What is a Chart Formation?
A chart formation is a pattern in the price data, or other metric, that a technical trader recognizes and can thus anticipate what the price may do next, based on how that pattern has played out when it appeared on prior occasions.
There are multiple types of chart formations, some well known, and other formations or patterns that traders may find on their own.
- A chart formation is when a financial chart moves in such a way as to create a recognizable pattern.
- Traders use these patterns to signal trading opportunities, either to enter or exit positions.
- If a pattern occurs regularly, traders can look at how the price has historically performed when the pattern appears to get a baseline for how future occurrences of the pattern may perform.
What a Chart Formation Tells You
Chart formations are used in the practice of technical analysis, whereby traders attempt to predict future movements in a security's price by studying the past changes in price and volume (or other metric).
There are many common types of chart formations, or chart patterns, that traders use in order 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 watch 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, and sometimes get trapped in, false breakouts. 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 chart formation.
Example of a Chart Formation
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 an asset's price.
The first peak is the left shoulder, the middle peak is the head, and the final peak is the the right shoulder. The head must be higher than the left and right shoulders. Between each peak is a pullback, or swing low.
A head and shoulders top is a chart formation that indicates the reversal of a previous uptrend. The head and shoulders top must occur within an uptrend.
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.
The daily chart of the EUR/USD currency pair shows the head and shoulders chart pattern.
Other chart patterns, such as triangles, channels, wedges, and others, are all drawn or highlighted based on certain 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 pattern is any pattern that occurs on a financial data chart. A candlestick pattern is specific to candlestick charts. Candlestick charts are a specific type of price chart that show how the price moves using "candles". When candles with a certain appearance occur in a specific order, that is a candlestick pattern. There many candlestick patterns.
Limitations of Using Chart Formations
Chart formations won't always result in the price move expected. The ensuing price move may also be smaller or larger than expected.
Trading chart patterns means relying on historical patterns and finding the probabilities related to those historical patterns. This gives a baseline for what to expect in the future. 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, some trade them on breakouts, others wait for false breakouts, or a combination of these methods.
Chart formations are best used in conjunction with other forms of analysis, such as technical indicators, trend analysis, price action, and possibly fundamental data.