Chart formations will greatly help us spot conditions where the market is ready to break out.
This a head and shoulders formation, except it is upside down. A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
With this formation, we would place a long entry order above the neckline. Our target is calculated just like the head and shoulders pattern. Measure the distance between the head and the neckline, and that is approximately the distance that the price will move after it breaks the neckline.
You can see that the price moved up nicely after it broke the neckline.
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. In my experience, when the slope is down, it produces a more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is about the size of the distance between the head and the neckline.
Double bottoms are also trend reversal formations, but this time we are looking to go long instead of short. These formations occur after extended downtrends when two valleys or “bottoms” have been formed.
The price formed two valleys because it wasn’t able to go below a certain level. Notice how the 2nd bottom wasn’t able to significantly break the 1st bottom.
This is a sign that the selling pressure is about finished, and that a reversal is about to occur. In this situation, we would place an entry order above the neckline.
A double top is a reversal pattern that is formed after there is an extended move up. The “tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off it slightly, but then return back to test the level again. If the price bounces off of that level again, then you have a DOUBLE top!
Two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
As you probably guessed, descending triangles are the exact opposite of ascending triangles. In descending triangles, there is a string of lower highs which forms the upper line. The lower line is a support level in which the price cannot seem to break.
The price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers. Now most of the time, and we did say MOST – the price will eventually break the support line and continue to fall.
However, in some cases the support line is too strong, and the price will bounce off of it and make a strong move up.
The good news is that we don’t care where the price goes. We just know that it’s about to go somewhere. In this case we would place entry orders above the upper line (the lower highs) and below the support line.
This type of formation occurs when there is a resistance level and a slope of higher lows. What happens during this time is that there is a certain level that the buyers cannot seem to exceed. However, they are gradually starting to push the price up as evident by the higher lows.
The buyers are starting to gain strength because they are making higher lows. They keep putting pressure on that resistance level and as a result, a breakout is bound to happen. Now the question is, “Which direction will it go? – Will the buyers be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the price will break out past the resistance. However, it has been my experience that this is not always the case. Sometimes the resistance level is too strong, and there is simply not enough buying power to push it through.
Symmetrical triangles are patterns where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle. What is happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend. If this was a battle between the buyers and sellers, then this would be a draw.
Neither the buyers nor the sellers could push the price in their direction. When this happens we get lower highs and higher lows. As these two slopes get closer to each other, it means that a breakout is getting near. We don’t know what direction the breakout will be, but we do know that the market will break out. Eventually, one side of the market will give in.
This type of activity is called consolidation.