What Is a Pattern?
Patterns are the distinctive formations created by the movements of security prices on a chart. A pattern is identified by a line that connects common price points, such as closing prices or highs or lows, during a specific period of time. Chartists seek to identify patterns as a way to anticipate the future direction of a security’s price. Patterns are the foundation of technical analysis.
- Trading patterns can deal with historical price patterns of an asset. Examples for stocks would include: past stock prices, moving averages, and post earnings stock movements.
- Other types of patterns to consider can deal with macro data points. Examples would include how the overall market's price behavior is acting, whether or not a group is breaking out or down, and other historical tendencies a trader notices.
How Patterns Work
Patterns in security prices, perhaps better known as trading patterns, can occur at any point or measure in time. While price patterns may be simple to detect in hindsight, spotting them in real time is a much larger challenge. There are numerous types of patterns in technical analysis, including the cup and handle, ascending/descending channels, and the head-and-shoulders pattern.
There are two primary types of stock analysis: fundamental and technical. Fundamental analysis looks at the specifics of a company’s business, conducting research on earnings projections, balance sheets, price-to-book ratios and much more. Technical analysis is mostly involved with pattern recognition, regardless of performance. These patterns are then used to uncover pricing trends. Fundamental analysis can help determine what to buy, while technical analysis can help determine when to buy. Well-rounded investors will apply both studies.
Technical analysts use chart patterns to find trends in the movement of a company’s stock price. Patterns can be based on seconds, minutes, hours, days, months or even 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 catchphrase among technical analysts. A trend can often be found by establishing a line chart. A trend line is the line formed between a high and a low. If that line is going up, the trend is up. If the trend line is sloping downward, the trend is down. Trend lines are the foundation for most chart patterns.
They are also useful for finding support and resistance levels, which can also be discovered through pattern recognition. A line of support is a historical level that a stock price hasn't traded below; a line of resistance is a historical point where a stock hasn't traded above.
There are two basic types of patterns: continuation and reversal. Continuation patterns identify opportunities for traders to continue with the trend. There are also retracements or temporary consolidation patterns where a stock will not continue with the trend. The most common continuation patterns include ascending and descending triangles, flag patterns, pennant patterns and symmetrical triangles.
The opposite of a continuation pattern is a reversal pattern. These are employed to find favorable opportunities to base a trade on the reversal of a trend. In other words, reversal patterns seek to unearth where trends have ended. "The trend is your friend until it bends" is another catchphrase for those looking for a reversal in a trend. Common reversal patterns are double tops and bottoms, head-and-shoulders patterns and triple tops and bottoms.