Learn These 4 Profitable Chart Patterns
If you’re just starting out as a trader, the sheer number of technical analysis patterns can be downright overwhelming. With literally hundreds of patterns to look for anytime you analyze a chart, it’s no surprise that new technical traders often suffer from analysis paralysis when they’re just starting out.
But it doesn’t have to be that way…
Today, I’d like to show you four simple chart patterns that could help you find your next profitable trade in 2012.
In his book, The Definitive Guide to Point and Figure, Jeremy du Plessis argues that:
“Some authors go on to list tables of patterns, but the need to learn patterns indicates a lack of true understanding of how a pattern is created. There is no point in trying to learn dozens of patterns; it is better to understand what causes them.”
As a market technician, that’s one of my favorite quotes. When it comes to chart patterns, it’s absolutely true that rote memorization will only get you so far. Instead, it pays (literally) to understand how and why patterns are created.
At their most simple construction, patterns are just different arrangements of support, resistance, and trend lines. While I won’t get into too much detail over how those individual building blocks work, you should be able to see a lot in common with the four patterns I’m about to show you. So, rather than trying to memorize the pattern on these four formations, memorize the combination of support, resistance, and trendlines that combine to create them…
First up is the ascending triangle, a bullish pattern that’s formed by a horizontal resistance level to the upside, and uptrending support below shares. Those two technical levels form a shape that resembled a right triangle. As shares bounce in between them, they get squeezed closer and closer to a breakout above that resistance level. When the breakout happens, it’s a strong buy signal for shares.
The bearish opposite of the ascending triangle is a descending triangle. In a descending triangle, shares have horizontal support and downtrending resistance. The shorting signal comes when that horizontal support level gets broken.
One of the most well-known technical formations is the head and shoulders top. It’s a bearish pattern that’s identified by a peak (the head), with smaller peaks on each side (the shoulders). Even though the head-and-shoulders is likely the most well known technical pattern, it’s still a valuable one: an academic study conducted by the Federal Reserve Board of New York found that the results of 10,000 computer-simulated head-and-shoulders trades resulted in “profits [that] would have been both statistically and economically significant.”
On the opposite side is the inverse head and shoulders, which, as the name implies, is just a flipped version of the head and shoulders top. It’s a bullish pattern.
In both cases, the trade signal comes when shares push through the neckline (sometimes called “shoulder level”) in the chart above.
A consolidation channel (sometimes called an “If/Then Trade”) is a channel that’s bounded by both a horizontal resistance level and a horizontal support level. Frequently, consolidation channels come after large moves. They’re an opportunity for a stock to bleed off some volatility and for traders to think about their next moves. Unlike the other patterns we’ve looked at, this setup doesn’t have any directional bias until it triggers.
The trigger happens when shares push outside of the channel. When that happens, the high probability move is to take a position in the direction of the breakout.
4. Double Top
Finally, we’ll look at the double top; as the name implies, it’s a topping pattern (thus it’s bearish). The double top can be identified by two swing highs that peak at approximately the same price level — that price level is a strong resistance level, above which there’s a glut of supply of shares that overwhelms buying pressure. A double top becomes a short signal when shares push through the intermediate trough that separates the tops.
Not surprisingly, a pattern called a double bottom is the bullish opposite of the double top.
While we’re hardly taking an exhaustive look at all of the potential patterns that you may encounter in the market, these four patterns provide a good sample of how the building blocks of support, resistance, and trend create actionable patterns. By keeping these four patterns in mind the next time you look at a chart, you’ll be better able to spot other, more unconventional setups than traders who resort to rote memorization.