Just as the shape of individual candlesticks are visual representations of investor psychology, the patterns that several candlesticks form do so as well.
If you buy a book on Amazon, or Google search for some articles about chart patterns, chances are, you’re going to be confused.
For the novice trader, studying chart patterns can feel like grade-school all over again. You’re studying these arbitrary shapes that you’re supposed to memorize without any of the necessary contexts.
Patterns have weird names like Symmetrical Triangle or Fifth Wave Extensions. Authors often use unnecessary jargon like ‘subwaves,’ ‘amplitude,’ or ‘wedge,’ which make no sense to the uninitiated.
Plain and simple, chart patterns, like candlesticks, are a visual representation of investor psychology. Some patterns repeat themselves through history, whether you’re looking at the price of gold in the 15th century or a chart of the hottest new unicorn IPO.
Technology hasn’t changed investor psychology. The only difference is that there’s more noise in the data nowadays from automated trading.
Let’s take a look at a few profitable stock chart patterns.
Head and Shoulders Pattern
The head-and-shoulders is probably the most well-known chart pattern out there. It’s a reversal pattern, which means that this pattern is betting on the reversal or failure of a previously defined trend.
Let’s remove ourselves from the visual pattern and shape of the head-and-shoulders and try to understand what’s going on in human terms.
The head and shoulders is a trend failure pattern. This means that the previously defined trend, downtrend in the above example, fails when the H&S is successful.
Let’s bring our attention to Shoulder #1 and the Head. Cover the rest of the chart with your hand. At this point, the bears are still in control, and the downtrend is working out well.
It’s around Shoulder #2 where bears get in trouble. A higher-high is made (along the neckline). This is indicating that bulls are getting more aggressive and threatening the status of the downtrend. Then, a higher low is made in Shoulder #2, further weakening the downtrend.
The head & shoulders pattern is simply a visual representation of a trend reversing or failing. When price breaks through the neckline, the pattern is confirmed, and H&S traders have entered their positions.
A Note on Reversal Patterns
It should be noted that the term “reversal pattern” can be a bit misleading. When a trend ends, it doesn’t necessarily mean a new trend in the opposite direction immediately begins. It’s more likely for there to be a significant counter-trend move, then sideways consolidations for a while before a new trend begins.
The flag pattern got its name because the pattern’s price action resembles a flag on a flagpole.
Flags are trend pullback patterns. This means that you’re taking advantage of a momentary pause in the prevailing trend to hop aboard the trend.
Take a look at the above example. It’s an ideal bearish flag pattern. The steep red line is the ‘flagpole,’ and the green price channel is the ‘flag.’ When price breaks to the downside of the green price channel, traders short the stock and close the trade at the consolidation marked in black.
Let’s again remove ourselves from the jargon and visuals of the chart pattern and break down what’s really going on.
In the above example, at the very beginning of the chart, the stock is within a downtrend and has just made a sharp downward move. Because stocks hardly move in a straight line, the stock pulls back a bit and drifts higher (as marked in the green).
Note that the pullback’s price action is considerably less aggressive than the price action of the flagpole.
As for exit strategies, there are dozens of ways to skin a cat. One way that works well is to stop a stop loss above the flag, and wait to see what the market gives you if the trade works out well, exit when the momentum slows down.
A good flag setup will be harmonious with the longer-term trend. A Bearish Flag Pattern should be matched by a downtrend on the daily/weekly chart to maximize your probability of success.