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Understand The Best Chart Patterns In 3 Simple Steps

I am a big believer in chart patterns and there are a few that can produce very reliable signals. However, it’s never about the patterns themselves, but what those chart patterns tell you about the market dynamics and how traders move price.

In this article I want to explain how to “decode” any chart pattern so that you will be able to understand price movements in a much better way. In the second part we will take a look at the 4 best chart patterns and how you can use them to make better trading decisions.

 

The 3 components of chart patterns

All chart patterns, whether it’s the Head and Shoulders, triangles, wedges, pennants or the Cup and Handle, are made up of the 3 same components. If you understand how to read those 3 components, you can make much better trading decisions and understand price in a new way.

 

#1 The foundation: highs and lows

Although it sounds very basic, the analysis of how highs and lows shape on your charts builds the foundation of any chart pattern analysis. We will get into the nitty gritty soon, but all future chart analysis is based on understanding highs and lows.

 

Higher highs and lower lows

The first premise is that higher highs signal a healthy uptrend, while lower lows signal a downtrend. We will soon learn about the nuances of highs and lows and get into the advanced concept, but this is the starting point.

 

Lower highs and higher lows

When you see that price fails to make a new high or low, it can serve as an early warning signal that a change in direction is imminent.

The screenshot below shows that price first stopped making lower lows during the downtrend and then even started making higher highs and higher lows. This is a classic trend change pattern and patterns such as the Head and Shoulders or the Cup and Handle are built upon this principle as we will see later.

 

Highs_lows

 

#2 Strength of a trend: length and steepness of trend-waves

The strength of a trend  is defined by the individual trend waves that exist between the highs and lows. Here, you should specifically look at the length/size and the steepness of those individual trend waves to get a feeling for trend strength.

Most conventional chart analysis only focuses on the highs and lows themselves, but an important part is understanding what happens between the highs and lows.

In the screenshot below you can see that the first trend-wave (first black arrow) was very steep and long. The second wave was less steep and shorter in duration. The final third trend wave was much shorter and also just barely broke the previous high – we also saw more price wicks which are another rejection and exhaustion signal. Putting all the clues together, the reversal could have been anticipated by understanding the concepts of trend-wave length and steepness.

length

 

 

#3 Strength of trends II: depth of pullbacks

Once you have identified that price is in a trend, the pullbacks within that trend can provide valuable information of what might happen next.

The screenshot below shows an uptrend with many consolidations and retracements in between. However, just before price reversed into a downtrend, the final retracement was much larger in size and duration, showing that something had changed in buyer-seller sentiment and balance.

Whereas a short and shallow retracement means that the ongoing trend is still intact, when retracements become more frequent and larger in size, it can foreshadow a potential trend shift as buyer and seller balance is slowly shifting.

depth

 

Part 2 – Understanding the 4 best chart patterns

Usually, chart patterns are not that clear cut and far from the textbook examples that you’ll usually find in trading literature or on other trading websites. Thus, it is even more important to understand how to decode chart patterns to make the right trading decisions.

We will now take a look at the 4 most commonly traded and discussed chart patterns and see how our previous 3 principles apply to each one.

 

Triangles

A triangle shows a temporary period of consolidation within a trend or at the beginning of a new trend. During an uptrend, a triangle is formed when the retracements and pullbacks become smaller and smaller; buyers step in earlier each time to push price back up. Triangles are much more reliable during established trends as they signal accumulation of positions before the next trend continuation.

triangle_up

 

Head and Shoulders

A Head and Shoulders pattern signals a potential reversal and by decoding the individual parts of this chart pattern you’ll quickly see how this pattern describes sentiment shifts nicely:

From the left shoulder to the head, price makes a higher high. Often, the left shoulder forms after an ongoing trend and the head is then usually just the last push. Then, the right shoulder fails to make a new high which is the first indication that the trend might be over. The break of the neckline then signals that price is going to make a lower low, confirming the trend reversal.

