What it means
Technical analysis looks at past prices and trading volume instead of company accounts. Its followers believe that human behaviour repeats, so similar shapes in a chart tend to lead to similar outcomes.
A pattern is one of those shapes. Patterns are usually grouped into two types.
Reversal patterns suggest that a trend is about to change direction, while continuation patterns suggest that a pause is temporary and the trend will go on. Well-known examples include head and shoulders, double tops and bottoms, triangles and flags.
Take head and shoulders. The price makes a peak, a higher peak, and then a lower peak, with a flat support line called the neckline joining the dips.
If the price falls through the neckline, analysts often expect a further decline. To use patterns, traders look for confirmation, such as a break through a key price level on heavy trading volume.
They then set a target based on the size of the pattern and a stop-loss, which is an order that closes the trade if the price moves the wrong way. This keeps the possible loss limited.
The limits are important. Patterns are open to interpretation, many do not play out, and researchers disagree about whether they have real predictive power.
Finance professionals treat them as one input, alongside fundamentals and risk limits. Context matters when reading a pattern.
The same shape on a chart of a thinly traded share means less than on one with heavy volume, and a pattern formed in a quiet market is less reliable than one that follows a long trend. Good analysts therefore combine patterns with volume, news and the wider market trend.
In practice
Real-world examples.
Example
A trader notices that a stock has formed a double top, where the price twice failed to rise above $80. When it drops below the dip between the peaks, she sells her holding. She expects the decline to continue. She places a stop-loss just above the second peak in case the pattern fails.
Example
A company treasurer who hedges foreign currency looks at a chart showing a triangle pattern in an exchange rate. She uses it only to choose the timing of a hedge, not to decide whether to hedge. The risk policy still sets the amount. She records the reason for the timing in the hedging log.
Example
An investor sees a flag pattern in a share that has risen sharply and then moved sideways. He buys when it breaks upward, expecting the previous rise to continue. He sets a stop-loss below the bottom of the flag. The flag's height also gives him a target for taking profits.
Formula
Calculation
Head and shoulders price target = neckline - (head - neckline)
A stock forms a head and shoulders pattern with a head peak at $60 and a neckline at $50. The height of the pattern is 60 - 50 = $10. When the price breaks below the neckline at $50, the target is 50 - 10 = $40. A trader selling short at $50 might place a stop-loss at $53 to limit the loss to $3 per share if the pattern fails.Case study
Seen in the real world.
Sandpiper Capital is an illustrative, fictional trading firm that tested chart patterns on ten years of data. The analysts counted how often a head and shoulders pattern was followed by the expected fall.
The results were mixed, with about half of the signals working and the other half failing. After allowing for trading costs of $15 per trade, the strategy's average profit was close to zero.
In the illustrative outcome, the firm decided to use patterns only to confirm decisions based on other analysis. The lesson was that a pattern that looks convincing on a chart still needs testing before money is staked on it. The firm also noted that the winning trades were bigger than the losing ones when a stop-loss was used, which kept the strategy from losing money overall in the test.
Watch out
Common mistakes.
- Treating a pattern as a certain prediction, when it only suggests a higher chance of a particular move.
- Seeing patterns everywhere after the fact, which is easy when looking at old charts.
- Trading without a stop-loss, which leaves the loss unlimited if the pattern fails.
Questions
People also ask.
What is the difference between reversal and continuation patterns?
Reversal patterns suggest a trend is about to change direction, while continuation patterns suggest it will carry on after a pause. Knowing which type is in play helps decide whether to wait or to act.
Do chart patterns work?
Opinions differ, and evidence is mixed, so most professionals use them as a supporting tool and not the only reason to trade. Anyone relying on them should test the idea on past data and include trading costs.
Where do patterns appear?
They are used on charts of shares, currencies, commodities and other traded assets over any time period. Shorter time frames tend to produce more false signals than longer ones.
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