DEFINITION of 'Pattern'
In technical analysis, patterns are the distinctive formations created by the movements of security prices on a chart. A pattern is identified by a line connecting common price points (such as closing prices, highs or lows) over a period of time. Chartists try to identify patterns to anticipate the future price direction.
BREAKING DOWN 'Pattern'
Also known as trading patterns, patterns in security prices can occur at any point or measure in time. Although price patterns may be easy to see in hindsight, they are much harder to spot in real time. There are many different kinds of patterns in technical analysis, including the cup and handle, ascending/descending channels, and the head-and-shoulders pattern.
There are two types of analysis for stocks: fundamental and technical. Fundamental analysis looks at company performance. If revenues have gone up over the past three years, it may be safe to assume they will go up next year. Technical analysis is primarily concerned with patterns, regardless of performance. These patterns are then used to find trends in pricing. Fundamental analysis is used to determine what to buy, whereas technical analysis is used to determine when to buy it.
Technical analysts use chart patterns to find trends in a company's price. The analyst looks for trends in the movement of the stock. Patterns can be based on seconds, minutes, hours, days, months or ticks and can be applied to bar, candlestick and line charts. The most basic form of chart pattern is a trend line.
"The trend is your friend" is a common saying among technical analysts. The trend is often located by forming a trend line. A trend line is the line formed between a high and a low. If the trend line is going up, the trend is up. If the trend line is going down, the trend is down. Trend lines form the foundation for most chart patterns. Trend lines are also used to locate support and resistance levels, which are also part of pattern recognition. A line of support is a level a stock price won't go below; a line of resistance is a level the stock won't go above.
There are two basic types of patterns: continuation and reversal. Continuation patterns are used to find opportunities for traders to continue with the trend. These are retracements or temporary consolidation patterns. Different names have been given to the most common continuation patterns, such as ascending triangles, descending triangles, flag patterns, pennant patterns and symmetrical triangles.
Reversal patterns are the opposite of continuation patterns. They are used to find opportunities to enter a trade on the reversal of a trend. In other words, reversal patterns find areas where trends have ended. Common reversal patterns are the head-and-shoulders patterns, triple tops and bottoms, or double tops and bottoms.