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5. Chart Patterns - the “Tea Leaves” of Chartists
As price bars are printed across the charts, they sometimes form patterns. Many chartists believe that these patterns have a predictive quality, a sign of what’s to come for the markets. We don’t necessarily buy into that notion, but recognizing patterns on a chart is as important as recognizing support and resistance: we want to see market reaction to the obvious chart patterns observed on the charts. More on that later.
Patterns come in all shapes and configurations. They “tell” us all kinds of different things. Maybe you’ve heard the gurus on TV speak of “head-and-shoulders” patterns, “cup-and-handle” patterns, “pennant” formations or “declining wedges.” Some are reversal patterns, some are continuation patterns, some are consolidation patterns. Patterns can be found on all charts in all time frames.
> Hey, to be honest, we look at patterns like we look at constellations in the sky. On a clear night, we can find 4 or 5 Big Dippers! On a price chart, we can find a couple of pennant formations, maybe a cup-and-handle pattern or two! Chart patterns, like beauty, are sometimes in the eye of the beholder and you may not “behold” a particular pattern someone else has spotted!
However, it is important to recognize the obvious ones - just because everyone else will - so we’ll cover a few popular ones here:
head-and-shoulders pattern
This is considered a reversal pattern and, as such, is much more reliable a “predictor” when it occurs during an uptrend. What happens basically is that prices push to new highs (the “left shoulder”), then pull back a bit before bouncing to new highs (the “head”). Prices pull back again, then bounce higher - but not as high as the previous high of the “head” - before pulling back again (the “right shoulder”). If this reversal pattern is valid, prices should continue to drop once they fall below the “neckline.”
This chart of Alcoa has 2 head-and-shoulders patterns:
This is considered a reversal pattern and, as such, is much more reliable a “predictor” when it occurs during an uptrend. What happens basically is that prices push to new highs (the “left shoulder”), then pull back a bit before bouncing to new highs (the “head”). Prices pull back again, then bounce higher - but not as high as the previous high of the “head” - before pulling back again (the “right shoulder”). If this reversal pattern is valid, prices should continue to drop once they fall below the “neckline.”
This chart of Alcoa has 2 head-and-shoulders patterns:
Reproduced with permission of Yahoo! Inc. ©2013 Yahoo! Inc. YAHOO! and the YAHOO! logo are registered trademarks of Yahoo! Inc.
Reproduced with permission of CSI ©2013. Data Source: CSI www.csidata.com
To add more significance to the pattern as it is developing, chartists will watch the volume. They want to see good volume as the left shoulder is formed, less volume as the head is formed and even less as the right shoulder is formed. That type of volume action would indicate that the buyers are becoming less aggressive, meaning that even if this is not a full trend reversal, it is at least a significant pullback - just we see in the example above!
NOTE: The exact opposite, an “inverted head-and-shoulders pattern,” is a bullish reversal pattern. It would look just like the pattern above if you flipped it over. The only difference would be the volume changes - chartists want to see increasing volume on the right shoulder in this scenario, indicating buyers are getting more aggressive. The inverted head-and-shoulders pattern is a more reliable “predictor” when it occurs in a downtrend.
NOTE: The exact opposite, an “inverted head-and-shoulders pattern,” is a bullish reversal pattern. It would look just like the pattern above if you flipped it over. The only difference would be the volume changes - chartists want to see increasing volume on the right shoulder in this scenario, indicating buyers are getting more aggressive. The inverted head-and-shoulders pattern is a more reliable “predictor” when it occurs in a downtrend.
cup-and-handle pattern
This is a bullish continuation pattern, or consolidation pattern. During an uptrend prices reach a point where they pull back, then gradually rise again over a few trading periods forming a rounded bottom (the “cup”). When prices rise back close to the same level as the left side of the cup, they pull back briefly then move higher again (the “handle”). The pattern is considered valid if prices move higher than the “top of the cup” and continue higher.
This is a bullish continuation pattern, or consolidation pattern. During an uptrend prices reach a point where they pull back, then gradually rise again over a few trading periods forming a rounded bottom (the “cup”). When prices rise back close to the same level as the left side of the cup, they pull back briefly then move higher again (the “handle”). The pattern is considered valid if prices move higher than the “top of the cup” and continue higher.
Reproduced with permission of Yahoo! Inc. ©2013 Yahoo! Inc. YAHOO! and the YAHOO! logo are registered trademarks of Yahoo! Inc.
Reproduced with permission of CSI ©2013. Data Source: CSI www.csidata.com
Chartists will watch volume on this pattern in the handle area. They want to see an increase in volume as prices “break out” above the top of the cup. This confirms that buyers are coming back into the stock after the pullback.
pennant or flag formations
Pennant formations - sometimes called flag formations - are also bullish continuation patterns. Prices make a sharp move higher (the “flagpole”), then pull back in a tight range for the next few trading sessions (the “pennant” or “flag”). The flag can be symmetrical, like a pennant, or look like a waving flag such as the one pictured below.
Pennant formations - sometimes called flag formations - are also bullish continuation patterns. Prices make a sharp move higher (the “flagpole”), then pull back in a tight range for the next few trading sessions (the “pennant” or “flag”). The flag can be symmetrical, like a pennant, or look like a waving flag such as the one pictured below.
Reproduced with permission of Yahoo! Inc. ©2013 Yahoo! Inc. YAHOO! and the YAHOO! logo are registered trademarks of Yahoo! Inc.
Reproduced with permission of CSI ©2013. Data Source: CSI www.csidata.com
When it comes to volume, chartists ideally want to see strong volume during the creation of the flagpole itself, the lesser volume on the pullback that creates the flag. Volume should increase as prices break out above the top of the flag and continue higher, making the pattern valid.
Seeing and recognizing chart patterns is probably more art than science. Some folks say it’s akin to “reading tea leaves.” We won’t argue - at times spotting patterns can be pretty arbitrary (like those Big Dippers in the sky!). But there are 2 good reasons we need to at least be aware of them:
1. Most other chart watching traders/investors keep an eye out for them. Many of them open, close or add to positions in their portfolios when they see the patterns beginning to form. That kind of buying and selling moves markets, so it’s good to “see it coming.” Anything that tips us off as to why the markets are moving in a particular direction helps us out!
2. As we mentioned at the beginning of this section, observing the market reaction to chart patterns can be very informative. We watch to see how prices react to major patterns - that tells us a lot about the strength or weakness of the current trend.
Did a bullish type of pattern play out to the upside? The uptrend is likely to continue. Did a bearish type of pattern play out to the downside? Then the downtrend is likely to continue. Did a bullish pattern fail to result in higher prices? Be careful - that uptrend could be in trouble...
As trend followers, we don’t make portfolio moves when we see a chart pattern forming. We wait and observe the price action around that pattern, then make any needed portfolio moves. We'll leave it to the traders and speculators to jump in early!
Check out our Resource Box below for more info on these and other chart patterns.