Lesson 5 - Chart Pattern Analysis

What is a Pattern

sometimes called a "formation", is a configuration of price action that isbounded, above and below by a line or a curve

What the pattern lines means

The lines can be trend lines or support and resistance levels.

● The lines can also be a curve, which is less defined than an trend line. Curves looklike "smiles" or "frowns"○

We want to buy smiles

We want to sell frowns

Common Pattern Characteristics

All patterns have a combination of an entry and an exit.

● Entry - describes the trend preceding the formation of the pattern

● Exit - this is the signal to take some sort of action; usually buy or sell

When are entry and exits significant

A pattern can occur after a decline meaning the entry is from above.

A pattern can occur after an advance meaning the entry is from below

The exit can be downward or upward.

A top formation has an entry from below and downward exit

Pattern Names

Fractal, Pullbacks and Throwbacks, Failures

Fractal

The patterns can take place over any timeframe and the analysis and characteristics arethe same for all.

A pattern on a monthly chart has the same meaning as if it occured on a weekly chart,daily chart or minute chart.

The pattern is the same type and will usually have the same general characteristics

Pullbacks and Throwback

Prices will have a tendency to retest support or resistance after breaking from a pattern

● Pullbacks occur when prices break to the downside and then rally back to thebreakout level

● Throwbacks occur when prices break to the upside and then sell off to thebreakoutlevel.

These are not precisely defined

Pullbacks and throwbacks decrease the extent of the move in the direction of the breakout. What does this mean from a trading strategy standpoint?

This means that pullbacks and throwbacks can provide opportunities to enter a trade at a better price while still following the prevailing trend.

How This Affects Trading Strategy:

Better Entry Points: Instead of entering immediately on a breakout (which may be risky due to false breakouts), traders can wait for a pullback or throwback to confirm the move.

Reduced Risk: Entering on a retracement allows for tighter stop-loss placement, reducing the risk of large drawdowns.

Confirmation of Trend: A successful pullback or throwback that respects the breakout level as new support/resistance adds confidence in the direction of the trade.

Profit Target Adjustments: Since pullbacks and throwbacks reduce the extent of the breakout move, traders may need to adjust their target levels accordingly.

incorporating pullbacks and throwbacks into a strategy can enhance risk management and improve trade execution by avoiding impulsive entries and waiting for confirmation.

Pullbacks (after an upward breakout)

- When the price breaks above resistance and then temporarily declines before resuming its upward trend, it allows traders to enter long positions at a potentially lower price rather than chasing the breakout

Throwbacks (after a downward breakout)

- When the price breaks below support and then temporarily rises before continuing downward, it gives traders an opportunity to enter short positions at a higher price.

Failures

All breakout have the potential to fail. Accept this as a fact. This is why risk managementis so important.

What we are looking for is an "edge" that tells us that the odds favor a certain outcome.

We define a failure rate as when the stock moves less than 10% in the expecteddirection before reversing by 20%.

If the failure rate is 33%, the odds of gain are 50/50. Any pattern with a failure rate greater than 33% should be disregarded.

Bar Chart Patterns

Double Top, Double Bottom,

Double Top

A bearish reversal chart pattern that is typically associated with line and bar charts. The pattern forms with two prominent peaks that are roughly equal, a moderate trough in-between and a support break. Look for volume to increase on the break.

Trends in A Double Top Bar Chart

Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the Double Top Reversal, a significant uptrend of several months should be in place.

First Peak: The first peak should mark the highest point of the current trend. As such, the first peak is fairly normal and the uptrendis not in jeopardy (or in question) at this time.

Trough: After the first peak, there is generally a decline of 10-20%. Volume on the decline from the first peak is usually inconsequential. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand.

Second Peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high.

Support Break: Breaking support from the lowest point between the peaks completes the Double Top Reversal. This too should occur with an increase in volume and/or an accelerated descent.

Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would inferthat the bigger the formation is, the larger the potential decline

Double Bottom

A bullish reversal chart pattern that is typically associated with line and bar charts. The pattern forms with two consecutive troughs that are roughly equal, a moderate peak in-between and a resistance breakout.

Trends in A Double Bottom Bar Chart

Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the Double Bottom Reversal, asignificant downtrend of several months should be in place.

First Trough: The first trough should mark the lowest point of the current trend. As such, the first trough is fairly normal inappearance and the downtrend remains firmly in place.

Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. Volume on the advance from the firsttrough is usually inconsequential, but an increase could signal early accumulation. The high of the peak is sometimes rounded ordrawn out a bit from the hesitation to go back down. This hesitation indicates that demand is increasing, but still not strong enoughfor a breakout.

