What Is a Chart Formation?
A chart formation is a pattern created by price data or other metric that a technical trader recognizes from a past analysis. Thus, they can anticipate what the price may do next based on how that pattern played out when it appeared previously.
There are multiple chart formations; some are well known, while other formations or patterns traders may find on their own.
- A chart formation is when metrics graphed on a financial chart move in such a way as to create a recognizable pattern.
- Traders use these patterns to signal trading opportunities to enter or exit positions.
- If a pattern occurs regularly, traders can backtest it, or look at how the price has historically performed when the pattern appears to get a baseline for future occurrences.
What a Chart Formation Tells You
Chart formations are used in technical analysis, whereby traders attempt to predict future movements in a security's price by studying past changes in price and volume (or other metrics).
Traders use many common types of chart formations, or chart patterns, to predict future price changes. Some widely followed chart formations include the Double Top and Bottom, Head and Shoulders top and bottom, Rising Wedge, Triangles, Price Channel, and Cup With Handle.
Chart formations have different probabilities attached to them, as the price won't always move as expected when a formation occurs.
Traders will watch for chart formations and then wait to see if the price stays in the pattern or breaks out. Either of these situations presents potential trade possibilities. Traders may also watch for false breakouts and sometimes get trapped in them. A false breakout is when the price moves out of a pattern, making people think the price is now moving in that breakout direction, but then the price quickly reverses and heads back into the previous trend.
Example of a Chart Formation
One example of a popular chart formation is the Head and Shoulders Top. This chart formation consists of three successive peaks in an asset's price.
The first peak is the left shoulder, the middle peak is the head, and the final peak is the right shoulder. The head must be higher than the left and right shoulders. Between each peak is a trough, called a pullback or swing low.
A Head and Shoulders Top is a chart formation that indicates the reversal of a previous uptrend (bullish-to-bearish trend). In addition, the head and shoulders top must occur within an uptrend. This daily chart of the EUR/USD currency pair shows the Head and Shoulders Top chart pattern.
When the price drops below the swing low that occurred after the head or the price drops below the trendline connecting the two swing lows within the pattern (called the neckline), the pattern is considered broken, which indicates a downtrend is likely underway.
Other chart patterns, such as triangles, channels, wedges, and others, are all drawn or highlighted based on specific characteristics. Similar to the Head and Shoulders, if the price holds or breaks out of the pattern, these price moves may present trading opportunities.
What Is the Difference Between a Chart Formation and a Candlestick Pattern?
A chart formation is any pattern that forms on a trading data chart. These charts generally track prices at specific intervals, represented by points on the graph. The patterns can also appear on candlestick charts, but chart formations are different than candlestick patterns. Chart patterns include names like Triple Bottoms, Diamonds, Wedges, or Head and Shoulders.
A candlestick pattern is specific to candlestick charts. Candlestick charts are a specific price chart that shows an asset's opening, closing, high, and low prices. Candlestick patterns tend to use one, two, or three candles in a pattern. When candles with a certain appearance occur in a specific order, a candlestick pattern is formed.
Candlestick patterns have exotic-sounding names like Three Black Crows, Dark Cloud Cover, Evening Doji Star, and Spinning Top Doji. This daily chart shows the Spinning Top Doji pattern, which warns of a possible reversal.
Limitations of Using Chart Formations
Chart formations won't always result in the price move expected—it may also be smaller or larger than expected.
Trading chart patterns means relying on historical patterns and finding the probabilities and variables related to those historical patterns. This gives a baseline for what to expect in the future. However, since most patterns will look different and appear in different market conditions, it can be hard to find and calculate accurate probabilities for how these patterns could work in the future.
Chart patterns are tradable, but there are multiple ways to trade them. Some traders trade them assuming they will continue, and some trade them on breakouts; others wait for false breakouts or a combination of these methods.
Chart formations are best used in conjunction with technical indicators and trends, price action, and fundamental analyses.
What Is a Chart Formation?
A chart formation is a pattern in price data on a price chart that traders recognize as a possible indication that an opportunity exists or a market is about to change.
What Is the Most Accurate Chart Pattern?
Many traders believe the Head and Shoulders Top, which indicates a bullish-to-bearish change, is a reliable pattern.
What Are the Most Profitable Chart Patterns?
How profitable a pattern is depends on when the trader enters or exits a position and how large the price action is.