What is a 'Chart Formation'

A chart formation is a graphical representation of a stock’s performance over time. Typically chart formations are depicted using a two dimensional graph, with time represented on the x axis, and price represented on the y axis. Stock volume, or the total number of times a particular stock has changed hands during a given period, is charted on the same graph using the same x axis, but a different y axis.

BREAKING DOWN 'Chart Formation'

Chart formations are used in the practice of technical analysis, whereby traders predict future movements in stock price by studying the past changes in price and volume. Technical analysis is the practice of using past data on stock prices and the volume at which stocks are traded to predict future movements in a stock price. Technical analysis is engaged in based on the principle that all important, public information about a company’s performance is near instantaneously incorporated into the price of the stock, making it almost impossible to actually buy a fundamentally undervalued stock or to short sell a fundamentally overvalued stock.

There are many common types of chart formations, or chart patterns, that traders use in order to predict future changes in stock prices. Some widely followed chart formations include: the double top reversal, head and shoulders top, rising wedge, symmetrical triangle, ascending triangle, price channel and cup with handle. 

Examples of Chart Formations

One example of a popular chart formation is the head and shoulders top. This is a chart formation that is comprised of three successive peaks in a stock price over time. The first peak is the left shoulder, the middle peak is the head and the final peak is the the right shoulder. A head and shoulders top is a chart formation that indicates the reversal of a previous uptrend. Therefore, it is important for traders to first establish an ongoing uptrend in the stock price before acting on a head and shoulders top. If you believe you have identified a previous uptrend that has culminated in a head and shoulders top, this chart formation recommends that you sell the stock in question.

Traders should be careful to make sure that all the telltale signs of a head and shoulders top are in place before acting on it. The left shoulder of the chart formation should be the peak of the uptrend that you have identified, followed by a pullback in the stock. The next peak, which in a classic head and shoulders top would be higher than the first, is followed by another pullback and a third peak that is not as high as the second. 

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