Best chart patterns for timing your investments
You’re ready to take your crypto trading to the next level, and are diving deep into crypto price charts. But what do you do with them? You might try drawing some trendlines, support and resistance levels, and add some indicators, but you’re not sure what to do next. If all of the information is in the chart, why don’t you know when to buy, and when to sell?
This is where chart patterns come in. Chart patterns are patterns in the movements of asset prices that repeat themselves over time. And, because they repeat themselves, this means they can be helpful for predicting how an asset’s price will move in the future, empowering you to make more informed investment decisions.
In this article, you will learn about the best chart patterns, how to read them, spot trends and formulate strategies around them.
However, keep in mind that while I share which patterns typically indicate whether it’s time to buy, sell or hold, this should not be taken as financial advice. This is simply based on what these patterns have indicated historically, but could change in new market environments.
What are chart patterns?
Chart patterns are graphical representations of an asset’s price. At their simplest, when the price goes up, the chart goes up, and when the price goes down, the chart goes down.
Chart patterns are used for technical analysis when making decisions about trading and investing in assets, as different patterns indicate buying and selling opportunities. Simply, the core philosophy of technical analysis is that history repeats itself. This means that if an asset’s price has moved in a certain pattern in the past, which led to a certain result, that result might happen again if it performs the same pattern in future.
Ultimately, understanding common chart patterns can help you make smarter trading decisions.
Why are chart patterns important?
Charts are important for any investor because they give a graphical presentation of an asset’s price action. On a candlestick chart, for example, you can see the open, close, high and low values for every trading period. Looking at these over time can help you identify trends in an asset’s price.
As a trader, you can detect patterns in these charts that highlight buying and selling opportunities. Combining this knowledge with other technical insights helps make more informed trading decisions.
The best thing about chart patterns is that they repeat (this is how they are identified as patterns, after all!). This means which makes it possible to stay ready when you spot a familiar pattern and approach your trades accordingly.
What are the different types of charts?
When it comes to trading charts, there are a range of options you can use. The most common ones are line charts, bar charts and candlestick charts.
A line chart is simply that - the price of an asset over time is plotted on a chart, and a line is drawn between each price level. This is the simplest form of chart, and is helpful for identifying trends.
A bar chart includes the opening price, high, low and closing price for each trading period.
Finally, a candlestick chart also covers these four elements (open, high, low and close). The main difference is that the area between the opening and closing price is coloured in, lending it more emphasis. The colours are green and red, with green indicating that the period had bullish price action, and red indicating that the price action was bearish.
In this article, I use candlestick charts because they carry more data than other charts and make it easy to spot the emotion in the market after each price movement.
Components of a candlestick chart
A candlestick chart has 3 major components: an upper shadow, a lower shadow, and the body. Every candlestick represents the price action for a specific time interval of trading. For instance, a 1-minute candle shows the price fluctuations within that one minute.
The body of the candle is either red or green. And you can find four data points from a candlestick: high, low, open, and close. Open is the first trade price for the given interval, and close is the last. Open and close values decide the size of the body. When close is greater than open, you get a green body—denoting a net price gain. On the other hand, if open is greater than close, it shows a net price drop, and the body would be red in colour.
Low represents the lowest price of that period, and high shows you the highest trade price. The lower tail or shadow extending below the body shows the low, and the upper tail or shadow extending to the top of the body represents the high.
The 2 types of chart patterns you should know
You can identify trends by connecting points on the candlesticks with a line - these will form an ascending, descending or horizontal line, and these lines indicate the trend.
An upward trendline connects ascending points and happens when prices set higher highs and higher lows. Meanwhile, a lower trendline happens when highs fall further along with the lows. If the trendline is horizontal, the price is ranging or moving sideways, meaning it is not increasing or decreasing over time.
There are two categories of commonly observed price patterns: continuation and reversal. Let’s look at what these are and the types of patterns within each of them.
A continuation pattern is a temporary interruption in the ongoing trend. When a pattern takes shape, you cannot tell if it is a continuation or a reversal of the ongoing pattern. This is possible only after careful analysis and understanding whether the price moves above or beyond the continuation level. Besides, the longer a price pattern takes to complete, the larger the movement would be after the pattern.
Generally, investors should sell if they spot a pattern indicating a continuing downward movement. Conversely, it is a good time to buy if you spot an upward trend.
The major patterns that fall under continuation patterns are:
Pennants are a set of two converging trendlines. Note that this trendline would be moving in two different directions before converging—one would be an up trendline and the other a down trendline.
One key feature of pennant formation is that it happens alongside a volume decline. After the pennant, the price pattern continues in its previous manner.
The projected price is usually equal to the height of the pennant. You can place a stop below the upward trendline of the pennant.
An upward pennant indicates time to hold or buy, whereas, in the case of a downward pennant, you should sell it.
