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Pattern: The essentials of technical analysis

Updated: Sep 19, 2020

Whenever a trader talks about price action, Why pattern becomes the 2nd most priority to him/her?

If you are thinking what about the first one (C’mon, we all know its support/ resistance/ trend line). So, what makes patterns so reliable? Is it the holy grail of trading? Which pattern has a high rate of winning probability? Let’s figure out...


technical analysis

Why patterns form?

So, basically patterns are the indecisiveness of price movement created by the buyers and sellers. A pattern is identified by a line that connects common price points, such as the closing prices or highs or lows, during a specific period of time. Chartists seek to identify patterns as a way to anticipate the future direction of a security’s price. Patterns are the foundation of technical analysis.


Kinds of pattern:

There are three kinds of pattern which are mostly seen in charts and having a high win rate: -

· Reversal chart patterns

· Continuation chart patterns

· Bilateral chart pattern

 

REVERSAL PATTERNS

Double Top/Bottom pattern


REVERSAL PATTERNS
REVERSAL PATTERNS

The double top/bottom is one of the most common reversal price patterns. The double top is defined by two nearly equal highs with some space between the touches, while a double bottom is created from two nearly equal lows. Generally, the wider the gap between touches, the more powerful the pattern becomes.

The pattern is complete when price breaks below the swing low point created after the first high in a double top, or when price breaks above the swing high point created by the first low in a double bottom. The pattern is considered a success when price covers the same distance following the breakout as the distance from the double high to the recent swing low point in a double top, or the distance from the double low to the recent swing high in a double bottom (see red arrows).

This is actually the first of our patterns with a statistically significant difference between the bullish (double bottom) and bearish (double top) version. As we can see, the double bottom is a slightly more effective breakout pattern than the double top, reaching its target 78.55% of the time compared to 75.01%.

Head & shoulder /Inverse Head & shoulder pattern

Head & shoulder /Inverse Head & shoulder pattern

The head and shoulders patterns are statistically the most accurate of the price action patterns, reaching their projected target almost 85% of the time. The regular head and shoulders pattern is defined by two swing highs (the shoulders) with a higher high (the head) between them.


Head & shoulder /Inverse Head & shoulder pattern

The pattern is complete when price breaks through the "neckline" created by the two swing low points in a head and shoulders, and the two swing high points in an inverted head and shoulders. In the chart examples above this line is horizontal, but it can also be sloped as the swing points do not have to be exactly the same to have a completed pattern. These patterns are considered complete when price breaks out from the neckline and moves a distance equal to the distance from the neckline to the head of the pattern.

 

CONTINUATION PATTERNS

Bullish/Bearish Flag Pattern

Bullish/Bearish Flag Pattern

The flag is a continuation pattern that can occur after a strong trending move. It consists of a strong bullish trending move followed by a rapid series of lower highs and lower lows for a bull flag, or a strong bearish trending move followed by a rapid series of higher lows and higher highs for a bear flag. These patterns are small hesitations in strong trends, so they are usually only composed of a small number of price bars (about 20). Longer and wider patterns are defined as channels (see above).

The flag pattern appears as a small rectangle that is usually tilted against the prevailing trend in price. The best flag patterns have two features: 1) a very strong run in price (near vertical) prior to the setting up of the flag and 2) a tight flag that occurs right on the upper (or lower) edge of that run. The higher and tighter (narrower) the pattern, the higher percentage that the pattern will break favourably in the prevailing trend direction.

This pattern is considered successful when it breaks the upper trend line in a bull flag (or the lower trend line in a bear flag) and then proceeds to cover the same distance as the prior trending move starting from the outer edge of the pattern. Note that most pattern projections are measured from the breakout point, but flags, pennants, and channel patterns are all measured from the outer edge of the pattern instead as shown by the red arrows in the chart examples.

Bullish/Bearish Rectangle Pattern

 Bullish/Bearish Rectangle Pattern

The rectangle price pattern is a continuation pattern that follows a trending move. It is very similar to the channel pattern, except that the pattern does not have a slope against the preceding trend which gives it a higher chance of successful continuation.

The rectangle pattern is defined by a strong trending move followed by two or more nearly equal tops and bottoms that create two parallel horizontal trend lines (support and resistance). The only difference between the bullish and bearish variations is that the bullish rectangle pattern starts after a bullish trending move, and the bearish rectangle pattern starts after a bearish trending move.

It's worth noting that these rectangle price patterns are essentially failed double and triple tops/bottoms. Because the swing points following the double and triple highs or lows don't break to confirm the patterns, those reversals are not confirmed. This is why it can be very dangerous to try to anticipate double and triple tops/bottoms, because often they don't fully complete and the price will resume the prior trend.

The rectangle pattern is complete when price breaks the resistance line in a bullish rectangle, or when price breaks the support line in a bearish rectangle. The pattern is considered successful when price extends beyond the breakout point by the same distance as the width of the rectangle pattern.

 

BILATERAL PATTERN

Ascending/Descending/Symmetrical Triangle

Ascending/Descending/Symmetrical Triangle

The triangle pattern usually occurs in trends and acts as a bilateral pattern. It's defined by a bullish/bearish trending move followed by two or more equal highs and a series of higher lows for an ascending triangle pattern, and a bearish trending move followed by two or more equal lows with a series of lower highs for a descending triangle pattern.

The pattern is complete when price breaks above the horizontal resistance area in an ascending triangle, or below the horizontal support area of a descending triangle. The pattern is considered successful if price extends beyond the breakout point for at least the same distance as the pattern width (see red arrows).

Symmetrical triangles differ from ascending triangles and descending triangles in that the upper and lower trend lines are both sloping towards a central point. In contrast, ascending triangles have a horizontal upper trend line, predicting a potential breakout higher, and the descending triangle has a horizontal lower trend line, predicting a potential breakdown lower. Symmetrical triangles are also similar to pennants and flags in some ways, but pennants have upward sloping trendlines rather than converging trendlines.


So, there are many more patterns which are likely to seem on the charts, but these are mostly seen and mostly traded patterns.


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