When price trends, a line connecting them is called a trendline.

Defining Trends. Trendlines are lines drawn on a price chart to connect a series of peaks or valleys, highlighting the direction of price movement. These lines can be straight, curved, or diagonal, and they serve as a visual guide to the prevailing trend.

Types of Trendlines. There are three main types of trendlines: external, internal, and curved. External trendlines rest on the peaks or valleys of price action, while internal trendlines cut through price. Curved trendlines follow the shape of a curved price trend. The type of trendline used is a matter of personal preference.

Trendline Significance. The more times price touches a trendline, the more significant it becomes. Breakouts from trendlines with widely spaced touches and longer lengths tend to be more reliable and lead to larger price moves. The angle of the trendline also matters, with those sloping between 30 and 45 degrees being the most reliable.

3. Support and Resistance: Battlegrounds of Supply and Demand

Underlying support changes into overhead resistance as one trader’s floor becomes another trader’s ceiling.

Zones of Price Action. Support and resistance are price zones where buying or selling pressure is strong enough to halt or reverse a price trend. Support is a price level where buying demand is expected to stop a decline, while resistance is a price level where selling pressure is expected to stop a rise.

Dynamic Nature. Support and resistance zones are not static; they can change over time. For example, a support level can become a resistance level if price breaks below it, and vice versa. This dynamic nature reflects the ever-changing balance of supply and demand in the market.

Identifying Zones. Support and resistance zones can be identified using various techniques, including prior peaks and valleys, horizontal consolidation regions, round numbers, Fibonacci retracements, and trendlines. These zones are not always precise lines but rather areas where price is likely to pause or reverse.

4. Top Buy Signals: High-Probability Entry Points

High and tight flags are the best performing chart pattern.

High and Tight Flags. These patterns form after a rapid price increase (at least 90% in two months) followed by a brief consolidation period. They have the highest average rise (51%) and the lowest failure rate (1%). Look for tight flags with receding volume and light breakout volume.

Pipe Bottoms. These patterns consist of two adjacent, downward price spikes on the weekly chart. They are often found at the bottom of a downtrend and have an average rise of 43%. Look for long spikes with a large price overlap and high volume.

Inverted and Ascending Scallops. These patterns resemble an upside-down "J" and often appear in uptrends. They have an average rise of 38%. Look for a smooth, rounded turn at the top and a retrace of about 54% of the prior up move.

Three Rising Valleys. This pattern consists of three consecutive valleys, each higher than the last. They have an average rise of 41%. Look for similar-shaped valleys and a downward volume trend.

Rounding Bottoms. These patterns show a gradual rounding turn from a downtrend to an uptrend. They have an average rise of 43%. Look for a smooth, bowl-shaped turn and a rising price trend leading into the pattern.

5. Top Sell Signals: Recognizing Exit Opportunities

The steeper the trendline, the worse the performance.

Head-and-Shoulders Tops. These patterns consist of three peaks, with the middle peak (the head) higher than the other two (the shoulders). They signal a potential trend reversal. Look for similar-shaped shoulders and a neckline that slopes downward.

Diamond Tops and Bottoms. These patterns are rare and difficult to find, but they can signal significant trend changes. They are characterized by a broadening price range followed by a narrowing one. Look for a quick price rise or decline leading to the pattern.

Double Tops. These patterns consist of two peaks at or near the same price level. They signal a potential trend reversal. Look for a valley between the two peaks and a close below that valley to confirm the pattern.

Descending Triangles. These patterns have a flat bottom trendline and a downsloping top trendline. They often signal a continuation of the downtrend. Look for price to touch each trendline at least twice and a downward volume trend.

Ascending Broadening Wedges. These patterns have two upsloping trendlines that diverge over time. They often signal a trend reversal. Look for three touches of each trendline and a volume trend that slopes upward.

6. Special Situations: Navigating Market Nuances

Trade with the trend.

Bull and Bear Markets. Trading with the trend means buying in a bull market and selling or shorting in a bear market. The industry trend is more important than the market trend.

Bull and Bear Traps. These are situations where price breaks out in one direction but then reverses, trapping traders who bought or sold too early. Be prepared for a quick reversal and use stops to protect your position.