Wedges are similar to pennants because they consist of converging trendlines, but the only difference is that the lines travel in the same direction—up or down. A wedge pointing down shows a short pause in the price rise trend. Similarly, if there is a rising wedge, it is a brief interval before the price continues to fall further.
Ideally, you can hold your positions if it is a rising wedge and sell if it rises because its price will fall further.
Flags are pairs of parallel trendlines with slight upward or downward slopes. These appear with an upward slope when there is a pause in the downward trend or a downward slope when there is a pause in the upward trend in the market. If you spot an upward flag, it is better to buy and hold, and in the case of a downward flag, the right thing to do is sell.
Once the flag forms, trading volume typically declines and recovers at the end when the price breaks out and continues in the same direction before the flag.
Triangles are one of the most frequent chart patterns applied for chart analysis. There are three types of triangle patterns:
A) Symmetrical triangle
As two trendlines converge and form a symmetric triangle, it signals a breakout—you cannot predict its direction. You should note the market sentiment and trend to understand in which direction the breakout will happen.
B) Ascending triangle
These contain a horizontal upper line and a rising lower trendline. It usually points to a likely upward price movement. Triangles indicate it is a good time to buy and hold.
C) Descending triangle
In these, the lower trendline is flat, and the upper trendline is falling. These represent a downward price trend, and signals you should sell.
5. Cup and handle
Cup and handle is a pattern that represents a continuing bullish trend. However, note that only after the pattern reveals itself can it confirm the bullish trend.
In the pattern, you find a cup-shaped dip and rise of trendlines followed by a horizontal handle to the cup’s right. The handle may resemble a pennant or flag pattern.
Once the pattern is complete, the market breaks out in a bullish trend; hence, it is a signal for buying.
Patterns that show a reversal of ongoing price trends are called reversal patterns. These patterns appear when the bullish or bearish movement runs out or nears its end. Once the pattern reveals itself, the price trend will continue in the opposite direction.
When reversal patterns happen at the high points of a market movement, they are called distribution patterns. This is because traders will be more enthusiastic about selling the asset since the price will fall shortly afterwards.
When the reversal pattern reaches the bottom of a price movement, they are known as accumulation patterns. This is because traders will be more interested in buying the asset than selling when the prices are about to rise.
Here are the important reversal patterns:
1. Head and shoulders
Head and shoulders patterns appear at market price movement’s highest or lowest points. It appears in three steps: the first spike, whether high or low, followed by a higher spike, and then a third spike similar to the first one.
When an upward trend encounters a head and shoulder pattern, it witnesses a reversal. Likewise, when a downward trend is interrupted by an inverted head and shoulder pattern, it will reverse to start an upward movement.
So when you spot an upward-facing head and shoulder, it indicates time to sell. Similarly, it is time to buy if you spot downward head and shoulders.
2. Double tops and double bottoms
Double tops and bottoms signal that a market attempted to overcome support or resistance levels but failed.
A double top resembles the letter M where an initial push towards a resistance level is followed by another attempt, which also fails. The aftermath of the pattern is a trend reversal to a downward direction. When you spot this pattern, take it as a signal to sell.
Double bottoms resemble the letter W and happen when the market tries to break through the support level but fails eventually. It results in a reversal into the upper direction and hence a good time to buy.
3. Rounding bottoms and rounding tops
Rounding bottoms and tops are slightly different from the cups and handle pattern but have the opposite outcome.
Rounding bottoms occur when the asset’s price is close to the resistance and traces a smooth ‘U’ shape. This indicates that a bullish trend is on the way. If you buy the asset near the ‘U’ shape, you will be in for a boost to your portfolio.
Rounding tops happen when the prices increase and trace a smooth inverted ‘U’ shape but do not break resistance. Such a pattern could signal an upcoming downward trend, so it is a good time to sell.
Actionable tip for trading: Wait for the pattern to end before making your decision
A breakout happens when a stock price moves with high volumes outside the support or resistance level. If stock prices break above resistance, it is profitable to hold the stock; if it breaks below the support level, it is better to sell the stock.
Support is the price level at which the downward trend of the concerned stock is expected to stop. Similary, the resistance level represents the stage where the price level is not expected not rise further.
Note that breakouts are subjective as not every trader uses the same support and resistance.
Traders often make hasty decisions because they fear missing out on a breakout or major uptrend. However, this is unsafe and might lead to failed breakout scenarios.
Always wait for the confirmation of a breakout before making the trade. This may obviously lead to some missed trades but will surely keep away failed breakouts. In other words, enter the market when the candle representing the potential breakout pattern has closed outside the pattern.
Final words on chart patterns
You can go ahead and apply the above knowledge to your trading charts. Initially, work on reading and identifying chart patterns by matching them with the best chart pattern strategies discussed above. Save screenshots of important patterns and build a library on your own. Practice consistently, and you will become good at it. Then, you’d be ready to apply your wisdom to real-life markets.
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