Chart Patterns, or Price Patterns, are tools for displaying data that reflect investor psychology and sentiment. It shows what has happened with the stock in the past and can be used to project future price direction. Some of the most commonly used Chart Patterns are Flags, Triangles and Rectangles.
Rectangle is the most common Chart Pattern. When a price reaches similar Highs and Lows multiple times, we get a Rectangle chart pattern. These patterns are consolidations of intermediate-term trends and can last several weeks to months. The time horizon is very important when analyzing Chart Patterns. If you are a day trader, these patterns will not have much relevance for you. But for a Swing trader who holds a position for 30-60 days, these patterns are very important. So, the longer the time period that is being analyzed, the greater the relevance of these patterns.
The parallel Support and Resistance Levels of Rectangular Patterns can be horizontal or have a slight slope. Several well-known patterns fall into this category, including the Double Top, Triple Top, Double Bottom, Triple Bottom, Head and Shoulders and Inverse Head and Shoulders.
The Rectangle Pattern is usually created by two or more touches on both Support and Resistance, Short-Term Trend creating similar Highs and Lows, Intermediate-Term Trend and decreasing Volume. The entry into Rectangle Pattern is caused by break in direction countering the previous Trend, leading to an above-average Volume and reversal of the pattern.
Figure 41A shows that there was a sell-off in May, June and July. Then, the green line becomes a Support and the stock touches the green line twice. Next, there is an above average volume as indicated by the green line in the volume section at the bottom sloping to the right. The stock breaks Overhead Resistance formed by the red line.
This is the classic formation for the Rectangle Pattern. Also you can see a reversal on the pattern-before it was bearish sentiment, now it has changed to a bullish sentiment. This can happen after earnings announcements.
Figure 41B shows an example of Uptrend Reversal called Head and Shoulders Top. Unlike in the Rectangle Pattern, here you will see three touches to the top. The first touch on the left can be considered as the left shoulder, the second one in the middle is a bit higher and can be considered as being at head level and the third can be considered to be over your right shoulder. Also, at the bottom of the average volume, you see a break out of the neckline from the head and shoulder pattern. This is the reversal pattern.
Be aware of the dominant trend in the market – even if you are not looking to trade in the same direction. Price patterns can give a glimpse of what a stock’s future may be because investors tend to react to price movements in a fairly predictable manner. If you learn to distinguish the patterns that are forming before the next major price move occurs, you can take part in some extremely profitable trades. Price patterns are not infallible, but they certainly put the odds in your favor. Looking at the Short-Term Trend and Long-Term Ratings can help improve your chance of being successful, especially if you look at Tradespoon’s predictions and overlay it with some of the longer-term Chart Patterns.