Second Trough: The decline off of the reaction high usually occurs with low volume and meets support from the previous low.

Advance From Trough: Volume is more important for the Double Bottom Reversal than the double top. There should be clearevidence that volume and buying pressure are accelerating during the advance off of the second trough.

Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate atarget. This would imply that the bigger the formation is, the larger the potential advance.

Rectangle

A Rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easilyidentifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines thatmake up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation zones, boxesor congestion areas

Trends in A Rectangle Bar Chart

Prior Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not toomature.

Four (4) Points: At least two equivalent reaction highs are required to form the upper resistance line and two equivalent reactionlows to form the lower support line. They do not have to be exactly equal, but should be within a reasonable proximity.

Volume: Rectangles do not exhibit standard volume patterns. Sometimes volume will decline as the pattern develops. Other times,volume will gyrate as the prices bounce between support and resistance.

Breakout Direction: The direction of the next significant move can only be determined after the breakout has occurred.

Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price(3%), time (3 days) or volume (expansion) for confirmation.

Target: The estimated move is found by measuring the height of the rectangle and applying it to the breakout.

Triple Top

The Triple Top Reversal is a bearish reversal pattern typically found on bar charts, line charts and candlestick charts. There arethree equal highs followed by a break below support. As major reversal patterns, these patterns usually form over a 3 to 6 month period

Trends in A Triple Top Chart

Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the Triple Top Reversal, an uptrend shouldprecede the formation.Three Highs: All three highs should be reasonably equal, well spaced and mark clear turning points to establish resistance. The highs do nothave to be exactly equal, but should be reasonably equivalent to each other.Volume: As the Triple Top Reversal develops, overall volume levels usually decline. After the third high, an expansion of volume on thesubsequent decline and at the support break greatly reinforces the soundness of the pattern.Support Break: As with many other reversal patterns, the Triple Top Reversal is not complete until a support break. The lowest point of theformation, which would be the lowest of the intermittent lows, marks this key support level.Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price (3%), time (3days) or volume (expansion) for confirmation.Target: The distance from the support break to the highs can be measured and subtracted from the support break for a price target. The longerthe pattern develops, the more significant the ultimate break.

Triple Bottom

The Triple Bottom Reversal is a bullish reversal pattern typically found on bar charts, line charts and candlestick charts. Thereare three equal lows followed by a break above resistance. As major reversal patterns, these patterns usually form over a 3- to 6-month period.

Trends in A Tripple Bottom Chart

Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the Triple Bottom Reversal, a cleardowntrend should precede the formation.Three Lows: All three lows should be reasonably equal, well-spaced and mark significant turning points. The lows do not have to be exactlyequal, but should be reasonably equivalent.Volume: As the Triple Bottom Reversal develops, overall volume levels usually decline. After the third low, an expansion of volume on theadvance and at the resistance breakout greatly reinforces the soundness of the pattern.Resistance Break: As with many other reversal patterns, the Triple Bottom Reversal is not complete until a resistance breakout. The highestpoint of the formation, which would be the highest of the intermittent highs, marks resistance.Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price (3%), time (3days) or volume (expansion) for confirmation.Price Target: The distance from the resistance breakout to lows can be measured and added to the resistance break for a price target. Thelonger the pattern develops, the more significant is the ultimate breakout.

Descending Triangle

a bearish formation that usually forms during a downtrend as a continuationpattern. There are instances when descending triangles form as reversal patterns at the end of an uptrend, but they are typicallycontinuation patterns. Regardless of where they form, descending triangles are bearish patterns that indicate distribution.

Trends in A Descending Triangle Chart

Prior Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the descendingtriangle is definitely a bearish pattern, the length and duration of the current trend is not as important as the robustness of theformation.Lower Horizontal Line: At least 2 reaction lows are required to form the lower horizontal line.Upper Descending Trend Line: At least two reaction highs are required to form the upper descending trend line.Volume: As the pattern develops, volume usually contracts. When the downside break occurs, there would ideally be an expansionof volume for confirmation.Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern andsubtracting it from the support breakout.

Ascending Triangle

The ascending triangle is a bullish formation that usually forms during an uptrend as a continuation pattern.There are instances when ascending triangles form as reversal patterns at the end of a downtrend, but they are typicallycontinuation patterns. Regardless of where they form, ascending triangles are bullish patterns that indicate accumulation.

