One of the major premises of technical analysis is that history repeats itself. For the technician the recurrence of identifiable patterns and formations that have preceded important movements of the market in the past provide important clues as to the probable direction of price movement in the future. Chart patterns are formations that appear on the charts which provide you with forecasting tools of impending price movement. Some patterns are more reliable than others for price forecasting. . None of the chart patterns are infallible. They have a high probability of success but are not guaranteed to work all of the time. Technicians must always be on the alert for chart signs that prove their analysis to be incorrect. After trend lines, support and resistance lines have been drawn on a chart, one of the most important and most difficult decisions you will have to make is determining the timing of entering and exiting the market as well as determining when a major top in a rising market or a major bottom in a declining market has occurred.
There are two types of patterns that develop on charts, the reversal pattern and the continuation pattern. Reversal patterns indicate that an important reversal in trend is taking place. Knowing where certain patterns are most likely to occur within the prevailing trend is one of the key factors in being able to recognize a chart pattern. Some of the most common reversal patterns include; the head and shoulders top and bottom, double tops and bottoms, triple tops and bottoms, key reversals, island reversals, rounding bottoms and tops, "V" formations or spike bottoms and tops. There are a few important points to be considered which are common to all of these reversal patterns.
1. The existence of a prior major trend is an important prerequisite for any reversal pattern.
If a price pattern has not been preceded by an existing trend, there is nothing to reverse and the pattern would therefore be suspect. Knowing where chart patterns are most likely to occur within a price trend is one of the key factors in identifying price patterns.
2. The first signal of an impending trend reversal is often the breaking of an important trend line.
The breaking of a major trendline signals a change in trend, not necessarily a trend reversal. The breaking of an uptrend line might signal the beginning of a sideways trend which may later form either a reversal or continuation pattern.
3. The larger the pattern the greater is the price movement potential.
The height of the pattern measures the volatility, the width of the pattern measures the amount of time required to build and complete the pattern. The greater the height of the pattern ( the volatility ) and the longer it takes to build - the more important the pattern becomes and the greater the potential for the ensuing price move.
4. Topping patterns are usually shorter in duration and more volatile than bottoms.
Price swings at major tops are wider and more violent. Tops usually take less time to form than bottoms. For this reason it is usually less risky to identify and trade bottoms than tops however the time spent in establishing a top is generally shorter than the time spent establishing a market bottom. Therefore, a market manager can generally do better by trading the downside of the market rather than the upside of the market. This has important implications for farm managers, due to the fact that the natural tendency is to trade the former rather than the latter.
5. Volume is usually more important on the upside
Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume, particularly at market bottoms. Market tops tend to fall on their own weight once a trend reversal is underway. At a market bottom, if the volume pattern does not show a significant increase following the upside breakout, the entire price pattern should be questioned. The second type of chart pattern is the continuation pattern. Continuation patterns suggest that market is only pausing for a while before the prevailing trend will resume. Another difference between reversal and continuation patterns is their time duration. Reversal patterns usually take much longer to form on the chart and represent major changes in trend. Continuation patterns, on the other hand, are usually shorter-term in duration and are often classified as intermediate term chart patterns. Some of the most common continuation patterns include; flags, ascending and descending triangles, symmetrical triangles, pennants, gaps, and rectangles.