Dead-Cat Bounces. These occur when a stock plunges, bounces briefly, and then resumes its decline. Avoid trading stocks with a recent dead-cat bounce.

Inverted Dead-Cat Bounces. These occur when a stock rises sharply on good news, then quickly declines. Swing traders should sell the day after the rise.

Flat Bases. These are long, horizontal price movements that often precede a strong breakout. Look for chart patterns that form after a flat base.

Gaps. These are areas on a price chart where price jumps, leaving a gap. Area or common gaps close quickly.

Lower Highs and Higher Lows. Lower highs signal a bearish trend change, while higher lows signal a bullish trend change.

Partial Rises and Declines. These are brief price moves that signal a breakout in broadening patterns and rectangles.

Tails (or Spikes). These are long price spikes that often mark short-term turning points.

7. Busted Patterns: Profiting from Failure

A busted pattern occurs when price breaks out in one direction, fails to move more than 10% before reversing, and breaking out in the opposite direction.

Trading the Unexpected. Busted patterns occur when a chart pattern breaks out in one direction but then reverses and breaks out in the opposite direction. These patterns can provide excellent trading opportunities if you know how to identify them.

Single, Double, and Triple Busts. A single bust occurs when price reverses after a breakout. A double bust occurs when price reverses again, and a triple bust occurs when price reverses a third time.

Busted Pattern Performance. Busted patterns often lead to larger price moves than non-busted patterns. For example, busted rectangles with downward breakouts have an average rise of 61%.

Trading Busted Patterns. To trade a busted pattern, wait for price to close outside the trendline boundary on the opposite side of the initial breakout. This confirms the busted pattern and signals a potential trade.

8. Trading Checklists: A Framework for Success

Plan your trade and trade your plan.

Before Buying:

• Check the market and industry trends.
• Review the chart pattern history.
• Score the chart pattern.
• Check for divergence and failure swings.
• Get a quote before trading.
• Is the stock trending up?
• Is the stock trading near the yearly high?
• Look for overhead resistance and underlying support.
• Avoid mental stops.
• How likely is a throwback or pullback?
• Check for dead-cat bounces.
• Is the price trending up or down?

When to Sell:

• The stock is about to hit your stop.
• A bearish chart pattern has broken out downward.
• The chart pattern busts.
• The stock has closed below an upsloping trendline.
• Stock falls more than 62% retrace.
• The 1-2-3 trend change method signals a trend change.
• Price has hit the target.
• The averages are dropping.
• Stocks in the industry are topping out.
• Look at the weekly scale.
• The market is up, but the stock is down.
• Historical price review.
• Check the indicators.
• Indicators are diverging from price.
• Indicator failure swings.
• Overhead resistance.
• Is a throwback or pullback happening?

General Trading Tips:

• Tighten stops.
• Trade tall patterns.
• Narrowing prices.
• Don’t forget busted patterns.
• Trade with the trend.
• Reversal chart patterns must have something to reverse.
• Don’t average down.
• Trade on the intraday scale.
• Raise that stop as price rises.
• Never lower a stop.
• Fall in love, but not with a stock.
• Follow the same stocks each day.
• Choose chart patterns that work for you.
• Keep a trading diary and review it periodically.
• Explore.
• Diversify.
• Don’t overdiversify.
• Hold more stocks in a bull market, fewer to none in a bear market.
• Check commodities.
• Tune your system.
• Ignore chat room chatter.
• If you have to ask, you’re making a mistake.
• Set price targets.
• Late entry.
• Watch for a throwback or pullback.
• Don’t short a stock.
• Price drops faster than it rises.
• Price reverses one month after the breakout in a bear market.
• Price moves most in the first week after a breakout.

Trading Psychology:

• Are you trading because you want to trade?
• Are you not trading?
• If you get stopped out of several stocks, walk away.
• Follow the system.
• Don’t overtrade.
• Learn from your mistakes.
• Focus on the positive.
• Push the comfort zone.
• Ignore profits.
• Obey your trading signals.
• Don’t trade when you’re upset.
• Abandoning a winning system.

Last updated: January 26, 2025