Chart Patterns, Exams of Decision Making

Download Chart Patterns and more Exams Decision Making in PDF only on Docsity! Chart Patterns Learning chart patterns might be the fastest way to making consistent money in the stock market. For centuries, the market has displayed the same characteristics, over and over again. After all, it’s all about the buying and selling, supply and demand. Human emotions plotted on a graph in ticks and candles and lines and bars. To that end, the more you learn about these repeatable patterns, the more insight you’ll have. It’s a lot like learning a new language. At first glance, it all seems like gibberish. It’s the patterns that give it meaning. For example, “love” may sound different in another language, but it means just the same. So it is in the market. Learn the patterns of accumulation (buying), distribution (selling), and stalemate (sideways action), and you’ll be well on your way to exploiting opportunities. In this guide to chart patterns, we’ll outline for you the most important patterns in the market: From candlestick patterns to bear traps, triangle patterns to double bottoms, we’ll cover it all. Candlestick Patterns What is a Candlestick? Very simply, a candlestick is a plot of price over time. This can be any time frame. For example, a one minute candle is a plot of every traded price of a stock or asset during that one minute interval. Likewise, a 5 minute candlestick is a plot of all the prices that stock traded in 5 minutes worth of time. This is all very basic information until you realize that candlesticks are telling a story of buyers and sellers during that timeframe. The formation of a candlestick How to Read Candlestick Patterns in Trading The value of candlesticks, which have been around for centuries, is in the story they tell. As you can see from the image above, a single candlestick shows the open, high, low, and close of the price action during that time interval. To the naked eye, this might seem inconsequential. However, to the trained candlestick chart reader, all of that information is very, very useful in decision making. Here’s why. Imagine a stock opens at $1 on a 1-minute candle but gets hit with a lot of selling pressure during the first quarter of the time interval. During the first 15 seconds, it trades below the opening price. This forms the lower wick of the candle. Then, for the next 30 seconds, demand enters and the price of the stock moves higher to $1.50. It is safe to assume that bulls were able to overcome sellers during that time. Bullish or Green Candlestick Although this could be considered an indecision candle, the overall nature of the candle leans to the bullish side. It closed higher than it opened. There are plenty of other types of bullish candlesticks more bullish than this one. For example, a marubozu candle occurs when price opens at the lows (no/small wick) and closes at the highs (no/small wick). We usually consider these very bullish candlesticks in that bulls were in control during the entire time interval. Notice how strong the green, bullish reversal candle is on this chart. It was enough to overcome the entire red candle preceding it — and the wicks are super tiny. This tells us demand was strong during the formation of the candle. Bullish reversal candles For more examples like this one on bullish candlestick patterns, check out our guide to the 6 best bullish candlestick patterns. Bearish Candlestick Chart Patterns Contrary to bullish candlesticks, bearish candlestick patterns are just what you would assume. They reveal that bears were in control during the time interval that the candle pattern was formed. Likewise, they may represent a reversal pattern after a strong uptrend, or a continuation pattern during a downtrend. For bearish candlesticks, we assume the price opens higher than it closes. In other words, bears took control at some point after the open of the candle and pushed price lower as the candle formed. Here’s an example of what this might look like: Bearish candlestick formation Beyond just candlesticks, there are many bearish candlestick combination patterns. These create a series of candles which produce a bearish “event,” per se. They could be parabolic reversals, tweezer tops, abandoned babies, evening stars, or other unique patterns. Hammer Candlestick Patterns Hammer candlestick patterns are somewhat similar to shooting stars in that they often signal reversals. In fact, they can be bullish or bearish depending on the context. Hammer candlestick patterns As you can see, a hammer candlestick pattern often signals a reversal of a downtrend, much like a shooting star does on the opposite end of a trend. Both hammers and shooting star candles look the same, don’t they? In the Hammer candlestick pattern example, we have sellers capitulating into stronger hands who buy up their shares. This leaves a long bottoming wick, and signals a reversal. To take this trade, you simply buy the breakout above the hammer candle after it is formed, risking