Last Updated on 7 September, 2021 by Samuelsson
There are many different trading patterns out there, and it may be quite difficult to learn all of them. But as a trader, you need to learn the most common ones, especially if you intend to learn price action trading.
In this post, we will show you some of the most common trading patterns. In fact, this is the best trading pattern cheat sheet you may ever get. But before we go into the different patterns, let’s understand what trading patterns are and how they come about.
What are trading patterns?
Also known as chart patterns, trading patterns are identifiable structures or shapes formed by a group of price bars over several trading sessions, which may indicate how the price will likely move in the near future. Many trading patterns are formed as price consolidations after a trend in one direction, so they may either indicate a trend continuation or a potential reversal.
While every technical trader can use trading patterns to improve their chart analysis, price action traders mostly base their trading strategies around those patterns as they depend on them to spot trading opportunities. And truly, if you understand how to read those patterns, you can spot profitable trade setups that indicate the footprint of institutional traders.
How trading patterns arise
The trading patterns you see on the charts of various financial markets are created by the action of traders and investors as they are buying and selling their positions in different timeframes. These patterns are often formed by price bars that are clustered around the same level, which implies that the price is consolidating in readiness for a serious move.
A price consolidation is a period when the price trades around the same level or within the boundaries of a range. It forms when institutional investors and traders are either accumulating or distributing positions, so they are not yet ready to push the price in a particular direction. Accumulation implies gradually taking long positions, while distribution implies gradually disposing of their positions. These institutional traders (also called smart money) try to do these quietly.
Accumulation mostly occurs at the end of a downtrend and is followed by the emergence of a new uptrend, while distribution mostly occurs at the end of an uptrend and is followed by the emergence of a downtrend. However, the problem is knowing when each trend is about to end because an uptrend or a downtrend can continue after a consolidation, making it difficult for you to know if it’s an accumulation or a distribution.
Whatever is playing out in a trading pattern, what is clear is that the patterns emerge through buyers’ and sellers’ behavior. Here are a few things that can help you understand them:
- In every trade, buyers and sellers are equal; it is just the price levels that they meet at that change.
- The actions of buyers and sellers create price swings, which can be trending upward (higher lows and highs) or downwards (lower highs and lows) and can be delineated with trend lines
- When the price is moving sideways between two levels, it is said to be in a range — the upper level is the resistance while the lower level is the support.
- Most trends in price are interrupted by trading ranges before the trend continues.
- An important support level in a range is fiercely defended by buyers as they come in to buy at that level whenever the price falls to it.
- The resistance level in a range becomes stronger the more it is defended by sellers who usually try to sell at that level.
- Upward price swings emerge when buyers are willing to take out the sellers at higher price levels and push the price up; the opposite happens for downswings.
- Stocks have patterns of accumulation into weakness during uptrends.
- Stocks have patterns of distribution into strength during downtrends.
- A breakout of a long-term trend trading range or trend line can signal the continuation or reversal of a trend.
Types of trading patterns
In the picture below, you will see some common trading patterns in stock charts. We will discuss some of them. The two major categories of trading patterns:
- Continuation trading patterns
- Reversal trading patterns
Continuation trading patterns
These are called continuation trading patterns because the trend preceding their formation is likely to continue after they are formed. Depending on the trend where the pattern is formed, it can be classified as bullish or bearish. In an uptrend, they are called bullish patterns, but in a downtrend, they are bearish patterns.
Examples of bullish continuation patterns include:
- Bullish flag
- Cup with handle
- falling wedge
- Ascending scallop
- 3 rising valleys
Examples of bearish continuation patterns include:
- Bearish flags
- Descending scallop
- Inverted cup and handle
- Rising wedge
Reversal trading patterns
These are called reversal chart patterns because after they are formed, the trend is likely to reverse. They are classified as bullish reversal patterns when they form at the bottom of a downtrend or bearish reversal patterns when they are formed at the top of an uptrend.
Examples of bearish reversal patterns include:
- Head and Shoulder
- Double Top
- Triple Top (Top Rectangle)
Examples of bullish reversal patterns include
- Inverse Head and Shoulder (diamond bottom)
- Double bottom
- Triple bottom (bottom rectangle)
See the pictures below:
How to trade with these chart patterns
While the trading patterns are easy to spot if you know them, they are not easy to trade because smart money always tries to manipulate things to trap traders in the wrong direction. Generally, the most popular way to trade these patterns is to trade the breakout. But there are many false breakouts, which can trap traders in the wrong move.
So, you need to have a way of know when the breakout is genuine so you can make a trade. Here are clues that can tell you if a breakout is likely genuine:
- The breakout occurs in the direction of a preceding trend if the pattern is a continuation type.
- There was an initial false breakout in the opposite direction
- The breakout happens on a huge volume