What Are Chart Patterns?

Market participants buy and sell securities for many reasons: the hope of gain, fear of loss, tax consequences, short-covering, hedging, stop-loss triggers, price target triggers, fundamental analysis, technical analysis, broker recommendations, etc. Determining why investors buy and sell can take time and effort, so making sense of chart patterns can help.

Chart patterns put all buying and selling into perspective by consolidating the forces of supply and demand into a concise picture. This visual record of all trading provides a framework to analyze the battle between bulls and bears. More importantly, chart patterns and technical analysis help determine whether bulls or bears are winning the battle. This allows traders and investors to position themselves accordingly.

In many ways, chart patterns are more complex versions of trend lines. So before continuing, it's important to read and understand Support and Resistance levels and Trend Lines.

Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly, or monthly, and the patterns can be as short as one day or as long as many years. Gaps and outside reversals may form in one trading session, while broadening tops and dormant bottoms may require many months to form.

The head and shoulders pattern in the chart below took seven months to form.

The pattern in CIENA Corp. (CIEN), on the other hand, formed in a single day.

Much of our understanding of chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, Technical Analysis and Stock Market Profits, laid the foundations for modern pattern analysis. In Technical Analysis of Stock Trends (1948), Edwards and Magee credit Schabacker for most of the concepts put forth in the first part of their book. We would also like to acknowledge Messrs. Schabacker, Edwards and Magee, and John Murphy as the driving forces behind these articles and our understanding of chart patterns.

Pattern analysis may seem straightforward, but it is no easy task. Schabacker states:

“The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula.”

Even though Schabacker refers to “the science of chart reading”, technical analysis can at times be less science and more art. In addition, pattern recognition can be open to interpretation, which can be subject to personal biases. To defend against biases and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions drawn. While many patterns may seem similar in nature, no two patterns are exactly alike. False breakouts, bogus reads, and exceptions to the rule are all part of the ongoing education.

Careful and constant study is required for successful chart analysis. In the earlier example of the head and shoulders reversal pattern in AMZN, the stock broke below the neckline of the head and shoulders. This is a bearish signal, but you must continue your analysis to confirm the bearish trend.

Some analysts might have labeled the pattern in the chart below as a head and shoulders pattern with neckline support around 17.50. Whether or not this is robust remains open to debate. Even though the stock broke neckline support at 17.50, it repeatedly moved back above its support break. This might be considered a sign of strength, which would warrant a reassessment of the pattern.

Two basic tenets of technical analysis are that prices trend and history repeats itself. An uptrend indicates the forces of demand (bulls) are in control, while a downtrend indicates the forces of supply (bears) are in control. But prices don't trend forever, and as the balance of power shifts, a chart pattern begins to emerge.

Certain patterns, such as a parallel channel, denote a strong trend (see chart below). However, most chart patterns fall into two main groups—reversals and continuations. Reversal patterns indicate a trend change and can be broken down into top and bottom formations. Continuation patterns indicate a pause in trend and that the previous direction will resume after some time.

Just because a pattern forms after a significant advance or decline does not mean it is a reversal pattern. Many patterns, such as a rectangle, can be classified as either reversal or continuation. Much depends on the previous price action, volume, and other indicators as the pattern evolves. This is where the science of technical analysis becomes the art of technical analysis.