to the low of the wick. Inverted hammer patterns can also signal reversal in a downtrend. It simply means that sellers were not able to continue pushing the stock price lower. Once they realize this, they give up and begin covering their positions, pushing the price higher. For more on how to trade hammer candlestick patterns, check out this guide. Doji Candlestick Patterns Doji candlesticks are often referred to as indecision candles. They can show up red or green on a chart, but aren’t exactly considered bullish or bearish. They typically indicate a stalemate between both forces. Like the example above, what you typically find in a doji candlestick is a very narrow body with wicks on either end. Similar to what we discussed above, this informs the chart reader that both bears and bulls created a tug-of-war while this candle was forming, and neither really won, despite the candle closing green or red. However, if you spot the doji candlestick pattern in certain contexts, it might signal a reversal. We discuss this in our tutorial on dojis. Here are a few examples of where you might see doji candlesticks, and how they differ from the large marubozo style of candlestick patterns: Comparably, doji candles are narrow-bodied with long wicks. Ideally, you’ll want to wait until the next candle forms after a doji to make a decision as to who has the upper hand – bull or bears. This will keep you safe in your trading decisions. Here is an example of a gravestone doji reversal pattern: Triangle Patterns What is a Triangle Pattern? Triangle patterns are a collective of candles that form a general chart pattern over time in the formation of a triangle. They can be ascending triangles, descending triangles, or symmetrical triangles. For all intents and purposes, the simple way to spot one of these is to draw a trend line across the top and bottom of the most recent price action of the stock in play. If you find that stock coiling into an apex, it is likely forming a triangle pattern. These can be called by different names. Some like to call them pennants, others like to call them wedges. Aside from maybe a few nuances here or there, they are all basically the same — chart patterns that resembles a triangle. Triangle patterns How to Read a Triangle Chart Pattern Triangle patterns begin with broader price range and volatility. Over a period of time, they contract into an apex on lower volatility and narrowing price range. This is accompanied with a series of higher tops and higher bottoms, or lower tops and lower bottoms or a symmetrical sideways pennant of lower highs and higher lows. Some variances to this can occur, like a flat base or flat top. Regardless of the formation specifics, the goal as a trader is to determine the path of least resistance once the stock leaves the formation. Along those lines, we typically see ascending triangles resolve downwardly; descending triangles usually resolve upwardly. Volume and price action are also key in how to read a triangle pattern. Every chart pattern should tell you a story, much like candlestick patterns. Are bulls absorbing downward pressure in a descending triangle? Or, are bears selling to the bulls in an ascending triangle? Each pattern will show you, if you look intently enough, the path of last resistance on the horizon. Once you spot it, the triangle pattern gives you a great risk to reward setup for your trade plan. Let’s look at each type of triangle pattern a bit more in depth. Descending Triangle Patterns The descending triangle pattern is one of the most recognizable chart patterns in trading. It usually forms as a reversal at the end of a down trend or as a continuation pattern in an uptrend. It offers a chance for bulls to reload after profit taking in a stock. Often labeled a descending wedge, it is important to note that the stock can resolve in either direction, up or down. For that reason, it’s always best to respect your stops. However, it is generally assumed to be a bullish pattern. In our tutorial on descending triangles, we teach you a handful of ways to trade this pattern. One of the most popular is the breakout strategy. In this strategy, you wait for the stock to put in a series of volatility contractions, then buy on the breakout of the upper trend line. Similar to the volatility contraction pattern we discuss in our best small account strategy, it can lead to big gains under the right circumstances. Here are a few chart examples of what to look for in a symmetrical triangle pattern. Symmetrical triangle false breakout In this example we have a false breakdown. As you can see, it is sometimes difficult to judge such a tight pattern. However, as the pattern evolved and reclaimed, you could flip your bias and risk off the most recent low for a long trade. Here’s an example of managing your risk and setting your targets for the symmetrical triangle pattern: Symmetrical triangle pattern breakout In this example we measure the widest part of the triangle and apply it to our breakout