Chart Patterns
Building on trend lines and support/resistance, chart patterns are specific formations that signal either a reversal or a continuation of the current trend.
Reversal Patterns
Reversal patterns signal a change in trend direction. They form at the end of an existing trend.
| Pattern | Prior Trend | Signal | Description |
|---|---|---|---|
| Head and shoulders | Uptrend | Bearish reversal | Three peaks: left shoulder, higher head, right shoulder; breakdown below the neckline confirms reversal |
| Inverted head and shoulders | Downtrend | Bullish reversal | Three troughs: left shoulder, lower head, right shoulder; breakout above the neckline confirms reversal |
| Saucer (rounding bottom) | Downtrend | Bullish reversal | Gradual, U-shaped transition; represents slow accumulation by buyers |
| Inverted saucer (rounding top) | Uptrend | Bearish reversal | Gradual, inverted-U-shaped transition; represents slow distribution by sellers |
Head and Shoulders - The Most Tested Pattern
- Considered one of the most reliable reversal patterns
- The neckline connects the two troughs (for a head and shoulders top) or two peaks (for an inverted head and shoulders)
- The pattern is only confirmed when price breaks through the neckline with increased volume
- Without the neckline break, the pattern is not complete
How to Read It
- Left shoulder forms during the existing trend
- Head forms: a higher peak (top) or lower trough (bottom) than the shoulders
- Right shoulder forms: similar height to the left shoulder
- Neckline break: the confirmation signal
Exam Tip: Gotchas
- A head and shoulders pattern is NOT confirmed until price breaks through the neckline with increased volume. Just seeing three peaks does not complete the pattern. The neckline break is the trigger.
- Head and shoulders at a market TOP = bearish; inverted head and shoulders at a market BOTTOM = bullish.
- Saucer (rounding bottom) = bullish; inverted saucer (rounding top) = bearish.
Memory Aid: Head and shoulders: Top pattern = bearish (the market is "headed" down) | Inverted = bullish (the market is "picking its head up")
Continuation Patterns
Continuation patterns signal that the current trend will resume after a temporary pause.
- Consolidation: A temporary pause in the prevailing trend; prices trade in a narrow range before continuing in the same direction
- Flags and pennants: Short-term continuation patterns that form during sharp price moves
- Flag: A small rectangle that slopes against the prior trend
- Pennant: A small symmetrical triangle that forms after a sharp move
Exam Tip: Gotchas
- Consolidation means the trend will CONTINUE, not reverse. Flags, pennants, and consolidation patterns all signal a temporary pause before the prior trend resumes.
Stabilization
- Occurs when a new issue's price is supported in the secondary market by the managing underwriter
- A legal form of price manipulation permitted under SEC rules during the distribution period
- The stabilizing bid must be at or below the public offering price
- Purpose: prevent the new issue's price from falling below the offering price during the initial distribution
Exam Tip: Gotchas
- Stabilization by an underwriter is LEGAL during the distribution period. It looks like price manipulation, but SEC rules explicitly permit it for new issues.
- The stabilizing bid must be at or below the public offering price (never above it).