If candlesticks are the alphabet and indicators are the punctuation, then Chart Patterns are the full stories written by the market. A chart pattern is a distinct formation on a stock chart that creates a trading signal or a sign of future price movement.
The magic of chart patterns lies in **human psychology**. Thousands of traders see the same shape forming, and they all react in the same way (buying at a breakout or selling at a breakdown). This creates a self-fulfilling prophecy. In this module, we categorize patterns into three types: **Reversal, Continuation, and Bilateral.**
1. Reversal Patterns: The Changing Tides
Reversal patterns signal that the current trend is exhausted and about to flip. These are the most profitable patterns because they allow you to enter at the very beginning of a new move.
A. Head and Shoulders (H&S)
The "King of Reversals." It consists of three peaks: a left shoulder, a higher peak (head), and a right shoulder. The line connecting the lows of these peaks is the Neckline.
Psychology: Buyers tried to push the price higher (Head), but failed to sustain it. The Right Shoulder shows that buyers have lost all conviction.
B. Double Tops and Bottoms
A Double Top looks like an "M" shape. The price hits a resistance level twice and fails both times. A Double Bottom looks like a "W" shape and signals a bullish reversal.
The Signal: Enter on the break of the "Middle V" point.
Patterns work best when they are "obvious." If everyone sees the Head and Shoulders, everyone puts their orders at the same spot, creating massive momentum.
70% of breakouts return to touch the "breakout line" before taking off. This is called a retest. Patient traders wait for this for a safer entry.
2. Continuation Patterns: Taking a Breath
Continuation patterns occur in the middle of a trend. They indicate that the market is taking a "temporary break" to consolidate before continuing in the same direction.
A. Flags and Pennants
These are the strongest continuation signals. After a sharp move (The Flagpole), the price moves in a tight sideways range (The Flag).
Psychology: Early buyers are taking profits, but new buyers are so aggressive they won't let the price fall far.
B. Rectangles
A rectangle forms when the price is bounded by horizontal support and resistance. It represents a "tug of war" between bulls and bears. When the box finally breaks, the move is usually explosive.
Rule: The minimum target of a pattern is usually the height of the pattern added to the breakout point.
3. Bilateral Patterns: The Great Uncertainty
Bilateral patterns indicate that the market is winding up like a spring. The price could break in either direction. The most famous example is the Symmetrical Triangle.
- Ascending Triangle: Flat top, rising bottom (Bullish bias).
- Descending Triangle: Flat bottom, falling top (Bearish bias).
- Symmetrical Triangle: Both sides narrowing (Wait for the break).
4. The Volume Confirmation Rule
A pattern is only as strong as the volume supporting it.
The Rule: When the price breaks out of a pattern, volume must spike. If the price moves above a resistance line but volume is low, it is likely a **Bull Trap** (False Breakout). The big institutions use high volume to push the price through a level; without them, the move won't last.
Don't just buy because a line was touched. Look for a **strong candlestick** (like a Marubozu or Engulfing) that closes outside the pattern. The "Close" is the only price that matters in professional pattern trading.
5. Target Calculation (Measured Moves)
How do you know when to take profit? Use the **Measured Move Theory**.
If a Double Bottom is ₹20 deep, your profit target should be ₹20 above the breakout line. If a Flagpole is ₹100 tall, your target after the flag breakout should be another ₹100. This provides a mathematical framework for your risk-reward ratio.
Summary of Module 5
- Reversal patterns (H&S, Double Top) help you spot the end of a trend.
- Continuation patterns (Flags, Pennants) help you join an existing trend.
- Volume is the mandatory fuel for any valid breakout.
- Always look for the **retest** of the breakout level for the highest probability entry.
- Use the **Pattern Height** to set realistic profit targets.
Now that you can identify high-probability setups using patterns, you need one final piece of the puzzle. Trading is not just about finding winners; it's about not losing your capital when you are wrong. In the final module, we master **Risk Management & Trading Psychology**.