Summary:
Stock charts graphically explore the different possibilities in a trading environment. Markets are volatile and prices fluctuate rapidly. With charts, you can derive patterns, each representing a unique trend.
Stock chart patterns are an integral part of the technical analysis performed by traders and investors during decision-making. Chart formations are helping traders predict future movements in a security’s price more precisely by evaluating past trends in price and volume of stocks. These patterns leverage a wide variety of shapes to deliver insights into the potential price movements. In this blog we will explore what chart formations are, how they work and some common examples or patterns.
Definition of stock chart formation
In stocks, chart formation is also referred to as a price pattern or chart pattern. It is a recognizable and recurring pattern that indicates a particular stock’s price movements on the chart. These patterns also provide valuable insights into the psychology market participants and future price movements.
How does stock chart formation work?
Simply put, chart formations rely on past trends to predict the future scenario of different markets. It is based on the idea that patterns that occurred in the past are bound to remerge sometime in the future. Traders can anticipate whether a stock’s price is more likely to rise or fall or remain relatively stable. There are two major categories of stock chart formations:
| Continuous patterns | Reversal patterns |
| These patterns suggest that current trends will prevail. Traders recognize these patterns as opportunities for adding to the existing positions. It also enables them to explore new avenues. Triangles, flags, and pennants are some of the common continuation patters. | As the name suggests, these patterns indicate current trends will reverse. Traders typically leverage these patterns to identify potential entry or exit points. Some of the common reversal patterns consist of double tops, head and shoulders, and double bottoms. |
Examples of chart formation
Following are some common types of stock chart formations that provide some input about potential trading opportunities –
| Type | Definition | Pattern |
| Head and shoulders | This head and shoulders refers to a reversal pattern that signals a change in the trend. It consists of three peaks. The middle peak (the head) is higher than the remaining two (shoulders). This pattern is considered bearish when it forms at the end of an uptrend | |
| Double top and double bottom | Also reversal, the double top forms post an uptrend indicating a trend reversal to the downside. Meanwhile, a double bottom forms after a downward and hints a potential trend reversal to the upside. | |
| Cup and handle | It is a bullish continuation pattern, suggesting that following a period of consolidation (the cup), the price will continue its upward trend (the handle). | |
| Flag and pennant | These are short term continuation patterns symbolizing a brief pause in a trend before it resumes. Flags are rectangular whereas pennants are small symmetrical triangles. These patterns are generally formed after a strong price movement. | |
| Wedge patterns | These include rising and falling wedge. They are characterized by converging trendlines. A rising wedge is a bearish pattern that form after an uptrend, whereas a falling wedge represents a bullish pattern that forms after a down trend. They often result in breakouts in the direction of the current trend. | |
| Symmetrical triangles | Also features converging trendlines, however without any clear bullish or bearish bias. Traders trend to wait for a breakout to occur prior to making any trading decision. | |
| Ascending triangle | It is a bullish continuation trend with a horizontal resistance level along and an ascending support line. It suggests that the price is more likely to break to the upside. | |
| Descending triangle | Conversely, this is a bearish continuation pattern characterized by a horizontal support level and a descending resistance line. It indicates that the price is more prone to break to the downside. | |
| Bullish and bearish engulfing | These are candlestick patterns. In bullish pattern, a small bearish candle is accompanied by a larger bullish candle. This suggests potential reversal to the upside. Meanwhile, a bearish pattern is the exact contrast and showcases a potential reversal to the downside. | |
| Hammer and shooting star | Also candlestick patterns. A hammer is a bullish reversal trend with a small body and a long lower shadow representing potential buying pressure. A shooting star is bearish on the other hand with a small body and a long upper shadow, indicating potential selling pressure. |
These are some of the many chart patterns used by traders and investors to analyse the stock price movements. It is important to understand that the effectiveness of these patterns may vary depending on the time frame and market conditions.
The road to better decision-making in trading
Using chart formations and patterns can prove to be a valuable asset for traders and investors. Amalgamating chart patterns to form a comprehensive trading strategy can potentially lead to successful outcomes with minimum losses. You can embrace the stock trading world by better anticipating trends and price movements.
To learn how to read stock charts, click here.