What Are the Basic Chart Patterns?

The following sections briefly explain some of the most basic chart patterns used in data analysis.

Volume Chart Analysis

In addition to following price activity, many analysts follow volume patterns to help identify trends and trend reversals. You are able to show volume bars at the bottom of any chart in TradeStation. In this way, you can compare volume levels with price activity. Heavy volume is displayed in larger volume bars than light volume. Volume is important because it gives you a good indication of the strength or weakness of a price trend.

Logically, when a market price is in an up trend, there should be more buying than selling. Conversely, when the price is in a downtrend, there should be more selling than buying. In any valid up trend or downtrend, the volume bars should confirm that trend. For example, in a bullish trend there should be heavy volume.

If the price falls, but is accompanied by heavier than normal volume, the up trend may be losing momentum. Generally, heavy volume should always be in the direction of the existing trend. If not, it may indicate a change in the direction of the market.

Percentage Retracement

One of the basic concepts in data analysis is that history repeats itself. This is the basis for percentage retracement, and the reason why analysts apply studies that identify percentage retracement patterns.

We have learned that price data moves in peaks and troughs, and that trendlines drawn using these peaks and troughs indicate market direction. Intermediate trends are usually corrections to major trends, and near-term trends are usually corrections to intermediate trends. These "corrections" many times retrace the prior trend by a specific percentage amount before resuming the trend in the original direction. This is called percentage retracement.

The most commonly used percentage retracement amount is 50%. For example, a stock that's risen in price from 40 to 80, will often correct and retrace about 20 points (50%) before continuing its rise in price. An investor may want to consider purchasing the stock at the lower price, believing that the stock will soon begin its uptrend again.

In a downtrend, a price often regains half of a prior loss and then resumes its downtrend. Again, an investor may want to go short when the price regains half of this prior loss, hoping that the downtrend will then continue. 

Other retracement percentages that are used are one-third (33%) as a minimum retracement, and two-thirds as a maximum retracement. Some analysts also like to use 38% and 62% retracement percentages, which are based on a number series known as Fibonacci numbers. This series begins with the number 1 and adds each two succeeding numbers together. For example, 1 + 1 = 2, 1 + 2 = 3, 2 + 3 = 5, and so on. There are also other studies that use Fibonacci numbers to determine price movement.

Percentage retracement is frequently used by analysts to help identify buy and sell opportunities, as well as provide fairly reliable support levels.

Reversal and Continuation Patterns

Many chart patterns are very indicative of trend direction, and have been used for many years by chart analysts. Most of them will indicate either a change, or reversal, in trend, or the continuation of the current trend. In fact, the support and resistance level concept is basic in recognizing chart patterns.

This section briefly covers the reversal patterns termed double and triple tops and bottoms, and head and shoulders. These are the most common patterns used to recognize trend reversals. A popular continuation pattern, the triangle, is also covered briefly. All of these patterns only require the ability to spot peaks and troughs on a chart.

  • Double and Triple Tops and Bottoms - In an uptrend, a double top is a price chart with two prominent peaks at around the same high. The triple top is three prominent peaks, meaning that the sideways movement continued longer. If the price closes higher than the prior peaks, the uptrend will probably be resumed. However, if the price declines below its prior peak and begins to weaken, a trend reversal may be beginning.

A double bottom is a mirror of the double top, as well as for the triple top. If a chart shows two or three prominent lows at around the same price, and the price closes above the prior low, a new uptrend may be indicated.

  • Head and Shoulders - Similar to the triple bottom in that it uses three prominent lows. The difference in the Head and Shoulders pattern is the one prominent low in the middle with two slightly higher lows on either side resembling someone standing on their head. This is a bottoming pattern. When a trendline is drawn above the two peaks on either side of the prominent low, and a price breaks through that line, a new uptrend may be beginning. The top pattern is exactly the opposite and is sometimes referred to as an inverse head and shoulders.
  • Triangle - Indicates a market that has risen or fallen too far or too fast and needs to consolidate (or pull back into a more sideways direction). Once the market consolidation is complete, the market usually resumes its prior trend. Because of this, the triangle is referred to as bullish in an uptrend, and bearish in a downtrend.

The triangle can be identified by sideways price activity where the price action begins to narrow. If trendlines were drawn at the peaks and troughs, they would appear to converge. An ascending triangle, considered to be bullish, has a flat trendline at the high end of the price range, while the line along the bottom is rising. The descending triangle, considered to be bearish, has a flat trendline at the bottom with a falling line at the high end of the price range.