in order to set our 1st target zone. For more advanced early entry techniques, take a look at our explanation of VDU and Pocket Pivots for this strategy. The Double Bottom Pattern aka the W Pattern Trading the W pattern, or the double bottom, can be very lucrative and give you a definable area to risk off of. It is one of the more highly recognizable chart patterns in stock trading. After all, who doesn’t know what a “W” looks like? What is a W Pattern / Double Bottom? The W pattern is a consolidation pattern where a stock essentially retests a support area twice. Hence the “double bottom” name associate with the pattern. Usually you’ll find this pattern as a pause in an uptrend, or as a bottoming pattern in a downtrend. The double bottom signals to potential traders that the stock is having a hard time making new lows. As a result, long- biased traders may take advantage of the opportunity by buying the stock and risking off the support of the “W”. It’s also fair to mention that if you are familiar with the double top pattern, this is essentially the mirror image of that strategy. We discuss this strategy in depth in our tutorial here. How to Read a W Pattern / Double Bottom Chart Pattern There are many different schools of thought on how to read a double bottom, but we think it best not to overthink it. Some educators like to see the second dip of the “W” slightly undercut the first dip. Others may not require this. At the end of the day, what you’re looking for is a support area to form, whether the second dip is lower or not. Ideally, you want to see volume peak as the W pattern bases along the two “troughs” of the pattern. What this tells us is that weak hands are selling here, while stronger hands are absorbing their shares and supporting the stock. This will likely lead to higher volume along the lows. As the second trough of the double bottom forms, it should immediately be on your radar. You might also look for longer term support from any prior high volume bars from prior high volume days. These are often footprints of larger position holders who may decide to support their position here. We discuss this in a recent podcast episode on the Simcast regarding vwap boulevard. Trading the Bullish W Pattern / Double Bottom Chart Pattern For obvious reasons, the double bottom is considered a bullish chart pattern. There are never 100% certainties in the markets, however. And that is why it is always best to implement stops, and respect them! Let’s look at an example of where you could enter a bullish Failed double bottom pattern On the other hand, if you’re looking for a topping pattern, the double top is a great strategy to add to your arsenal. Much like the double bottom, a bearish double topping pattern fails after a retest of the highs. Ideally, you’ll take the trade short on the break of the signal line, setting your stop at the high of top #2. Double topping chart pattern This is another example from PLTR. As the stock runs up, it is clear that selling pressure is present given the amount of wicks on the candles. After the first sign of weakness, PLTR makes a failed attempt to set new highs in Top 2. This traps breakout buyers and then the bid is pulled. The path of least resistance is obviously downward from then on. Like our double bottom pattern, we would initiate a position on the break of the red signal line, set our stop at the highs, and measure the move for a potential target zone. More can be found on this setup in our W pattern guide found here. Golden Cross Chart Patterns The golden cross is a bit unlike some of the chart patterns we’ve already mentioned in that it requires two moving averages. In fact, you could almost trade without candles using this chart pattern, though we don’t recommend doing that. What is a Golden Cross Stock Pattern? A golden cross occurs when a stock’s faster moving average crosses a slower moving average to the upside. For this reason, golden cross stocks are usually found after they have been in a correction for a while. There is also a very specific set of moving averages involved in this strategy. The golden cross occurs when the 50 period moving average crosses above the 200 period moving average. This is typically seen on a daily chart, but it can also be found on smaller time frames like the hourly, 30-minute, or even intraday 1, 2, or 5 minute charts. It signals to trend followers that the current correction in a stock or the market could begin a new uptrend. How to Read the Golden Cross in Stock Trading? In order for a golden cross to occur, the 50ma must — obviously — be trading below the 200 moving average. To that end, you expect to see this happening in the context of a downtrend. Price is trading lower than it was 200 days ago. And along those lines, the faster 50ma will be below that longer time frame average. When the cross occurs, it signals to investors that momentum could be shifting. Couple this with other chart patterns like the double bottom we mention above, and you may find even