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Chart patterns

In the chapter about trend, it was mentioned how important is to identify trend in its early stages. Some techniques were described, like trend lines, support and resistance, channels etc. Recognition of the chart patterns is higher level of technical analysis.

Trend consists of series of peaks and troughs, which can move up, down or horizontally. Techniques from previous chapter (trend lines, support and resistance ...) are focused on upward or downward trend. Recognition of chart patterns is focused on horizontal movement.

Trend reversal is not immediate, it takes a certain time of transition. After transition process trend will probably reverse, but it could happen that transition is only pause in current trend. Chart patterns are used to analyze these transitions (horizontal movement).

Patterns can be classified as reversal patterns and continuation patterns. For both of them trading volume is extremely significant. In fact all patterns must be confirmed by volume. If pattern is not confirmed by volume it must be ignored.

All reversal patterns have certain common attributes:

  • The existence of the primary trend
  • Signal for trend reversal is usually a penetration of some trend line
  • As larger the pattern is, price change would be greater
  • Patterns related to tops are shorter than those relating to the bottoms
  • Patterns related to the bottoms usually have lower price changes
  • In most cases volume is more important for bottoms then to tops

The existence of the primary trend is necessary, because otherwise there would not be anything to reverse. It often happens that some chart pattern is identified, but before pattern is formed there was no trend on chart. In that case, there is nothing to reverse and pattern should be ignored.

The first sign of trend reversal is penetration of some trend line. But we should bear in mind that penetration does not necessarily mean a trend reversal. The trend may continue to move horizontally, and then to continue the original direction.

The larger the pattern is, it will cause greater price changes. Size of pattern is determined by its height and width. Height demonstrates price deviation and the width time needed for pattern creation. This means that if the deviation is higher and/or time needed for pattern creation is higher, pattern will cause a greater price change.

Patterns related to tops are usually shorter, but with larger amplitude of price changes. Therefore, it is easier to identify the bottoms then tops. However, tops are much more significant, because prices fall faster than they grow.

Trading volume is important for all patterns. Pattern can not be completed if there was no increase in the volume, but the importance of volume is higher when prices are rising.

Continuation patterns, unlike the reversal patterns, usually have a smaller width because they need less time to be created.

It should be noted that in study of patterns, and technical analysis in general, frequently are used words: usually, often, etc. This is because the conclusions of technical analysis are not strict rules. There are always exceptions, so that the presence of certain pattern cannot guarantee some behavior. We can only assume that something will probably happen, but it does not necessarily mean it would happen.

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