Chart patterns are shapes that appear on charts such that they are followed by familiar price movements and hence they can be used to predict security prices. They have predictive power because they reflect underlying human psychology such as fear, hope, greed, etc. Common examples include the internet stock bubble around 2000, and the following real estate bubble.
There are two types of chart patterns: reversal patterns, and continuation patterns.
A reversal pattern signals the end of a trend.
Head and shoulders
A head and shoulder pattern occurs just after a sustained uptrend. It has three segments:
The left shoulder which forms an inverted V representing a strong rally (at high volume) at a slope greater than the preceding uptrend, followed by the loss of the rally at a lower volume;
The head which is a more pronounced inverted V at a low volume but stronger rally. The price level falls to a point below the uptrend line which signals the beginning of the end of the uptrend.
The right shoulder is (almost) the mirror image of the left shoulder but at a lower volume.
While perfect head and shoulder pattern may be rare, in all such patterns, the head must be more pronounced than the shoulders which should be symmetrical such that they form a neckline. Volume plays an important role in head and shoulder pattern because it is the divergence between price (which is increasing) and volume (which is decreasing) at the head that signals the reversal.
Once the head and shoulders pattern is formed, the price is expected to decline. Technicians often set rules (either in percentage terms or by way of time-lapsed) to determine that the neckline has occurred. The decline is generally more pronounced if the initial uptrend is strong. Once the neckline is breached, the security is expected to fall below the neckline by the amount of the difference between the top of the head and neckline. A trader would short the stock such that its target price would be as follows:
$$ Price\ Target =Neckline – (Head – Neckline) $$
Inverse head and shoulders
The inverse head and shoulder pattern is just the opposite of the head and shoulder pattern. It has three segments, but they follow a downtrend. The left shoulder forms a V, followed by a more pronounced head, which is in turn followed by another symmetrical right shoulder.
Since an inverse head and shoulder pattern predicts an end to the downtread, the new price target can be worked out as follows:
$$ Price\ Target\ (Inverse) =Neckline + (Neckline – Head) $$
Double tops and bottoms
In a double top, an uptrend reverses twice at the same price such that volume is lower during the second reversal signaling diminishing demand. Similarly, double bottoms occur when the price reaches a low, recovers, dips again and then recovers such that the appreciation is equal to the difference between the peak and bottom of the pattern.
These indicate that at some price level investors are willing to sell the stock and that the price would decrease eventually. It also signals that if a stock has sustained two bottom outs, it is expected not to decline further.
Triple tops and bottoms
A tripe top consists of three peaks occurring at the same price level and the triple bottoms represent three troughs at the same price.
In reality, it is hard to tell whether a pattern is a double top or a triple top unless it has occurred. This is one of the key criticisms of technical analysis. However, in general, we can conclude that the greater the number of times a trend reverses, and the greater the time interval over which it occurs, the greater the significance of the pattern.
A continuation pattern signals a resumption of the trend in place before the pattern. It signals a transfer of ownership from one group of investors to another. For example, if one group sells, it depresses price but as the other group starts buying, the uptrend resumes. This pattern is often called a healthy correction because the long-term trend stays intact.
Triangles are a continuation pattern formed by connecting the trendline connecting highs and a trendline connecting lows. There are three forms of triangles: ascending triangles, descending triangles, and symmetrical triangles.
An ascending triangle occurs when the trendline connecting highs is horizontal, but the trendline connecting lows slopes upwards. This signals that the buyers are bullish and that the sellers are taking profit by selling at what they might believe as intrinsic value.
In a descending triangle, the low price trendline is horizontal, and the trendline connecting highs decline. This shows that at some price investors become active and buy the security such that lows remain horizontal. However, since the highs decline continuously, the pattern may be followed by a downtrend.
In a symmetrical triangle, the trendline of highs slopes downwards and the trendline of lows slopes upwards such that they reach a consensus. It shows that buyers are becoming more bullish while sellers are becoming more bearish.
If a trendline breaks out of a triangle, it is expected to move further in the trend at least by an amount equal to the height of the triangle at its formation.
A rectangle pattern is formed when prices move such that two horizontal trendlines, a resistance line representing the high points and a support line representing the low points, are parallel to each other. It shows that at some price (the high point) investors are selling the security and at the low price, they are buying.
Flags and pennants
Flags and pennants are short-term continuation patterns that typically exist over a week. Flags are like rectangles and have a slope opposite to the general trend while pennants are like triangles. The same trend continues after the flag and pennant at least by a magnitude equal to the distance between the start of the trend and the start of the flag or pennant.