Overall, trading is made up of technical analysis, fundamental analysis, and luck. Traders will do whatever they can to improve their technique and have an edge as they compete with hedge funds, whales, and market makers to get their slice of the pie. This is one reason why chart patterns like double top pattern, double bottom pattern, cup and handle pattern, inverse cup and handle pattern, head and shoulders pattern, inverse head and shoulders pattern, bull flag pattern, and falling wedge pattern have become highly popularized
These trading patterns are another way of analyzing the historical price patterns of a stock using moving averages, supports, and resistances to find pricing trends. They are usually used in conjunction with fundamental analysis, but these highly recognizable patterns have become an important tool for all traders to know because they help them time their entry, exit, and target price.
While there are a countless number of trading patterns, understanding some of the most common and most relied upon can improve your trading technique across commodities, securities, and cryptocurrencies. As with most aspects of technical analysis, the pattern’s effectiveness is reinforced by traders’ belief that they are accurate. Even though trading patterns are more psychological than scientific, they can be accurate predictors of a breakout or downtrend.
Double Top and Double Bottom Pattern
Most investors are familiar with the double top pattern and double bottom pattern because they simply form an “M” or “W” on the chart. The difference between them is that the double top pattern is a bearish reversal pattern while the double bottom pattern is a bullish reversal pattern. This means that when the stock is showing a bullish trend, the double top pattern will signal an oncoming bearish trend and vice versa for a double bottom pattern. Its worth noting that, the double bottom pattern is considered to be a more effective breakout pattern than the double top.
Double Top Pattern
A double top pattern forms when a stock follows a bullish uptrend before testing resistance twice. This forms the letter M as it dips in between each attempt. When it fails to break resistance on the second attempt and falls back to the support, the pattern is completed and signals a downtrend. Traders can find an entry point a little below support.
Triple Top Pattern
The triple top pattern follows a similar logic except that it tests resistance three times before falling below support – also signaling a downtrend. Despite the double and triple top’s effectiveness, a major downside is that it can be misidentified – putting investors in a difficult position.
Double and Triple Bottom Pattern
A double bottom pattern forms at the end of a downtrend and takes the shape of a W because it touches support twice before breaking out above the resistance. Similarly, a triple bottom pattern can form in the same way except that it touches the support three times before breaking resistance. Typically, investors search for an entry point after price action completes the full W. This means the ideal entry point is slightly above the resistance.
Investors can set a stop loss below the support line as well to minimize risk. Many use the double bottom’s height to set their price target, estimating that if the difference between the support and resistance was equal to $4 then they should set their price target at $4 above the resistance.
However, just like the double top pattern – the double bottom pattern can be incorrectly identified. As a result, investors should take their time before making a decision based on these chart patterns. In general, the double bottom pattern and triple bottom pattern are believed to be slightly more effective than the double or triple top pattern.
The same chart patterns used for securities are applicable to cryptocurrencies as well. Typically crypto follows technical analysis better than securities which are more heavily impacted by fundamental factors. As David Martin of Blackforce Capital shared:
“In crypto, it’s still retail dominated, so everyone’s looking at chart patterns. So if you understand what everyone else is doing, you understand the trade even better. It’s basically technical analysis on technical analysis. Once you figure out, where does everybody think there’s support, where does everybody think there’s resistance, you can set your trade up based on how everyone else is reading the market.”
Cup and Handle Pattern
The cup and handle pattern indicates a bullish uptrend but forms when price action is in a holding pattern – making it useful for predicting the stock’s next movement when there are no clear signals. Already trending upwards, price action will dip after testing resistance before reversing again after touching support. This forms the rounded cup portion of the pattern and should have a “U” shape once it touches the resistance a second time. However, it’s important to look for the handle which forms after touching the resistance a second time. This portion of the cup and handle pattern should drift downwards before finding a second, higher support and reversing back to the resistance.
Altogether, the handle portion should be roughly a half of or a third of the cup portion’s height. Once the handle is completed, trader’s will be able to recognize that the upwards trend is continuing as price action moves above the resistance. Since it is a bullish continuation pattern, many investors use the cup and handle pattern to identify buying opportunities. For additional confirmation investors can check for higher volume as the stock breaks past resistance and minimize risk by setting a stop loss at the bottom of the handle.
Some traders prefer to set their price target at roughly the same height as the handle while others will set their target at the same height as the body of the cup. In general, the price target depends on each trader’s risk tolerance as well as the overall market. Because there is no assurance that the stock will reach either price target, remaining aware of the market sentiment will help traders make more effective decisions. Like all trading patterns, the cup and handle pattern has its issues. Because the cup and handle pattern develops over a longer period of time, it can cause investors to make their decisions too late or be tempted to jump the gun and enter before the pattern is complete. Another issue of the cup and handle pattern is related to the depth of the cup. Sometimes a shallow cup can be a true signal – while other deep cups can be a false signal.
Many are predicting a breakout for gold as it develops a cup and handle on the weekly chart. This is an example of how technical analysis should work in tandem with fundamental analysis. Although the chart is showing the pattern, investors should also take into account other factors such as inflation and the war between Ukraine and Russia which has driven the price of gold up. As both of these catalysts are resolved in the near future – the price of gold will likely drop despite the pattern. Additionally, because this pattern has formed on such a long-term basis it will take years for investors to see gold hit their price target based on the pattern.
Inverse Cup and Handle Pattern
On the other hand, an inverse cup and handle pattern signals a bearish trend. The cup portion is formed when price action pushes upwards before swinging lower to the support. After forming a crescent there should be an upwards retracement off of the support but it should not reach the same level as the previous trend. Watch to see if volume is dropping during the handle’s formation and a downtrend should emerge offering an opportunity to enter a short position.
