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Patterns in Technical Analysis.
First of all, there are many patterns that can be used in technical analysis, and many ways to present them. For example, the Candlesticks charting technique uses patterns, Point-and-Figure technique uses patterns and so on.
This text is only dealing with the "traditional" price vs time charts, and only with the patterns that can be located visually on such charts. For other approaches, see corresponding sections of this site.
Triangle
The "classical" triangle has at least 5 waves, and the breakthrough happens at about 2/3 of the horizontal size of a triangle. It is not enough for the price to touch the side of a triangle, the price bar must close outside the triangle, otherwice we might have a false signal.
During the uptrend the triangle will more likely produce a false signal, especially if the breakthrough happened too close to the end of a triangle.
Symmetrical triangles.
This pattern can be considered as a sign that the market is "uncertain" in which direction to move. Both buyers and sellers are pushing the price towards some middle value. As it happens the volume usually is decreasing as everybody is waiting for the price to break out of the triangle. The moment it happens, the volume is usually increasing - due to psychological reasons.
It seems that the triangle USUALLY does not change the trend - if the price was going up, then it is most probable that it will break UP from the triangle and vice versa.
Ascending triangles.
This pattern is a variation of the Symmetrical triangle. Think of it in terms of "increasing pressure up and constant pressure down". The pattern will most probably be resolved UP.
As the pattern is forming, the volume is deminishing, and when the breakthrough occures, the pattern is usually expanding. It is a useful (but not mandatory) confirmation.
The price projection equals the maximim height of the triangle.
Descending triangles.
This pattern is a variation of the Symmetrical triangle. Think of it in terms of "increasing pressure down and constant pressure up". The pattern will most probably be resolved DOWN.
The length of the patter should be somewhere between few weeks and few months.
As the pattern is forming, the volume is deminishing, and when the breakthrough occures, the pattern is usually expanding. It is a useful (but not mandatory) confirmation.
The price projection equals the maximim height of the triangle, measured from the resistance breakout point.
Double top
This is a reversal pattern that forms after an uptrend. It consists of two peaks.
The important confirmation signal occures when the support line is broken after the second peak.
The decline after the first peak is somewhere between 10 and 20 %.
The duration of the pattern is somewhere between few weeks and few months.
The size of peaks is nearly equal.
The decline from the second peak may contain gaps and the volume should expand.
The support line should be broken, for the pattern to be clearly identified.
The price target equals the size of the peak.
Head and shoulders.
When the stock is going up, we can use the concept of a SUPPORT line, the line below the price, that price is constantly testing but cannot cross. Then when the trend is changing, the support line is broken AND for a short period of time the chart can be considered horizontal - the temporary support line is called a neckline.
Then the price is trying to reach the previous support line (and to restore the trend) but failing (right shoulder). This is the first "sell" signal. The second one is happening when the right side of the right shoulder penetrates the neckline - this sell signal is much stronger. Again as always, a lot of this strength the pattern gets from the fact that people know about it, believe in it and when it happens - they begin selling, therefore pushing the price down.
The volume is very important both for the head and shoulder formation, and for the reversed (bottom) head and shoulder. In both cases, the volume must expand when the resistance (support) is finally broken. Volume can be measured by the corresponding indicator (OBV, Chaikin Money Flow). Basically, the volume moves in the opposite direction to the price: the price is going up (to the top of the head) - the volume declines and vice versa.
The price target equals the distance between the neckline and top of the head.
Wedges.
Unlike with the triangles, both upper and lower edges are either going up (bearish formation) or down (boolish formation).
The volume is not that important for the rising wedge, but it is critical for the falling wedge. The volume should expand to confirm the break of a resistance.
Flags.
Flags are (sort of) variations of a triangles. They can be explained using the same logic and they predict the same thing. The pattern is considered part of the trend, which means that on the uptrend it is a sign that price will continue to increase and on the downtrend it is a sign that the price will fall.
They are usually preceded by a sharp advance or decline with heavy volume.
Rectangles.
Same as flags. A temporary slowdown in the trend that usually wouldn't change it.
They are usually preceded by a sharp advance or decline with heavy volume.
Bump and Run Reversal
The Bump and Run Reversal pattern was described by Thomas Bulkowski. The pattern forms after the price advanced too fast, based on speculation.
There are few tests that you should apply to the pattern before desiding that it qualifies.
First of all, the lead-in (price advice) part of a pattern should be long enough, at least as long as one month. We should be able to draw a support line.
The trendline should not be very steep, otherwise the bump will be hard to identify. Partially, the steepness of a trendline can be adjusted by choosing of the X-scale, of course.
When the bump forms, the angle between old and new support line should be about 50% of the angle between the ols support line and X axe.
We are only looking for bumps that are created by speculation and therefore cannot hold for a long time. According to Bulchovski, the distance from the highest point of the bump to the "old support line" should be at least two times higher than the distance from the highest point of the lead-in phase to the "old support line" (see image below). In English: our bump should be at least two times bigger, than the previous bump.
The volume is average during the price advance. However, as the price drops, the volume goes up.
Cup with Handle Pattern
The Cup with Handle Pattern is a bullish continuation pattern. It was introduced by William O'Neil.
The "cup" part is a pattern, that forms after advance (as it is a continuation pattern, we need a trend to continue), and looks as a "round bottom" formation, which can be rephrased as "a local minimum, but shaped as U, rather than as V".
The "handle" part is a trading range (sideways price movement) that forms after the "cup", and when the resistance of this range is broken, we are getting a signal that the stock is continuing its move.
As with most continuation patterns, the trend should be mature enough, few month is the best. If the trend is too mature, the value of the pattern is less.
Ideally, the depth of a cup should be 1/3 of the previous advance. If the price is volatile, it can be 1/2, or even 2/3. The cup's duration can be 1-6 months (ideally).
The handle is one of consolidation patterns, like the flag, or descending rectangle. It can go down, up to 1/3 of the cup's advance, but the LESS it goes down, the more bullish the pattern is. The handle's duration can be 1-4 weeks (ideally).
As with most breakouts, we should expect increase of volume after the "handle is broken".
Finally, the expected advance is equal the debth of a cup (the distance from the bottom to the right peak).
Rounding Bottom Pattern
The Rounding Bottom is a bullish reversal pattern. It is one of the long-term patterns, that usually takes many weeks to form - you will not find it on the intreday charts.
As it is a reversal pattern, there should be a downtrend to reverse.
The bottom of a pattern is shaped like U rather than V, and takes few weeks.
The right part of the rounding bottom pattern should take about the same time as the left part.
The bullish signal is generated when the price advances above the left high of a pattern.
The volume should decline as the price is declining and rise as price is rising. There may also be an increase in volume at the price breakout.
For a similar pattern, see "Cup with handle".
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