If you are an investor who has never recognized or analyzed a stock chart pattern, don’t worry — you are not alone. Analyzing these patterns is something that is done primarily by technical stock traders, but understanding them can still be a useful skill for ordinary investors. Let’s take a look at what stock chart patterns are, how they are analyzed, and the patterns most commonly identified by technical traders.
When you look at a chart that graphs out the price movements of a stock, you will see distinct patterns that technical traders believe can signal future movements in the price of the stock. Traders study these patterns to identify trends and then decide whether these trends will continue onward or reverse themselves. Continuation and reversal patterns can be found on stock charts that cover any period or length of time.
Technical traders base their decisions to buy and sell stocks on two key assumptions: that stock prices follow trends, and that history repeats itself. They look for trends that will signify future movements in stock prices and then make buy-and-sell decisions based on whether they think the trends will continue or reverse.
There are a number of different stock chart patterns that are commonly identified by technical traders who study stock charts. They include the following nine patterns:
- Cup and Handle — As the name suggests, this stock chart pattern looks like a cup, in which the stock price dips and then rises again, connected to a handle in which the stock price moves slightly downward and a little bit sideways. It represents a bullish continuation pattern where the upward trend in the stock price has paused momentarily but will continue once the price moves above a resistance line in the handle. The timeframe for this pattern can range from a few months to a year or longer.
- Rounding or Saucer Bottom — This is a bullish reversal pattern that indicates a shift from a long-term downward trend in a stock’s price to a long-term upward trend. This pattern can last from a few months to a few years. It is similar to the cup and handle, but without a handle signifying a downward and sideways movement.
- Head and Shoulders — This is a reversal pattern that signals an end to either an upward or a downward trend. The former, known as head and shoulders top, would be a bearish pattern, while the latter, or head and shoulders bottom, would be a bullish pattern.
- Flag and Pennant — These are short-term (usually no more than three weeks) continuation patterns formed by a sharp price movement in one direction (either up or down), followed by a sideways price movement, and then another sharp price movement in the same direction as the initial movement.
- Double Tops and Double Bottoms — This is a reversal pattern that is formed when a price movement tests resistance- or support-levels twice without breaking through. The price then reverses course and either plummets (a bearish pattern) or soars (a bullish pattern). Double tops and double bottoms are considered by technical traders to be among the most reliable stock chart patterns.
- Triple Tops and Triple Bottoms — These are the same thing as double tops and bottoms, except a price movement tests resistance- or support-levels three times without breaking through.
- Triangle — This is a continuation pattern that can be neutral, bullish or bearish. A symmetrical triangle is neutral because it does not indicate a price movement to the upside or the downside — the trend is not apparent until after the price movement has occurred. An ascending triangle is upward sloping and bullish, indicating an ongoing upward movement in price, while a descending triangle is the opposite.
- Wedge — A wedge is similar to an ascending or descending triangle and can indicate either a continuation or a reversal pattern. A falling (or descending) wedge would be bearish, while a rising (or ascending) wedge would be bullish. The timeframe for a wedge is typically three to six months.
- Gap — These are empty spaces between trading periods that most often occur when there is a significant price difference between the two periods. They are usually a sign that something big happened to the stock during the interim between trading periods — either positive, like a better-than-expected earnings announcement, or negative, like a major lawsuit being filed against the company.
It is important to note that stock charting is a very inexact science. Even the best technical traders have to admit that stock prices do not always move in the direction that a chart pattern might have indicated. If they did, then everyone would be a technical stock trader and would make accurate buy-and-sell decisions every time.
However, learning how to read stock charts and identify the most common stock chart patterns can be helpful if you know what do to with the information you glean from your analysis.