Head and Shoulders Pattern
A head and shoulders pattern forms after a bullish uptrend ends in the stock testing a new high, dipping, testing a higher high, and then dipping before testing the first high. In this way, the two lower highs are the pattern’s shoulder while the higher high is the head. There should be a “neckline” or support which connects the two lows and after completing the second shoulder – the market should break below that neckline signaling a bearish reversal.
One thing to keep in mind is that the head and shoulders pattern does not guarantee a reversal. In fact, traders should account for the strength and duration of the original trend before acting on a head and shoulders pattern. If price action has been in an uptrend for a long period of time, then a head and shoulders pattern which developed over the short term may not signal a reversal. However, the head and shoulders pattern is statistically the most accurate of the price action patterns because it reaches its projected target almost 85% of the time.
Some traders look for a buildup near the neckline after the pattern forms as a place to set up their stop loss as this is more ideal than setting a stop loss at the head or shoulders’ upswing. Instead, setting a stop loss a little above the upswing point in the buildup will deliver a better risk to reward ratio.
While there is not always buildup at the neckline, there is another opportunity to secure an entry after a break out with the downtrend. Typically there will be a pullback after the initial dive and this can be a chance for an entry as well as a good place to set a stop loss above the upswing when trading with the head and shoulders pattern.
Inverse Head and Shoulders Pattern
On the other hand, an inverse head and shoulders pattern signals a bullish reversal and occurs after a downtrend. It forms with a low, then a higher low followed by a lower low. The higher low in the middle is easily identifiable as the head while the two lower lows are the shoulders. Again there should be a neckline or resistance that connects the highs of the two shoulders.
While the neckline can be slanting downwards, this is not a strong reversal sign and often the stock will continue following a downward trend. If the neckline is horizontal, this is a stronger sign for the inverse head and shoulders pattern. If the second shoulder forms at a higher high than the first – this is a bullish sign and there is a better chance of an upwards breakout since price action is already tending towards it. Interestingly, the inverse head and shoulders pattern is as accurate as the head and shoulders pattern according to statistical analysis.
It’s important to wait for a breakout past the resistance before securing a long position. The inverse head and shoulders pattern has a major problem though. Bullish and bearish powers can easily impact this pattern. When the price drops to the first shoulder, bears can push the price down past the first trough – leading to a continued downtrend.
Bull Flag Pattern
A bull flag pattern forms during an upward trend after a pullback. The bull flag pattern begins to emerge with consolidation and signals that price action will continue along the same trend as before.
The flagpole should develop during a strong move from the support to the resistance before a pullback. Using a diagonal support and resistance traders can recognize the flag portion of the pattern as the price action between both areas. There should be at least three upswings from the diagonal support to the resistance but the pullback should not fall any further than 50% of the flagpole’s height. Some investors believe that the bull flag pattern signal is stronger when the flag is tighter.
Depending on whether the bull flag pattern is forming on the daily chart or the hourly chart, investors will need to wait a period of time for the upswings to fully develop. On the hourly chart, it will take at least three hours to form while on the daily chart it will need three days. You will know that the bull flag pattern is complete when price action breaks out above the flag’s resistance. But it’s important to watch for higher than average volume during the breakout because this could signal a strong upwards trend.
Many investors set their price targets at the same height as the flagpole, but depending on their risk tolerance investors may use the diagonal support or resistance as the base for estimating their price target. It’s possible for the stock to drop after its initial breakout above resistance, which is why investors can set a stop loss near the diagonal support to minimize risk in case of a retracement. Some consider flag patterns to be some of the most reliable trading patterns but according to statistical testing this is not the most reliable of the chart patterns.
If accurate, the bull flag pattern will signal the continuation of an upwards trend and the price typically surges with volume after the pattern is completed. However, a downside of the bull flag pattern is that there are several parts that must come together to provide a true buy signal.
Falling Wedge Pattern
The falling wedge pattern can be a bullish reversal pattern that forms after a downtrend or signal the continuation of an uptrend. These chart patterns can be easily marked on charts by drawing two trend lines that connect the highs and lows of a stock’s price action – giving the shape of a wedge.
The falling wedge pattern is characterized by lower lows and lower highs which means the resistance line should be at a steeper angle than the support. Each lower low signifies that momentum is being sucked out of the stock.
For example, during a downwards trend when the falling wedge pattern appears it shows that bears are losing the battle because they are unable to push the price significantly lower. When there is a strong upwards trend and the falling wedge pattern emerges it signifies a continuation because the bull momentum is stronger than the bears’ – otherwise the price would fall more sharply. This means the price will break to the upside past the resistance and the upwards trend will resume. Typically traders set their price target from the breakout point or tip of the wedge and measure from there using the height of the wedge. Some investors prefer the falling wedge pattern since it allows them to enter a trending market despite missing out on the initial move. Like all trading patterns, the falling wedge pattern can be misidentified. In fact, it is one of the most difficult to recognize chart patterns which can lead to losses for investors if a continuation pattern occurs instead of a reversal pattern.
Conclusion
These trading patterns are a few of the most commonly used, but its important to note that no chart pattern has 100% accuracy. No matter how perfect the setup, macro level events can change the market’s course in the blink of an eye.
However, using chart patterns in conjunction with fundamental analysis will help take your trading to the next level. Because trading patterns like the double top pattern, double bottom pattern, cup and handle pattern, head and shoulders pattern, bull flag pattern, and falling wedge pattern are based on technical analysis – these patterns can be used when trading stocks, crypto, or forex. All of these patterns can be used on any time-frame, but if the pattern develops on the daily or weekly chart, it will take a longer time for it to reach the price target.
Happy Trading!
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