Technical Analysis Price Patterns: Should You Use Technical Analysis?
What are trendlines in technical analysis?
Trendlines are straight lines that form due to the movement of prices on a chart. There are two main trendlines; an uptrend and a downtrend line. An uptrend line forms when there are higher highs and higher lows.
The higher highs show the resistance the hold prices down while higher lows show support that prevents prices from going below that level.
A downtrend line occurs when there are lower highs and lower lows. Lower highs show resistance levels while lower lows show the support level. To come up with these trendlines, you need two points; the starting and the ending point. The more points you can have the better.
These points are drawn above or below the candlestick body rather than the thin wicks below and above the body. The upper and lower parts of the candlestick body represent the opening and closing of a specific price at a specific time.
This is a temporary interruption of an existing movement on a chart. It can be thought of as a time where buyers and sellers relax. For example, during an uptrend, the bulls might cease moving. Likewise, during a downtrend, the bears might relax for a while.
At this point, you cannot tell whether the price will continue with the trend or change direction. However, most technical analysts assume the trend will continue as it were.
Here are some of the most common continuation patterns:
The Pennants pattern occurs when two trendlines converge. Here, the trends move in opposite directions. That is, there’s an up and downtrend. At the point of their meeting, the volume tends to decrease before the price rises sharply.
A pennant pattern that forms and follows a sharp downward trend is considered a bearish pennant while the pattern that follows a sharp price rise is called a bullish pennant. This pattern usually appears in the middle of a movement.
Unlike pennant patterns, flags do not converge. However, they show a similar trend movement. The parallel patterns can go upwards, downwards, or sideways depending on the price movement. Flags that slope upwards appear in downward trend markets, as such, they show a pause in trading.
Likewise, downward sloping flags appear in upward trending markets. The price will however break out at the end of the flags. That is, the price continues in the initial trend before the formation of the flags.
Wedges and pennant patterns are similar, however, the trendlines move in the same direction. A wedge that rises foreshadows an upward movement while a wedge that falls foreshadows an upward or downward movement on the chart. As such, you show wait for movement confirmation of downward-sloping wedges form.
This is yet another common pattern in technical analysis. This is because they appear frequently compared to other patterns. You can observe three patterns: symmetric, ascending, and descending triangles pattern. Let’s look at each.
Symmetric triangles pattern
The symmetric pattern forms when the trendline connecting the highs meets the trendline connecting the lows forming a triangle. In short, a downward trendline converges with an upward trendline. Unlike continuation patterns, a symmetric pattern does not foreshadow a direction.
An upward or downward trend is therefore possible. That said, they show that a breakout is possible at the end of the triangle.
Ascending triangles are characterized by a flat trendline connecting the highs and an ascending trendline connecting the higher lows. It foreshadows a sharp breakout resulting in an upward trend. It, therefore, shows that the buying pressure is more than the selling pressure.
Here, a flat trendline connects the lows, and a sharp declining trendline connecting the highs. This means sellers are exerting more pressure forcing the prices to go down. Once the pattern breaks, a downward breakout is expected.
Cup and handles pattern
This pattern tends to form a cup with a handle. It occurs in a bullish market. A steep downward and upward movement characterizes the cup section. A slight downward and upward movement characterizes the handle section.
You should consider using cups that form a profound U shape. Do not consider those that form a V shape. The U-shaped cups indicate a strong bullish movement. Ensure that the handle part forms on the right side of the cup.
Reversal patterns signal a reverse in a trend. Unlike a continuation pattern that shows a pattern will continue after a pause, a reversal pattern signals a trend will go in the opposite direction. There are four patterns namely head and shoulders, inverse head and shoulders, double tops and double bottoms, and triple tops and triple bottoms.
Let’s look at each!
Head and shoulders pattern
This pattern forms a shoulder, head, and shoulder type of diagram. A peak, followed by a large peak, and finally, a peak similar to the first one characterize it. This signals that the trend will go in the opposite direction. That is, it will form a downward trend.
Inverse head and shoulders pattern
This is an inverse of the head shoulder pattern. A trough, followed by a large trough, and finally a trough similar to the first trough characterize it. It signals that a downward trend is set to go upwards.
Double tops and bottoms
The top part of this pattern is characterized by an M shape while the bottom part is characterized by a W shape. It shows that the price is unable to penetrate through support or resistance. As such, the price is expected to go in the opposite direction.
Triple tops and triple bottoms
The pattern is similar to the double tops and bottoms. However, the price was denied penetration three times. As resistance grew so did the strength of the support level. You should therefore expect a reversal in trend movement.
Price gaps are intervals between the opening and closing of trading periods. Ideally, gaps are evident after a weekend or holiday. There are three types namely:
These gaps form at the start of a trend. For example, if an instrument is in its consolidation state and a disruptive event happens, we have a breakaway gap. Most technical analysts consider it as a continuation gap since it forms a strong trend.
This is yet another continuation gap. In fact, it is safer compared to breakaway gaps. When used with other patterns, it can allow you to make informed trading decisions.
These gaps form at the end of a signal and trend. They show that the trend is set to move in the opposite direction.
How do technical analysts interpret patterns?
There are three main steps to interpret patterns. They include:
The first and most important step is to identify the pattern. While they are easy to identify in historical data, it becomes daunting when they are forming. It is therefore crucial that you have the technical know-how to identify them during the formation period.
Most traders and technical analysts use patterns in historical data to predict how the trendline will move. They use the highs and lows to make patterns in real-time. This is why you need to understand different sections of a candlestick.
After you’ve identified the type of pattern, it is easier to evaluate it. You should consider pattern duration, volume, and volatility of the price swings. This will give you a better understanding of the pattern.
After you’ve identified and evaluated the patterns, you can use this information to forecast the movement of the pattern. You should, however, keep in mind that not all forecast comes to pass. As such, most traders and investors will combine technical analysis and fundamental factors to make a conclusion.
Candlestick patterns you ought to know
There are bullish and bearish candlestick patterns. Let’s look at the most common.
Bullish candlestick patterns
Hammer: it has a short body with a long bottom wick and is found at the bottom of a downward trend.
Inverse hammer: it has a short body with a long top wick.
Bullish engulfing: a small red candlestick and a large green candlestick form the bullish engulfing pattern.
Piercing line: Two candlesticks also form it; one large red followed by a large green one.
Morning start: it is considered a signal that prices will rise in a downward movement. It consists of a small red candle sandwiched between a large red and green candle.
Bearish candlestick patterns
Hanging man: it resembles the hammer but forms at the end of an upward trend.
Shooting star: it is similar to the inverse hammer but forms in an uptrend.