In fact, chart patterns analysis is closely rooted in the principles of technical analysis. It dictates that, in the short term, investors can look at the past price history to predict future price movements. Trading using chart patterns is subjective. Yet, amid this subjectivity, some aspects are easy to follow. While there is still a level of subjectivity involved, the general consensus is broadly the same.
Why do Chart Patterns Occur?
Firstly, there is no clear answer to this. Prices remain irrational and there is no guarantee that past patterns will continue to form. More importantly, even if a pattern that is easy to recognize, forms on the charts, there is only a 50% probability that it will work as intended.
Chart patterns form as a result of consolidation. Because prices tend to move in a zig-zag pattern, a strong rally or decline is followed by a period of consolidation. As these consolidations continue to occur, they have become more familiar with traders.
This also makes chart patterns trading easier to spot and trade across the board. Thus, chart patterns are not just confined to a particular class of market instruments, but it appears across all types of markets.
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Types of Chart Patterns
Chart patterns can be primarily classified into a continuation or a reversal pattern.
A continuation pattern is where certain patterns tend to have a higher probability of showing that price will continue to maintain the trend.
A reversal pattern, on the other hand, is the exact opposite. These are patterns that form during a reversal, but they have a higher probability of suggesting a shift in the trend or direction.
Due to the fact that trend following, or trend trading is the most widely followed form of trading, continuation patterns seem to give a slight edge over reversal patterns. These patterns (both continuation and reversal) form across all time horizons. Thus, they make it easy for traders of all kinds to use them in the technical analysis.
Most Popular Continuation Patterns
While there are many different continuation patterns, a few have managed to stand out. These are also the most popular forms of continuation patterns in technical analysis.
Of course, as mentioned earlier, the occurrence of a chart pattern does not guarantee that price will behave as expected. Therefore, traders need to also account for other factors such as the risk in the trade and so on.
Flag or Pennant Pattern
The flag or pennant patterns are the easiest to spot and trade. The consolidation occurs after a strong movement in price. This consolidation, however, lasts for a short time before the momentum picks up.
The bullish and bearish flag/pennant patterns give traders a measured move. In other words, by analyzing the flag/pennant patterns can indicate the minimum price movement one can expect.
The rectangles pattern follows the same concept of the flag or pennant pattern. Unlike the consolidation taking the shape of a channel or a pennant, as the name suggests, the rectangle pattern is when price consolidations sideways.
As a result, it creates a rectangle, which is preceded by a strong bullish or a bearish move in price. Following the basic principles of chart patterns, upon breakout in the direction of the previous trend, traders can ascertain the projected price.
Ascending/Descending Triangle Pattern
The ascending and descending triangle patterns form in the middle of a trend. The earlier you spot them, the better the chances of riding the trend. These patterns are marked by a horizontal resistance or support level.
Consequently, price forms either lower highs or higher lows. A successful breakout from these patterns results in a continuation of the previous trend. But these patterns can also signal a correction if the breakout is unsuccessful.
Tips for Trading Continuation Patterns Successfully
There are numerous other patterns that one can talk about. However, the key to the above three is in their simplicity. So, if you are just starting off, the above three patterns are very easy to follow.
As with any method of technical analysis, traders should exercise caution. There is always a risk of pattern failure. Thus, traders need to account for this by using good risk management principles.
Still, as trend-following remains the most popular way of trading, the continuation patterns can give you better confidence when trading.