10.8 Interpreting chart patterns

Hanumant Dhokle

Chart Patterns

There are a number of chart patterns and empirical rules for predicting the future trend. Let us understand few important patterns:

Channel Formation:

As you see, a channel is a series of uniformly changing tops and bottoms. A channel pattern results when the resistance levels and support levels change at the same rate which remains constant over a period of time. A downward sloping channel implies that prices will fall in future. Similarly, an upward sloping channel shows that prices will rise. If there is a penetration of the price at the channel boundary, then you may expect a price rise or fall depending on whether the upper or lower boundary is penetrated (refer graph below for upward and downward channels).

Triangle Formation:

A triangle is composed of a series of prices fluctuations wherein each top (or bottom) is followed by progressively lower (higher) rallies. Basically, there are three types of triangles. The symmetrical triangle top is characterized by a downward sloping line and the bottom defined by an upward sloping line. The ascending triangle is characterized by a top line being horizontal and an upward sloping bottom line. For a descending triangle the bottom line is horizontal and there is a downward sloping upper line. Prices may break out or break down from the symmetrical triangle. In this formation, the market is uncertain. The ascending triangle gives a bullish formation. Chartists believe that triangles represent a pattern of uncertainty. It is difficult to predict which way the price will break out.

Wedge:

There is hardly any difference between a wedge and a triangle. According to some chartists, a wedge is a formation when the bottoms change in opposite direction (with the ups decreasing and the bottoms increasing over a period of time) or when they are changing in the same direction at different rates. According to such chartists, a triangle is an extreme form of a wedge where top and bottom boundaries intersect to form a triangle. The slope of the wedge shows the general direction of movement of price (refer the graph). There are two types of wedges, falling wedges and rising wedges. Falling wedges indicate temporary interruptions of upward price rallies. Rising wedges indicate interruptions of a falling price trend. Technical analysts see a breakout of this wedge pattern as either bullish (on a breakout above the upper line) or bearish (on a breakout below the lower line).

Flags and Pennants:

Formations commonly known as flags and pennants often appear after a swift upward movement of prices. They typically signify a pause after which the previous price trends are likely to resume. A series of flags in a rising market shows that the market may not come down sharply. Similarly, a series of flags in a falling market indicates that prices may not rise quickly (see the figure).

Gap:

A gap in a chart is essentially an empty space between one trading period and the previous trading period. They usually form because of an important and material event that affects the security, such as an earnings surprise or a merger agreement. This happens when there is a large enough difference in the opening price of a trading period where that price, and the subsequent price moves, do not fall within the range of the previous trading period. Sometimes good or bad news will come out when the stock market is closed, creating a severe imbalance of buyers or sellers. For example, if the price of a company’s stock is trading near Rs 150 and the next trading period opens at Rs 180, there would be a large gap up on the chart between these two periods. Gap price movements can be found on bar charts and candlestick charts.

Head and Shoulders:

This is the most important pattern to indicate a reversal of a price trend. As seen, head and shoulders have four basic elements:

  1. A strong rally (i.e. upward advance) on which trading volume becomes very heavy followed by a minor reaction (i.e. decline) on which volume runs considerably less. Thus, the left shoulder is formed.
  2. The other rally follows which takes the peak at a higher level than the left shoulder. Once again due to reaction, prices fall below the top level of the left shoulder as trading activity declines. This creates the head.
  3. sequently, a moderate rally in the volume of shares traded lifts the price somewhat but fails to push it as high as the top of the head before decline sets in once again. Thus, the right shoulder is formed.
  4. Finally, the price movement falls below the neckline (a line joining the two points where the head and shoulders meet), which indicates a reversal. This is called confirmation or breakout. The drop in price is expected to be equal to the distance between the top of the head and the neckline. Thus, a breakout indicates emergence of a bearish market (see the figure)

Inverted Head And Shoulders:

An inverted head and shoulders formation looks like an upside down head and shoulders' formation. If there is a breakout (i.e. the price cuts the neckline after the second inverted shoulder is formed), it indicates a bullish market and a signal to buy (see the figure).

Cup And Handle:

A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed. As you can see in the figure, this price pattern forms what looks like a cup, which is followed by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security’s price. Once the price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year.

Double Tops and Bottoms:

This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests the resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals. In the case of the double top pattern, as seen in the figure below, the price movement has twice tried to move above certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom shown on the right, the price movement has tried to go lower twice, but has found support each time.

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