Trends in Ascending Triangle Chart

Prior Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the ascendingtriangle is a bullish pattern, the length and duration of the current trend is not as important as the robustness of the formation, whichis paramount.Top Horizontal Line: At least 2 reaction highs are required to form the top horizontal line.Lower Ascending Trend Line: At least two reaction lows are required to form the lower ascending trend line.Volume: As the pattern develops, volume usually contracts. When the upside breakout occurs, there should be an expansion ofvolume to confirm the breakout.Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern and applyingit to the resistance breakout.

Rising Wedge

The Rising Wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higherand the trading range narrows. Rising wedges definitely slope up and have a bearish bias

Prior Trend: In order to qualify as a reversal pattern, there must be a prior trend to reverse. The rising wedge usually formsover a 3-6 month period and can mark an intermediate or long-term trend reversal.Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reactionhigh should be higher than the previous high.Lower Support Line: At least two reaction lows are required to form the lower support line. Each reaction low should behigher than the previous low.Support Break: Bearish confirmation of the pattern does not come until the support line is broken in a convincing fashion.It is sometimes prudent to wait for a break of the previous reaction low.Volume: Ideally, volume will decline as prices rise and the wedge evolves. An expansion of volume on the support linebreak can be taken as bearish confirmation.

Falling Wedge

The Falling Wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This priceaction forms a cone that slopes down as the reaction highs and reaction lows converge. Falling wedges definitely slope down andhave a bullish bias

Prior Trend: To qualify as a reversal pattern, there must be a prior trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low.

The pattern usually forms over a 3-6 month period and the downtrend should be at least 3 months old.

Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction highshould be lower than the previous highs.Lower Support Line: At least two reaction lows are required to form the lower support line. Each reaction low should be lower thanthe previous lows.Support Break: Resistance Break: Bullish confirmation of the pattern does not come until the resistance line is broken inconvincing fashion. It is sometimes prudent to wait for a break above the previous reaction high for further confirmation.Volume: While volume is not particularly important on rising wedges, it is an essential ingredient to confirm a falling wedge breakout.Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure.

Head & Shoulders Top

A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successivepeaks, with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected toform support, or a neckline

Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern.Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete theformation of the shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend intact.Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent declinemarks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.Right Shoulder: The advance from the low of the head forms the right shoulder. The peak is lower than the head.Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of thehead and the beginning of the right shoulder.Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Volume tends to decline into the peaks and increase on tests of theneckline.Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincingmanner, with an expansion in volume.Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is thensubtracted from the neckline to reach a price target.

Head & Shoulders Bottom

The Head and Shoulders Bottom, sometimes referred to as an Inverse Head and Shoulders, is a reversal pattern that shares many common characteristicswith the Head and Shoulders Top, but relies more heavily on volume patterns for confirmation.

Prior Trend: It is important to establish the existence of a prior downtrend for this to be a reversal pattern.

Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the

formation of the left shoulder (1). The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact.

Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance

forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.

Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left

shoulder.

Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the

head and the beginning of the right shoulder.

Volume: While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the

validity of any breakout becomes suspect. The advance from the low of the head should show an increase in volume. For a breakout to be considered valid, there needs to be an

expansion of volume on the advance and during the breakout

Neckline Break: The Head and Shoulders Bottom pattern is not complete (and the downtrend is not reversed) until neckline resistance is broken. For a Head and Shoulders Bottom, this

must occur in a convincing manner, with an expansion of volume.

Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the

neckline to reach a price target.

Rounding Bottom

The Rounding Bottom is a long-term reversal pattern that is best suited for weekly charts. It is also referred to

as a saucer bottom, and represents a long consolidation period that turns from a bearish bias to a bullish bias.

Trends in Rounding Bottom Chart

Prior Trend: In order to be a reversal pattern, there must be a prior trend to reverse. Ideally, the low of a rounding bottom will mark a

new low or reaction low.

Decline: The first portion of the rounding bottom is the decline that leads to the low of the pattern.

Low: The low of the rounding bottom can resemble a “V” bottom, but should not be too sharp and should take a few weeks to form.

Advance: The advance off of the lows forms the right half of the pattern and should take about the same amount of time as the prior

decline.

Breakout: Bullish confirmation comes when the pattern breaks above the reaction high that marked the beginning of the decline at

the start of the pattern.

Volume: In an ideal pattern, volume levels will track the shape of the rounding bottom: high at the beginning of the decline, low at

the end of the decline and rising during the advance. Volume levels are not too important on the decline, but there should be an

increase in volume on the advance and preferably on the breakout.

A rounding bottom could be thought of as a head and shoulders bottom without readily identifiable shoulders.