Chart Patterns Traders and Investors Need to Know

Toni Turner |

stock market etfWhen we look at price patterns on a chart, to a great degree, we can think of them as human behavior plotted on a screen. On a price chart, in a muscular uptrend, we can see emotions ranging from optimism to greed to euphoria. We can also see downtrends that begin with mild anxiety, then morph into fear and downright panic. Yes, I know that a lot of the trading on the NYSE these days is program trading, but it's important to remember that these programs and black boxes were designed by people.

By now, most investors have experienced a fall in the market.. Because of that, I think it is absolutely key for people to understand how to read a very simple price history chart. This applies even to investors using financial planners because nobody has a bigger interest in the success of their money growing than the investors themselves.

Even a simple line on a weekly or monthly chart can tell us if a stock is healthy or not based on its price history. If it is making higher lows and higher highs, then that stock can be regarded as healthy. But if the price reverses from that uptrend and goes down to make lower lows, we wouldn't want to continue to own that particular stock unless we had a really good reason. When you see something falling and making a lower low, you sell first then ask questions later.

So while fundamentals are certainly important, they're elastic. When a nasty headline arrives, stocks of companies with perfectly good fundamentals can be tossed out with the others. .

Price charts give us the history of the stocks we own over a certain period of time. And despite having a connotation of being complicated, they can be made very easy to understand. After all, a price chart is a picture that many times, can be worth a lot more than one-thousand words.

Here are four price chart patterns investors and traders should know.

1. Head and Shoulders Pattern

Head and Shoulders Chart PatternA head-and-shoulders pattern is interesting human behavior on a screen. Typically, it's a top-reversal pattern. We see a stock that moves up in a very nice uptrend and makes a new high. When it pulls back, everyone gets very excited and the people that haven't gotten into the stock yet jump in with a full-court press. So all of these people buying the pullback forces the stock price much higher than the prior high. , If that new high may be runs into resistance, and retraces down to where it was when the first pullback occurred, this forms the left shoulder and the head of the "head and shoulders" pattern.

Now we have to look at volume to see what the stock is up against. If the volume is lower on the right shoulder, this means less people are looking to get into this stock. The right shoulder peak may come up a little bit and even come pretty close to equal the high of the left shoulder, and if the price falls back down again with lower volume, that can be the initiation of a top-reversal pattern known as the head-and-shoulders.

When the right shoulder is fully formed, and it breaks that support, or "neckline", then that's a full head and shoulders and should be recognized as such. At that point, the possibility of a down move certainly exists. But if price doesn't break that neckline, then the object is to not jump in and sell or short sell with both feet, because I've seen many times when this pattern simply turns into a continuation pattern. So you have to be wise. If you're long on the stock and it makes a head and shoulders pattern, you can put a price stop in at support, because it can be lethal when it drops and it can be a big gap. But if it doesn't drop, then usually, it flies higher at a great speed, because there is so many short sellers in that particular anticipation move.

2. Cup and Handle Pattern

A cup with handle pattern can be a top or bottom reversal pattern. William O'Neil, the owner of Investors Business Daily, coined this name because it resembled a coffee cup. For example, a bottom reversal pattern is basically when a stock is consolidating, so it pulls back and scoops out a cup configuration. The price falls down the support and scoops back up, and then it pulls back and up again, and in this case, it etches a little handle on the chart. Basically, this indicates a higher low, which tells us that buyers are coming in and not willing to let the price fall all the way back to the bottom of that cup. Buyers are going to buy it sooner because they're enthusiastic about that stock and will want to take advantage of any pullback. That can be a very positive pattern. Now when the price comes back up to the top of the cup, it forms the completed handle. If it breaks through that to the upside, then it is considered to be a very positive move, and many times the price will go higher from there.

3. Double Tops and Double Bottoms

These are probably some of the most in-your-face, pay-attention kinds of patterns, and quite simply, the double top is just what it sounds like. It's an "M" shape pattern, and is formed when the price rises to a new high, similar to what it does with a head and shoulders pattern. But the key with this pattern is, when it pulls back then tries to retest, there's not enough enthusiasm. So when it gets back up to that point, the buyers aren't willing to pay anymore for the stock, and when they don't want to pay anymore, like anything else in our world, it begins to lose value. Of course, that's when the short sellers come in and that's when people holding this stock begin to get fearful and sell it. All top reversal patterns pretty much end up with a simple premise: If it can't make a higher high--whether it's a brief pullback or something more extended--then it's time to tighten stops and at some point--take profits. A double bottom is the exact reverse of that situation.

4. Triangles, Flags, and Pennant Patterns

Traders use triangles, flags and pennants to find continuation patterns within the context of an uptrend or a downtrend. They're basically resting points. Just as a long-distance runner has to pause now and then for a rest, stock prices in an uptrend or even a downtrend have to pause now and then to rest. When they do, they can form formations called flags, pennants and triangles. We do have top and bottom triangle formations that we can draw, but flags, pennants and triangles, when read appropriately, are helpful to help us spot new potential breakouts or reversals, within the context of an uptrend or a downtrend.

At the end of the day, sometimes , I can study a single chart pattern and identify a bottoming pattern. Upon further observation, I can see a triangle, I can see a cup with a handle, or perhaps an inverse head and shoulders. Once your eyes are trained, you can see all kinds of patterns. The trick is to really take it down to the basics. Can it make a higher high? If it can, it's probably going higher. If it can't, then it's probably going lower, and the reverse is true.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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