Over a series of articles, I have reviewed the basics of technical analysis. With an understanding of trendlines, channels, support, resistance, triangles, and reversals, you have a basic foundation that can be applied to unique technical patterns.
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The following five stock chart patterns are unique, yet powerful. Understanding their uses will increase your likelihood of identifying market-changing events. These patterns are:
1. Gaps – Gaps occur when a price opens much higher (gap higher) or lower (gap lower) than the previous day’s close. Once a gap occurs, the new price represents an important price level. Gaps higher create support that should allow the stock to move higher and gaps lower create resistance that should pressure the stock lower. Until the gap is violated, we should assume the trend will continue in the gap’s direction. Amazon.com (AMZN) shows a gap higher on heavy volume (black arrow) that now acts as support (black line). As the stock has traded higher from that moment, it would take a close below $57.50 to indicate the bullish move is over.
2. Head and shoulders – This is a powerful pattern that marks a top and also provides a downside price target. When a head and shoulder forms, we see a rise within an existing uptrend to a new high that creates the left shoulder. Prices then move lower, but rebound to another new high to form the head. From that point, we see a decline that does not violate the initial sell-off from the left shoulder. Prices rally again, but the failure to top the recent high forms the right shoulder. By connecting the lows that occurred after the left shoulder and head were formed, we identify the neckline. Once the neckline is violated, the pattern is complete and prices will move lower.
To see this pattern in action, consider the Volatility index (VIX). In October, a strong uptrend took the VIX near 80 before a sell-off. This formed the left shoulder. A rally above 80 and subsequent decline created the head. When VIX then topped out near 70, the right shoulder was formed. The breaking of the neckline (blue line) pointed to lower prices. To estimate the downside target, we use the difference between the head and the neckline. This gives us a 35 target (blue box).
3. Triple bottom/top – This is a variation of a head and shoulders pattern. The main difference is that whereas the head and shoulders offers three points at different prices, the triple top/bottom offers them at the same price. Cliff Natural Resources (CLF) shows three highs at the same level (blue circles). This indicates a potential triple top that would drive prices toward $20.
4. Double bottom/top – This is more frequent as it requires only two data points whereas the triple top and head and shoulders require three points. When we see two prices at the same level, it indicates stocks have reached either a top or bottom. As with most technical patterns, reversals on heavy volume reinforce the movement. Returning to KO, the black circle indicates a spike in volume that accompanied the reversal. This should have warned all those owning the shares that the massive reversal was occurring.
5. Saucers – Saucers show a gradual turn from downtrend to sideways to uptrend. They are long-lasting base-building patterns that indicate trends are changing. Copper offers an example whereby a long downtrend eventually bottomed, moved sideways, and then pushed higher. This lets us know that the recent lows near $130 should serve as a long-term base years into the future.
While one list cannot capture every possible chart pattern, these five will allow you to develop a base of knowledge that leads to increased trading success.
Sean Hannon, CFA, CFP is a professional fund manager.
Further Education, Technical Analysis:
- Critical Support and Resistance Rules
- 5 Key Guidelines for Trading Stock Chart Channels
- Breaking Down Stock Chart Types
- How to Read Stock Charts
- 5 Main Assumptions Behind Using Technical Analysis
- Top 5 best Free Stock Chart Websites
- 5 Rules for Predicting Stock Market Trends
- Stock Chart Education Test (Answers)