Key Chart Patterns

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Identifying chart patterns may often be more art than science, but trading stocks without first looking at a chart is like “backing out of a driveway without a rearview mirror,” says Toni Turner, best-selling author of A Beginner’s Guide to Short-Term Trading (Adams Media, 2008). “I can’t imagine buying a stock or other financial instrument without first looking at its chart pattern.”

As a trader, it may pay to know the basic patterns you may see on a stock chart.

Why Chart Patterns Matter
Thomas Bulkowski, best-selling author of Encyclopedia of Chart Patterns (Wiley, 2005), says that “chart patterns are nothing more than buy or sell signals.” They can give you indicators of when to buy, when to sell, and also how far price is likely to move. He says that charts primarily tell the struggle between buying demand and selling pressure.

Turner agrees. “A chart pattern is not only the price history of a stock—it is also human emotion on a screen. You can see this by the price movement and the high-low range of the day.” Turner says that one of the reasons that patterns may help you make stock predictions is that humans “tend to act the same in similar circumstances.”

Analyzing Chart Patterns
There are dozens of chart patterns, each with a unique name: for example, triangles, cup and handle, flags, pennants, and the wedge. The three most popular patterns are the head and shoulders, double-bottom, and double-top.

A chart pattern can be either a reversal pattern or a continuation pattern. In a reversal, traders will study the chart to anticipate a trend change. A continuation pattern, on the other hand, simply means the previous trend will continue—an ideal setup for momentum traders. The head and shoulders reversal pattern is shown below.

Head and Shoulders

The very popular head and shoulders pattern looks like a human being—with a low creating the left shoulder and a new high forming the head. Next, the price moves down to form the right shoulder. The line formed between the left and right shoulders is called a neckline— which often acts as support or resistance. If the price crosses over this line, it may send a signal to traders that a pattern is changing. In this example, after the right shoulder is completed, the trader will attempt to sell a stock short if the price closes below the neckline. A broken neckline confirms that the upward trend of the stock has been reversed.

To calculate your entry and exit, you “measure from the neckline to the top of the head,” Turner says. “You take that number and subtract it from the neckline. That should help you target the next approximate low the stock will make.”
In the chart above, the calculation would be as follows:
Calculation:  Step One: 3.39 – 2.48 = 0.91
  Step Two: 2.55 – 0.91 = 1.64 (target price)

Double-Top

A double-top chart pattern is shown in the example above. The double-top, a common bearish reversal pattern, looks like a big “M.” It shows two peaks at about the same price level. The stock has failed twice to break through overhead resistance at 26.16 and sells off.

Double-Bottom

The double-bottom, shown above, looks like a “W.” This common bullish reversal pattern shows that the price failed to break through key support levels at 22.90. When confronted with a double-bottom, traders would ideally switch to a long position.

Although the double-bottom is easy to identify, it is not always reliable. Bulkowski says the double-bottom has a high failure rate; that is, unless traders wait for a valid breakout. 

Breakout
In the above example, a breakout occurs at 23.30, when the price closes above the highest price (or with a double-top, below the lowest price) in the chart pattern.

Bulkowski finds many opportunities by playing breakouts. “There are few secrets to chart patterns. But if the price closes outside the trendline boundary, that’s a trading signal. About half the time, an average of three days later, the price begins to round over (i.e., for an upward breakout, the price turns down). Ten days after the breakout, on average, the stock will have returned to the breakout price.”

He warns that if you can’t get into the stock by the time it moves 5% or more beyond the breakout price, skip the trade. “Your chances of making money by chasing a stock diminish the further away price moves from the breakout. I found this out by examining my own trades.”

If you are holding a long position on a stock, he says, and a pullback occurs, use this as an exit signal if you missed the original breakout. “You have been given a second chance! Take the exit signal and leave with as much money as you can.”

Components of a Chart Pattern
Many traders watch volume closely as chart patterns are forming. “Volume is the fuel that makes chart patterns,” Turner suggests. “It measures enthusiasm, positive or negative, for a certain stock. You need that excessive exuberance or fear to actually carve that pattern into a chart.”

Although Bulkowski acknowledges that it’s a good sign when price is accompanied by higher volume, he tends to ignore volume. “Price will do what it wants to do, regardless of the volume trend,” he says. “Price is the most important indicator; it never fails. To make a million dollars, just figure out where it’s going and for how long.”

As you gain more experience, you can pick and choose which indicators, including volume, are the most useful.

Bulkowski also advises that traders trade with the trend. “If you are trading a bullish chart pattern such as a double-bottom, triple-bottom, or inverse head and shoulders, your chances improve if the industry and the market are both moving up. Once the stock breaks out upward, jump in.” A winning trade is more likely if all three trends are moving in the same direction.

A Word of Caution
It is unwise to rely solely on chart patterns to make trading decisions. “The most effective way to read them is in combination with other chart indicators,” Turner suggests, “such as moving averages.” She also advises using money management techniques such as stop losses. “Once you eat enough glass, you will learn to put your stops in.”

“Sometimes new traders jump the gun and get into trouble,” she acknowledges. Turner recalls how many traders noticed a head and shoulders forming in July 2009. “In this case, the head and shoulders did a head fake and sucked in a lot of short traders. It only went lower for a day before turning around and rocketing up. The head and shoulders pattern was obliterated. Trade what you see, not what you think will happen.”

Waiting for Confirmation
No one said that reading stock patterns is easy. Although chart patterns don’t always work as expected, they are flexible enough to provide traders clues as to where the price might go. For this reason, learning how to read chart patterns is an essential part of a trader’s education. It can also save you money.

With enough experience, Turner says, you’ll learn how to spot chart patterns as they are forming. “Be sure to wait for confirmation of the pattern’s completion at the market close, not intraday. And don’t jump into the market without using stops.”

Learn more about charts in the Trading Knowledge Center.

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Michael Sincere is a freelance writer and the author of five books on investing and trading, including Understanding Stocks (McGraw-Hill, 2003) and Understanding Options (McGraw-Hill, 2006).

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