Being able to interpret highs and lows is all you need when it comes to reading the Head and Shoulders pattern.

headandshoulders

 

Double Top / Double Bottom

Double tops and double bottoms are reversal patterns as well and, similar to the Head and Shoulders pattern, the reasons and underlying dynamics are the same:

The second top, which fails to break the first high, signals that there are not enough buyers to push price higher anymore. Therefore, when you see a double top or double bottom it often signals a shift in price dynamics. If the double top is then followed by a break lower and new lows, the trend shift is confirmed.

double_tops

 

Cup and Handle

The Cup and Handle pattern is also just a series of highs and lows; the Cup and Handle formation below shows a slow transition from a downtrend into a new uptrend. First, you see a series of lower lows, followed by a consolidation at the bottom of the Cup and, finally, price starts making higher highs. When then price breaks the top of the Cup, the uptrend is confirmed. A potential Cup and Handle that does not break the previous highs becomes a double top pattern.

cupandhandle

 

Conclusion: Try to understand what price tells you

As you can see, you can understand and decode all major chart patterns by looking at how highs and lows form, how steep and long trend waves are and how deep retracements are. This knowledge also enables you to estimate the quality of chart patterns and it will help improve your chart reading abilities as well.

Let’s recap what we have learned about the building blocks of chart pattern analysis:

(1) Highs and lows build the foundation of all chart analysis

(2) A first shift in sentiment occurs once price stops making higher highs or lower lows

(3) The length and the steepness of trend-waves define the overall trend strength

(4) The depth of retracement in between trend waves tells you a lot about the balance between buyers and sellers

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24 comments

  1. very cool~~

  2. Hey!

    Very refreshing stuff, but most beginners forget about basics and price language!

    FX Protector

  3. I’m currently studying Bulkowski’s Visual Guide to Chart Patterns. Highly recommended. Bulkowski’s books are one of the best studies of western chart patterns I came across. He isn’t one of those academic traders who teach and write books but never really trade for living. He started trading with 2.000 bucks, made millions trading patters and retired at age 35. His statistical data of success rate for each pattern is priceless.

  4. This is the best of illustrating price action..

  5. excellent article. …especially for one who need to improve his trading for understanding market changing behaviour. …many thanks. ..Azhar

  6. TBH one of the best articles on reading price action, looking beyond the chart patterns and making sense of buyer and seller sentiment. A lot of new traders are looking for text book patterns, they trade them and lose money, coz they don’t understand the price dynamics behind the patterns. When you understand the price dynamics, buyer and seller sentiment behind the patterns, you know what patterns to take and which ones to leave. You know which patterns will break with momentum, you know what patterns might have false BO, because you are not only looking at the patterns, but you understand momentum, buying and selling pressure.

  7. I like your style.
    Thanks guys, its always good to get some advice.
    Best wishes on your travels

    Pat
    In Ireland

  8. I really love your articles. You guys are so refreshing. It really feels you are giving back without any ulterior motives like the many charlatans in this business on the web, preying on the hopes and dreams of others. I have recently found this site and I believe it is a one stop shopping for everything trading. Really great stuff! Thank you and keep up the good work.

    • Hello Michael,

      thanks for taking the time and leaving a comment. Our goal with Tradeciety was to create the highest quality trading education site and provide a different view on trading and the markets. I’m glad that you like our work.

      All the best
      Rolf

  9. Something i shall read again and again for a while, it HAS TO SINK IN. Thanks again Rolf.

  10. nice article, one again!

  11. Your Website layout and content is very good!
    Always clear explanations and a lot of info, for free, that others would charge for!
    Thanks for sharing your ideas and trading tips…much appreciated
    Cheers, Will

  12. Keep up guys, really enjoy your articles, crystal clear and easy to understand.

    Regards,
    Yugal

  13. Very helpful article in understanding price action. Thank you.

  14. Hi, am moved by your service. Appreciate your methods of explaining the basics but important information and that is in simple and easy to follow. May God bless you and your team. Great.

  15. hi,
    are those patterns are usefull for scalpers by using short term chart like 1 or 3 min charts?

  16. Your information is very useful! Thanks to all

  17. hello dear very good article
    may you write for us about the wicks of candlesticks in direction and counter trend and also in top and bottom of it ?

    REGARDS

  18. wow….Good understanding

    can you please help me how to know the early entry?

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