Common Chart Patterns and their Failures

Common Chart Patterns and their Failures

This article provides a comprehensive introduction to common chart patterns used in Technical Analysis and discusses their potential failures. It's geared towards beginners in trading and investing, aiming to equip them with a foundational understanding of these patterns and the importance of risk management.

Introduction

Chart patterns are visual formations on a price chart that suggest future price movements. Traders and investors use these patterns to identify potential trading opportunities. They are based on the psychology of market participants and the historical tendency of prices to behave in certain ways. However, it's crucial to understand that chart patterns are *not* foolproof predictors of future price action. They are probabilistic indicators and can, and often do, fail. This article will cover several common patterns, detailing their formation, the signals they offer, and the common reasons for their failure. Understanding these failures is as important as recognizing the patterns themselves. We will also touch upon the importance of Confirmation before acting on any pattern.

Understanding Trendlines and Support/Resistance

Before diving into specific patterns, a firm grasp of trendlines and support/resistance levels is essential.

Trendlines: These are lines drawn connecting a series of highs (downtrend) or lows (uptrend). A broken trendline often signals a potential trend reversal. However, trendlines are subjective; different traders may draw them slightly differently.
Support Levels: Price levels where buying pressure is strong enough to prevent the price from falling further.
Resistance Levels: Price levels where selling pressure is strong enough to prevent the price from rising further.

These foundational elements underpin the formation and interpretation of many chart patterns. A strong understanding of Volume Analysis can also help validate these levels.

Reversal Patterns

Reversal patterns signal a potential change in the current trend.

1. Head and Shoulders

Formation: Characterized by three peaks, the middle peak (the "head") being the highest, and the two outer peaks (the "shoulders") being roughly equal in height. A "neckline" connects the lows between the shoulders.
Signal: A break below the neckline suggests a bearish reversal, indicating a potential downtrend.
Failures: False breakouts are common. The price might dip below the neckline but quickly recover. This often happens with low volume. Also, a strong bullish trend can sometimes push through the right shoulder, invalidating the pattern. Fibonacci Retracements can provide potential target levels upon a confirmed break.
Risk Management: Don't enter a short position until a clear break *and* close below the neckline is confirmed, ideally with increased volume.

2. Inverse Head and Shoulders

Formation: The inverse of the Head and Shoulders pattern, appearing in a downtrend.
Signal: A break above the neckline suggests a bullish reversal, indicating a potential uptrend.
Failures: Similar to the Head and Shoulders, false breakouts can occur. A strong bearish trend can prevent the price from breaking above the neckline. Look for confirmation via Moving Averages.
Risk Management: A confirmed break and close above the neckline, with rising volume, is crucial.

3. Double Top

Formation: The price attempts to break a resistance level twice, failing both times, forming two peaks.
Signal: A break below the support level connecting the two peaks suggests a bearish reversal.
Failures: The price can sometimes momentarily dip below the support level before rebounding. A strong bullish catalyst can invalidate the pattern. Consider using the Relative Strength Index (RSI) to gauge overbought conditions.
Risk Management: Wait for a confirmed break and close below the support level.

4. Double Bottom

Formation: The inverse of the Double Top, appearing in a downtrend.
Signal: A break above the resistance level connecting the two bottoms suggests a bullish reversal.
Failures: False breakouts are common. A strong bearish catalyst can prevent the price from breaking above the resistance. Pay attention to MACD divergence for potential confirmation.
Risk Management: Confirm the break above the resistance level with increasing volume.

Continuation Patterns

Continuation patterns suggest that the current trend will continue after a period of consolidation.

1. Flags and Pennants

Formation: These are short-term consolidation patterns that resemble a flag or a pennant, respectively. They form after a strong price move.
Signal: A breakout in the direction of the original trend signals a continuation of the move.
Failures: Breakouts can be false, and the price can reverse direction. These patterns are often unreliable on their own and should be used in conjunction with other indicators. Bollinger Bands can help identify potential breakout points.
Risk Management: Look for a breakout with increased volume. Place a stop-loss order just below the pattern's lower trendline (for bullish flags/pennants) or above the pattern's upper trendline (for bearish flags/pennants).

2. Triangles (Ascending, Descending, Symmetrical)

Formation: Triangles are formed by converging trendlines.

   * Ascending Triangle:  A horizontal resistance level and an ascending support level. (Bullish)
   * Descending Triangle: A horizontal support level and a descending resistance level. (Bearish)
   * Symmetrical Triangle:  Converging trendlines, neither horizontal nor perfectly angled. (Neutral – breakout direction determines trend)

Signal: A breakout from the triangle in the direction of the prevailing trend signals a continuation.
Failures: Breakouts can be false. The price might test the breakout level before reversing. The pattern can sometimes resolve into a reversal instead of a continuation. Elliott Wave Theory can sometimes help explain the formation of these patterns.
Risk Management: Confirm the breakout with volume. Use a stop-loss order just below the pattern (for bullish triangles) or above the pattern (for bearish triangles).

3. Rectangles

Formation: A price consolidates between parallel support and resistance levels.
Signal: A breakout from either the support or resistance level suggests a continuation of the previous trend.
Failures: Often, the price will 'fakeout', briefly breaking one level before reversing. The pattern can also resolve into a reversal. Consider using Ichimoku Cloud to assess the overall trend strength.
Risk Management: Wait for a confirmed breakout with volume and a close outside the rectangle.

The Importance of Confirmation and Risk Management

As repeatedly emphasized, chart patterns are not guaranteed to work. Here’s a breakdown of crucial considerations:

Confirmation: Never trade solely based on a pattern’s appearance. Seek confirmation from other technical indicators, such as volume, moving averages, RSI, MACD, or oscillators. A breakout should ideally be accompanied by increased volume.
Risk/Reward Ratio: Always calculate your potential risk and reward before entering a trade. Aim for a risk/reward ratio of at least 1:2 or higher.
Stop-Loss Orders: Always use stop-loss orders to limit your potential losses. Place your stop-loss order at a level that would invalidate your trading idea.
Position Sizing: Never risk more than a small percentage of your trading capital on a single trade (e.g., 1-2%).
Context is Key: Consider the broader market context. Is the overall market bullish or bearish? What is the news sentiment? Market Sentiment Analysis can be valuable.
Beware of Noise: Short-term price fluctuations can create false signals. Focus on the overall trend and filter out the noise.

Common Reasons for Pattern Failure

Beyond the specific failures mentioned with each pattern, several overarching factors contribute to pattern failures:

Low Volume: Breakouts with low volume are often unreliable.
News Events: Unexpected news events can disrupt market patterns.
Market Manipulation: Large traders can manipulate prices to create false breakouts.
Over-Optimization: Trying to find perfect patterns can lead to over-optimization and inaccurate predictions.
Subjectivity: Pattern recognition is subjective, and different traders may interpret patterns differently.
False Breakouts: The most common failure. The price briefly moves beyond a key level before reversing.
Lack of Follow-Through: A breakout occurs but lacks the momentum to sustain the move.

Conclusion

Chart patterns are valuable tools for identifying potential trading opportunities, but they are not a magic formula for success. Understanding their limitations and incorporating sound risk management principles are crucial for long-term profitability. Remember to always seek confirmation, manage your risk, and be prepared for the possibility of failure. Continuous learning and adaptation are essential in the ever-evolving world of trading. Further research into Trading Psychology will also greatly improve your success rate.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners