An advantage of chart pattern analysis is that it is always valid. Mechanical trading systems and indicator readings gain and lose their effectiveness over time but proper chart analysis remains consistent. Chart pattern analysis is subjective, however, so practice helps to achieve reliability. Chart patterns do not call market tops or bottoms. In each chart, the analyst waits for a sign, such as a trendline break, to indicate that the trend has actually reversed. Instead of calling tops or bottoms, pattern analysis gives an early indication as to when a new trend has emerged.
In this article, we will cover four important chart patterns – the Rectangle, Right Triangle, Wedge, and Symmetrical Triangle.
A Rectangle pattern is formed when a security fluctuates back and forth in a narrow range. One horizontal line is drawn connecting the highs and another horizontal line is drawn connecting the lows. The upper trendline represents resistance and the lower trendline represents support. The more times a trendline is touched and a reversal occurs, the more powerful its support or resistance becomes. When a Rectangle pattern is forming, the security is often said to be consolidating, or in a trading range.
The direction of the breakout from this pattern cannot be predicted. On the bet that the pattern will continue intact, short-term traders can enter long positions when the security is near its lower support line and enter short positions when the security is near its upper resistance line. Stops are placed just outside the pattern. Most traders, however, wait for the eventual breakout from the pattern. Typically, the longer the security remains in the pattern, the bigger the move after the breakout. Ideally, the breakout comes with heavy volume.
In the image below, beginning in the summer 2002, the market stopped falling and a Rectangle pattern was formed.Trendlines are drawn at the upper and lower extremes of the price range.
Right Triangle Pattern
The Right Triangle is a pattern that exhibits a series of narrower price fluctuations. On one side of the fluctuation, the boundary of price action is horizontal. The boundary on the other side slopes toward the opposite (horizontal) boundary. An Ascending Triangle is a Right Triangle with a horizontal top and an ascending bottom. A Descending Triangle is the reverse.
In most cases, it is the horizontal trendline that is broken in this pattern. Therefore, caution should be exercised when a Descending Triangle is developing. Likewise, be ready to buy long when an Ascending Triangle is developing. If the security breaks the sloping trendline instead of the horizontal trendline, then the resulting move has less significance. If the downward sloping trendline on a Descending Triangle is broken, the stock may only rally to its previous reaction high.
The image below shows a daily chart of the Dow and an Ascending Triangle pattern. Notice the four occasions where the high point on the Dow touched the upper trendline but failed to break through it. Each sell-off, however, was less than the previous sell-off. Since this is an Ascending Triangle, this suggests the eventual break will be to the upside. In fact, that’s what happened.
Unfortunately there are false breakouts where a breakout occurs but the security reverses direction and heads lower. When this happens, the upward sloping trendline can work as a good stop loss. If the security crosses this trendline, positions can be closed.
A Wedge is a pattern bounded by trendlines that are not parallel and that both slope in the direction of the overall trend. The range of the price fluctuation narrows as price approaches the point where the trendlines intersect. Wedges are typically formed after a strong upward or downward move. For a stock in an uptrend, a break below the Wedge means the security should begin a sideways consolidation or move lower. The opposite is true for a downtrending stock. Ideally, volume dries up when the security is in the Wedge and then the breakout occurs on heavy volume.
The image below shows the S&P 500 with a Wedge pattern. Since this is an upward sloping Wedge, the pattern is fulfilled when the lower support trendline is broken. That happened on May 19.
Symmetrical Triangle Pattern
Whereas the Right Triangle has one horizontal trendline and one sloping trendline, the Symmetrical Triangle pattern has two sloping trendlines that form two sides of the triangle. Since they slope in opposite directions, the trendlines intersect somewhere around the middle of the existing price range. That is, the price fluctuates up and down but each move is smaller than its predecessor.
The descending tops in the price movement are defined by a downward sloping boundary line (resistance line) and the low points in the fluctuation are defined by an upward sloping line (support line). The upper and lower lines need not be of equal length.
The image below shows the S&P 500 02/17/09, the day the index broke below the symmetrical pattern. Each rally was less than the previous rally and each decline was less than the previous decline. The S&P 500 eventually fell below its support. The pattern turned bearish and the market continued to fall.
We’ve shown several important chart patterns covering recent market activity. Our examples use weekly, daily, and real-time charts. The length of the chart is significant. A completed pattern on a weekly chart implies a long-term move while a pattern on a real-time chart may forecast a move that will last only part of that trading day.
All of our examples use market indexes. The same patterns work for stocks as well as other traded securities.