A chart pattern is a combination of support and resistance levels formed by candlesticks in a specific shape that helps define whether the market will move in the same direction or change.
There are two types of technical analysis patterns: reversal and continuation.
Reversal Chart Patterns
The type name explains the idea of reversal patterns. These patterns predict that the trend will change in the opposite direction after its formation. If the price goes down, a reversal chart pattern indicates that the market will go up soon. If the market goes up, a reversal pattern sends you an alert that you should close a long position and be prepared, as the market will soon go down.
Reversal chart patterns predict that the trend will soon change in the opposite direction.
Let's make a list of the most effective and famous reversal chart patterns:
- Head and Shoulders and Inverted Head and Shoulders
- Double Top and Double Floor
- Triple Top and Triple Bottom
Although chart patterns look different, it’s important to highlight one key rule for reading their signals. To define a take-profit level, measure the distance between the support and resistance levels at the point where the pattern starts to form. It will be the distance between the entry point and the take profit level. The entry point is the place where the price breaks the support or resistance level depending on the trend.
As for the stop loss level, there is the idea of counting the distance between support and resistance levels and dividing it by two. The concept suits the best risk/reward ratio of 1:2. However, it’s good that you evaluate the market conditions and use a trailing stop loss in case of an uncertain situation.
Continuation Chart Patterns
Continuation chart patterns appear when the current trend stops. This is why they are sometimes called "consolidation patterns". Trend lines serve as support and resistance levels. They occur on the chart when buyers and sellers cannot compete with each other and the price consolidates for a while. These patterns show that the market will continue to move in the same direction.
Continuation chart patterns appear when the current trend pauses but continues to move in the same direction later.
Take a look at the list of the most famous continuation chart patterns:
- Pennants or flags
- Wedges: ascending and descending
- Triangles: ascending, descending, symmetrical
For most patterns, the trading idea is similar. You should draw support and resistance lines and count the distance between them at the point where the pattern starts to form. This is the size of the area between the entry point and the take profit level.
As with reversal patterns, the entry point occurs when the price breaks the support or resistance level with respect to the prevailing trend.
The stop loss level is different. To define the size of the risk you are about to take, place the stop loss above resistance for bearish patterns and below support for bullish patterns.
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