Three of the most powerful chart patterns

This article highlights three of the most powerful charting patterns that can be utilised, as a means to find market opportunities and moments when volatility could pick up.

IG Analyst

Publication date : 2017-10-18T14:53:44+0100

Source: Bloomberg

Traders use a whole host of techniques to analyse charts, from indicators, to patterns, historical cycles and much more. However, while much of the methodology utilised by traders revolves around indicators that are derived from the price, it is the price itself that is the most important aspect of any chart.

With that in mind, the utilisation of charting patterns is of particular importance, as it is simply the method of reading swing highs and swing lows to derive a market view. Below are three patterns which are particularly powerful when seeking to read charts.

Head and shoulders

The head and shoulders formation is one of the most famous patterns, given its distinctive name and shape. However, it is also one of the most powerful reversal patterns, given the implications in terms of swing highs and swing lows. Taking a standard head and shoulders pattern as an example (rather than inverse), the creation of higher highs and higher lows within an uptrend will be fully negated when we have both a lower high and lower low.

The head and shoulders pattern necessitates both of those factors, thus pointing towards a reversal. The longevity of such downside can be difficult to predict, with wider factors (such as historical trends) playing a major role. However, many will aim for a downside target, which equals the neckline to head distance (see below).

On this occasion we have a particularly strong pattern, with the prevailing downtrend coming back into play. For many, betting against the trend is a big no. So, finding a head and shoulders that could be marking the end of a retracement could be an especially useful way of trading a reversal pattern with the trend.

AUD/USD chart

Wedge

This formation is one of the most commonly seen patterns out there, with a wedge forming through the tightening of the price, as it experiences well-coordinated highs and lows. That means that for a rising wedge, we see both higher highs and higher lows, while a falling wedge experiences lower highs and lower lows.

This pattern can be especially powerful as a countertrend retracement, with a market building energy before bursting back into the trend once more. The example below highlights how utilising a wedge pattern within a clearly defined uptrend or downtrend can bring about significant subsequent trend continuation moves. On the right of the chart, we saw the price rally back into previous support, which highlights how wedges can be utilised, alongside forms of support or resistance to then snap back into the trend.

One of the positives about this formation is that, as the wedge progesses, the tightening seen should give you a better idea of when the breakout will finally occur. The best way to provide confirmation that the market has broken out of its wedge retracement would be to await a closed candle below the first swing low (or high of a falling wedge). The closed candle affords us a greater chance that this will not be a fakeout. For even greater confirmation, await a closed candle below the absolute low of the market before the retracement started.

Gold chart

Triangles

Triangles similarly provide a pattern that sees the price gradually tighten, before a sharp breakout can occur. In much the same way as Bollinger band users will see a tightening in volatility as a precursor to a sharp move for that market, the tightening triangle can often provide a significant move upon completion.

There are three main forms of triangles: symmetrical, ascending and descending. The symmetrical triangle is highlighted below. This is typically seen as a continuation pattern, which means that the price is expected to complete with the price breaking in the direction of the trend. Crucially, the example below highlights the importance of utilising the first swing high or low as the true breakout signal, rather than a move through trendline resistance or support.

Given that the trendline may not always perfectly touch all peaks and troughs, the use of trendlines can result in a number of fake signals. On this occasion, the bullish signal came with a break up through 10,061. This level subsequently became support throughout early 2014, before the market moved higher once again.