more confirmation for your strategy. Ideally, you’d like to see the speed of upward movement on the shorter time frame overtaking the longer time frame’s rate of change. When this occurs, it may be time to buy. That being said, there are three stages of a golden cross that you should understand. moving average, you expect it to remain that way for some time. Take for instance this example of a golden cross in TSLA: TSLA Golden Cross Example TSLA’s golden cross in 2019 lasted until July of 2021 and resulted in an over 1000% increase in price by the time the 50ma crossed back below the 200ma. That’s a massive gain! Obviously, this won’t happen all the time, but it goes to show that a solid trending environment with a strong stock can create a really lucrative golden cross pattern. That being said, the golden cross strategy lasts only as long as the 50ma crosses above and stays above the 200ma. For this reason, you may get false signals in the early stages of the new uptrend, or along the way depending on how strong the uptrend is. Golden Cross Cheat Sheet Signals Although the golden cross pattern is pretty straight forward, here are a few examples for you to use as a cheat sheet when trading. You need to know that the opposite pattern of the golden cross is the death cross. In an uptrend, the 50 moving average crossing below the 200 moving average is a signal to longer term traders that the trend might be changing in the opposite (bearish) direction. It becomes your sell signal. Here is an example of using this strategy to complete your golden cross trade: Golden and Death Cross Buy/Sell Signals Although you wouldn’t have timed the top of CMG in this example, it is clear that you would have gotten the “meat of the move” from the original buy signal. Hopefully it is clear that a solid trending environment works best for this chart pattern. There are some caveats and other ways to manage your position, like trendline breaks, or selling at prior resistance levels. However, if you want to stay true to the trend following strategy, you’ll buy on the golden cross and sell on the death cross. For more information on trading this strategy, be sure to read our in-depth post on golden crosses. Bear Trap Chart Patterns Bear traps may conjure images of famous fur trappers and mountain men like James Beckwourth or Jedidiah Smith, but these men weren’t as deadly to brokerage accounts as bear trap chart patterns are. SOLY Bear Trap As SOLY began trading lower than the 11-1:30pm trading range, it retested the underside of that key level. From that point, the stock reclaimed the trading range and never looked back. In other words, bulls saved the stock and trapped the bears. The rest of the day, bears did their best to mitigate their losses by covering and fueling the stock price higher. To trade this, you want to set a trendline at the lows of the trading range that broke down. IF the stock reclaims 50% of the kill candle, take your long position and risk to the most recent lows. Example 2 In this example, we’ll point out a popular personality on Twitter who goes by AllDayFaders. He’s recognized the traps often over the years and explains them well in this thread: $AMC update on the "you gon learn today" setup. Do u think shorts learned or nah? pic.twitter.com/2CY8FzEHhx — AllDayFaders (@team3dstocks) May 27, 2021 As you can see, it is better to wait for the failed retest if you’re a short biased trader. Example 3 Often times, if you can combine multiple strategies, it will help your odds of success. In this 30m chart of Google, we see a bear trap combined with a hammer candlestick pattern. This gives us clear evidence of an impending reversal after a failed breakdown. Google bear trap and hammer candle Not only do we get a hammer candle reversal, but it comes on the heels of a descending triangle pattern as well. What better way to combine as many chart patterns as possible in order to create your trade thesis. And that’s exactly what you should be doing. Combining chart patterns and elements of trading together only increases your chances of success. If you’d like to learn more about the bear trap stocks pattern, please visit our detailed tutorial here. Chart Patterns Summary and Cheat Sheet As you can see, there are many different types of chart patterns in the stock market. We recommend taking your time while educating yourself with many of the resources we’ve listed here. Keep in mind that successful trading is a marathon, not a sprint. Not all chart patterns will work for you. For that reason, we always preach risk management. Learn to be wrong when the market doesn’t go your way. It will save you the headache and heartache of big drawdowns in your account. For more information on chart patterns, check out many of the resources here at TradingSim.com. Also, be sure to sign up for our 7-day free trial and practice these chart patterns in the simulator with no risk! We’ll leave you with this chart patterns cheat sheet of many of the more popular chart patterns.