This is a continuation of our article about chart types. Before we look at the patterns and how to predict market movements, it is a good idea to give this first article a read.
What is a Chart Pattern?
“Patterns are the distinctive formations created by the movements of security prices on a chart. A pattern is identified by a line connecting common price points (such as closing prices, highs or lows) over a period of time. Chartists try to identify patterns to anticipate the future price direction.” Investopedia
Technical Analysis is based on the assumption that history repeats itself, certain trading patterns that develop over the years tend to repeat themselves over and over again. These charting patterns tend to signal a high probability of a move in the forex market.
Importance of Chart Patterns
Chart patterns are heavily used in the financial industry and it’s important to understand how to use them. All the same, only use chart patterns if you’re convinced that they are created by the psychology of the market participants. Any information or data that is put into a chart will create patterns. Understanding the psychology behind the pattern of the pair you’re trading can make the difference between your success or failure. We need to believe that behind each pattern there is a psychology because if we doubt the psychology behind it, we can’t trade any patterns as we’re going to lack the confidence to execute our trades.
Types of Candlestick and Bar Patterns
Candlestick and bar patterns come in all varieties and shapes. However broadly speaking, we can say that candlestick patterns fall into one of two categories:
- Reversal Patterns: They produce a change in the direction of the prevailing trend, which can be bullish or bearish.
- Continuation patterns: They continue an overall long-term trend in the price and occurs in the middle of the trend. Simply put, it’s a pause in the trend.
Reversal and continuation patterns are useful because you can figure out whether the currency pair will keep going in the direction of the preceding trend, or whether it’s going to reverse direction. Nothing is set in stone because a reversal pattern 70% of the time might be a continuation pattern as well.
You can see these patterns at the top of an uptrend before reversing back down, or at the bottom of a downtrend before reversing back up. The basic principles behind reversal patterns are as follows:
- There must be an existing trend to reverse. If you spot a pattern on a chart you must be sure that the pattern actually means something.
- The size of the pattern must be related to the size of the move.
- Generally, in an uptrend, the reversal pattern happens quickly while in a downtrend it is slow.
The most common reversal patterns include Head and Shoulders, Pin Bars and Bullish/Bearish Engulfing Outside Bar.
Head and Shoulder Pattern
The best-known reversal pattern is the Head and Shoulder (H&S) pattern. It describes the emotions of the markets and how they are changing. The H&S pattern has a neckline that connects the first and the second troughs while the first and the third peaks are the Left Shoulder respectively the Right Shoulder. The H&S that occurs at the end of a downtrend is called an Inverse H&S pattern.
Pin Bar Patterns
A Pin Bar is a sharp reversal in price and it’s characterized by a long shadow or tail that generally has a small body. A bearish Pin Bar pattern signals the end of a bullish trend while a bullish Pin Bar signals the end of a bearish trend.
Bullish/Bearish Engulfing Outside Bar
The engulfing outside bars as the name suggest occurs when the second candle engulfs or cover completely the previous candle, where its high is greater than the previous bar’s high and where its low is lower than the previous bar’s low.
A continuation pattern is just a breathing space in a trend and as its name suggests it indicates that the trend is likely to continue. We mentioned before that sometimes these patterns can act as reversal patterns as well. The volume is important and can make the difference between whether the pattern is a reversal pattern or a continuation pattern. Going forward you’re going to learn the most common continuation patterns, which are: Triangles, Flags, and Rectangles.
The triangle pattern is a very powerful yet extremely simple formation in the Forex market that has the shape of a triangle. Triangles can be defined as a converging of the price range between two trendlines. There are three basic types of triangles:
Triangle patterns comes in different shapes and vary in their duration, but the main characteristic is that as the price continues to compress, eventually it will reach the climax of the triangle, thus making the breakout possible.
Flag patterns are continuation patterns that come after a strong up or down move and consist of a flagpole as the strong move to the downside/upside followed by a consolidation phase or a narrow range which is known as the flag.
The Rectangle pattern is a symmetrical formation where the price action moves sideways between two parallel lines that act as support and resistance. Its main characteristic is that the price hits the level of support and resistance several times before the breakout occurs in the direction of the prevailing trend.