Chart patterns are a valuable part of technical analysis but they alone may not be sufficient  to identify trading signals

A clever investor is one who can predict the changing tide and take positions in the stock market accordingly. It is here that chart patterns can come handy in giving an investor the big picture and help him/her identify trends of price movements, either continuation or reversal of the existing pattern of stock price movement. The theory behind chart patterns is that history repeats itself and certain patterns consistently reappear and tend to produce the same outcomes. For example, as market sentiment shifts from optimism to fear, a certain pattern may emerge before traders and investors start selling and send the stock price lower.

The two most popular chart patterns are reversals and continuations that can be found across any time-frame. A continuation pattern signals that the trend will continue once the formation is complete; whereas a reversal pattern signals that a prior trend will reverse upon completion of the formation. However, reversal patterns are not usually sudden and dramatic. When an ‘up’ trend changes to a ‘down’ trend or when a ‘down’ trend changes to an ‘up’ trend, it slows down, pulls back, goes in the direction of the trend and comes back till the trend is reversed slowly. A change in perception of the price of a given stock results in a change in the trend, which in turn alters either demand or supply of these stocks and this eventually moves the stock prices either up or down.

In an ‘up’ trend, demand for a stock slowly increases the price of the stock; whereas in a ‘down’ trend, low demand and high supply of the stock brings the price down. This sort of tug-of-war between buyers and sellers swings prices between optimistic and pessimistic perception levels and invariably creates reversal patterns on stock charts before the trend changes to the opposite side.

Having good knowledge about reversal patterns allows us to speculate positively about the end of a trend. We can square off our position at a right time to book maximum profits. It also allows us to take position in the opposite direction at the right time. On the whole, good knowledge of reversal patterns allows us to have smaller losses and larger profits. Here are some of the common reversal patterns about which an investor must remain vigilant:

Head and Shoulders: This is a pattern that indicates a likely reversal of the trend once it’s completed. A Head and Shoulder top is characterized by three peaks with the middle peak being the highest peak (head) and the other two being lower and roughly equal (shoulders). The lows between these peaks are connected with a trend line (neckline) that represents the key support level to watch for a breakdown and trend reversal.

Double Tops and Bottoms: This formation is easy to recognise and is also one of the most reliable chart patterns. This aspect makes it a favourite for many technically-oriented traders. The pattern is formed after a sustained trend when a price tests the same support or resistance level twice without a breakthrough. It signals the start of a trend reversal over the intermediate or long-term.

Wedges: This pattern is a reversal or, less commonly, continuation formation that’s similar to the symmetrical triangle except that it slants upward or downward. Rising wedges are bearish chart patterns that occur when trend is moving higher, prices are converging and prevailing trend is losing momentum. Falling wedges are bullish chart patterns that occur when the trend is moving lower and prices are converging, which signify that the bearish trend is losing momentum and a reversal is likely. The wedge pattern can be very difficult to identify and trade. This means that it is important to look for confirmations in other technical indicators. For example, most traders watch for a diverging relative strength index or moving average convergence-divergence trend line that confirms a reversal is likely to occur.

Triple Tops & Bottoms: These are reversal patterns that aren’t as prevalent as Head and Shoulders or Double Tops or Double Bottoms. However, they act in a similar fashion and can be a powerful trading signal for a trend reversal. Patterns are formed when a price tests the same support or resistance level three times and is unable to break through.

Rounding Bottom: This is a long-term reversal pattern that signals a shift from a downtrend to an uptrend and lasts anywhere from several months to several years.

Although chart patterns are an integral part of technical analysis, they alone may not be sufficient. Traders should combine these techniques with technical indicators and other forms of technical analysis to maximise their odds of success.

(The writer is Assistant Professor, Amity University)