Trading patterns refer to distinctive formations that appear on trading charts of individual stocks. Such patterns show up as transitions between rising and falling trends caused by price swings.
Pattern recognition is at the core of technical analysis, which focuses on trying to predict prices based on patterns that happen as stocks move up and down. The pattern recognition process involves tested methods that have proven to lead to profitable trades over the years.
Trading patterns can occur at any point while trading stocks. Spotting the various types of patterns requires learning to identify them, then practicing on smaller trades. There are three basic types of trading patterns.
Types of Trading Patterns
Continuation Trading Patterns
Continuation trading patterns are a set of chart patterns that affirm a prevailing trend, be it bullish or bearish. Often referred to as consolidation patterns, they indicate a consolidation period prior to sellers or buyers resuming control and pushing the price in a given direction.
Common continuation patterns include Pennants, which are formed using two converging lines, where flags are drawn using two parallel trend lines. Then there are wedges, which are constructed using two converging trend lines, angled either up or down.
Bullish Continuation Patterns
Bullish continuation patterns indicate that the price of the underlying stock is likely to continue moving higher once the consolidation phase comes to an end.
Bearish Continuation Patterns
Bearish continuation patterns occur when prices are running lower, followed by a period of consolidation. After some time, sellers resume control, pushing prices lower.
Bilateral Trading Patterns
Unlike continuation trading patterns that indicate price would ultimately move in one direction along a prevailing trend, bilateral chart patterns signal that price might move in any direction.
When the above-listed chart patterns occur in a chart, then the price could break in either direction, be it on the upside or downside. Technical analysts leverage these trading patterns by placing orders on top and at the bottom of the formation so as not to miss whichever direction the price decides to break. Once one price order is triggered, then cancellation of the other order usually comes into play.
Reversal Chart Patterns
Occasionally the price will reverse from a dominant trend and start going in the opposite direction. For instance, if the price was moving upwards in a chart, it might hit a point of resistance, then start retreating on huge volume, indicating a sharp reversal.
Should a reversal trading pattern form during an uptrend, it would indicate that the price will likely starting retreating lower. Likewise, when a reversal chart pattern forms during a downtrend, the price is likely to start moving up.
Below are some of the patterns commonly used to signal a possible reversal in the direction of trade.
Bearish Reversal Patterns
Double-top chart patterns are some of the best examples of bearish reversal patterns. Such trading patterns come in the form of two short-term swings higher, followed by a near-term high, followed by reversals lower each time. When a double-top chart pattern occurs, it will take the form of two brief forays into new high ground, two failures to break out, then a reversal lower.
Head-and-shoulders patterns also signal a bearish reversal. In this case, that reversal takes the form of two smaller price movements surrounding a larger price movement, with a silhouette that resembles a head and shoulders. When a head-and-shoulders pattern occurs, it’s a strong signal to sell a stock.
Bullish Reversal Patterns
Double-bottom chart patterns are essentially the flip side of double-top patterns. With a double-bottom, a price chart will resemble a W. An ideal double-bottom chart pattern sees the middle of the W trace higher than the midpoint of the overall pattern, but without hitting a new high. After that, the price heads lower, then shoots back up, setting up a potential breakout.
Bounces off the 50-day moving average occur when a stock’s price heads lower, then finds support at the line running through the chart that shows the stock’s 50-day moving average. When that bounce occurs, it’s often a sign that the near-term downtrend is over, and that a positive price rebound is on the way.