First of all, what are price patterns? Price patterns are pictures and formations, which appear on price charts of market items, that can be classified into different categories, and that have predictive value.
Two types of patterns: Reversal and Continuation
There are two major categories of price patterns- Reversal and continuation. As these names imply, reversal patterns indicate that an important reversal in trend is taking place. The continuation patterns, on the other hand, suggest that the market is only pausing for a while , possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of patterns as early as possible during the formation of the pattern.
We have three major reversal patterns: the head and shoulders, triple tops and bottoms and double tops and bottoms. In the other side we have 3 major continuation patterns: triangles, flags and rectangles. For all these patterns the volume plays and important confirming role. In times of doubt, a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted.
Preliminary points common to all reversal patterns
1-A prerequisite for any reversal pattern is the existence of a prior trend.
2-The first signal of an impending trend reversal is often the breaking of an important trendline.
3-The larger the pattern, the greater the subsequent move.
4-Topping patterns are usually shorter in duration and more volatile than bottoms.
5-Bottoms usually have smaller price ranges and take longer to build.
6-Volume is usually more important on the upside.
The head and shoulders
Let’s take a close look now at what is probably the best known and most reliable of all major reversal patterns. Most of the other reversal patterns are just variations of the head and shoulders. This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend. Picture a situation in a major uptrend, where series of ascending peaks and troughs gradually begin to lose momentum. The uptrend then levels off for a while. During this time the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken and a new downtrend now has descending peaks and troughs. (see the chart below of eurusd .)
The most important matter about this pattern is that the reversal of the trend is confirmed, once the neckline (the green line) is broken. The point where the neckline is broken is called the break out point. The above chart is for the time when the trend is upwards. The laws of a downward trend is the same, only the pattern will be upside down. (look at the chart below.)
As you see firs we had a downtrend, then after the formation of the inverse head and shoulders pattern, the trend is reversed and confirmed when the neckline is broken.
Triple tops and bottoms
Most of the points covered in the treatment of the head and shoulders pattern are also applicable to other types of reversal patterns. The triple top and bottom, which is much rarer in occurrence, is just a slight variation of that pattern. The main difference is that the three peaks or troughs in the triple top or bottom are at about the same level.( Look at the chart below)
The volume tends to decline with each successive peak at the top and should increase at the breakdown point. The triple top is not complete until support levels along both of the intervening lows have been broken. Conversely, prices must close through the two intervening peaks at the bottom to complete a triple bottom. (look at the chart below)
Here are a live example of a triple top pattern on usd/cad
Double tops and bottoms
Like the head and shoulders, double tops and bottoms are one of the most common reversal patterns. It is the most frequently seen and the most easily recognized. (see the below figure)
Example of a double top. This pattern has two peaks at about the same level. The pattern is complete when the middle trough is broken on a closing basis. Volume is usually lighter on the second peak and picks up on the breakdown.
Example of a double bottom. A mirror image of the double top. Volume is more important in the upside breakout. Return move to the breakout point are more common at bottoms.
At below you can see a live chart of a double top pattern.
These patterns usually indicate that the sideways price action on the chart is nothing more than a pause in the prevailing trend, and that the next move will be in the same direction as the trend that preceded the formation. Another difference between these patterns with reversal patterns is their time duration. Reversal patterns take much longer to build and represent major trend changes. Continuation patterns, on the other hand, are usually shorter term in duration and are more accurately classified as near term or intermediate patterns.
The most important continuation patterns are: Triangles, flags and rectangles.
Let’s begin our treatment of continuation patterns with the triangle. There are three types of triangles—symmetrical, ascending and descending. Each type of triangle has a slightly different shape and has different forecasting implications.
The below figures show examples of what each triangle looks like. The symmetrical triangle shows two converging trend lines, the upper line descending and the lower line ascending. The vertical line at the left, measuring the height of the pattern, is called the base. The point of intersection at the right, where the two lines meet, is called the apex.
The ascending triangle has a rising lower line with a flat or horizontal upper line. The descending triangle, by contrast, has the upper line declining with a flat or horizontal bottom line.
For the three above triangles, a close outside either trend line completes the pattern. The most important thing we should realize is that the volume should diminish as the price swings narrow within the triangles. This tendency for volume to contract is true of all continuation patterns.
In the real chart below you can see the three types of the triangles.
Both the ascending and descending triangles differ from the symmetrical in a very important sense. No matter where in the trend structure the ascending or descending triangles appear, they have definite forecasting implications. The ascending triangle is bullish and descending triangle is bearish. The symmetrical triangle, by contrast, is a neutral pattern. That means it can be both bullish and bearish.
The flag pattern represents brief pauses in a dynamic market move. In fact, one of the requirements for this pattern is that they be preceded by a sharp and almost straight line move. They represent situations where a steep advance or decline has gotten ahead of itself, and where the market pauses briefly to catch its breath before running off again in the same direction.
Flags are among the most reliable of continuation patterns. The below figure shows how this pattern look like. Notice the steep price advance preceding the formation on heavy volume. Also notice the dramatic drop off in activity as the consolidation patterns form and then the sudden burst of activity on the upside breakout.
At the below real chart you can see a bullish flag pattern.
Like the previous continuation pattern, the rectangle pattern represents a pause in the trend during which prices move sideways between two parallel horizontal lines. Look the figure below:
The rectangle is sometimes referred to as trading range or a congestion area. It usually represents just a consolidation period in the existing trend, and is usually resolved in the direction of the market trend that preceded its occurrence. A decisive close outside either the upper or lower boundary signals completion of the rectangle and points the direction of the trend.
Here is a real chart where you can see a rectangle pattern and its effect.
In this chart you can see the importance of the volume in forming the rectangle pattern. Notice how the volume increases at the time of the breakout which results the continuation of the previous trend.