In an attempt to decipher what the future holds, a major component of using charts to analyse market behaviour and mood is the identification of price patterns, as they can help you predict what is to come. Caution is needed, since the human eye is predisposed to seeing shape association and as a consequence the risk is that patterns are ‘read in’ before they have completed, but price shapes generally fall into two distinct categories.

When a pause occurs within a move which then reasserts itself this is known as a continuation pattern. Most easily seen on a bar chart, they develop as the market takes a rest so as to draw breath roughly midway into a rise or fall and can test the overall strength of a trend. By measuring the vertical distance the market had covered before the pattern started to appear and then extending that distance from the breakout point, a target price level can be established.

The majority of such events are best described as mimicking either a flag or a pennant in shape. The former will develop as prices start to trade downwards after an uptrend or upwards after a downtrend. Price action will be contained within a relatively narrow channel to produce a parallelogram shape reminiscent of a flag fluttering from a flag pole. As the pattern finishes and prices regain the trend, it becomes evident that the flag is flying at half-mast. A pennant only differs from a flag in that the price action traces out a small triangle shape before it continues in the direction of the original trend. Typically flags and patterns play out relatively quickly and can give strong signals on intra-day charts too.

Rectangles can behave either as a continuation or lead into a trend change. Action develops between two distinct price levels and over time a ‘block’ can be seen on the chart that itself might offer up the opportunity for range trading as distinct support and resistance price levels become apparent. Targets from rectangle patterns are derived from the width of the rectangle along with similar techniques that are applied to flags and pennants.

Turning points

In contrast to continuation features, tops, bottoms and head-and-shoulders patterns signal turning points. A head-and-shoulders consists of three points, the middle one of which makes, in the case of a top, a higher high than either its preceding or following peaks. The reverse is the case for inverse head and shoulders moves seen at bottoms.

To guard against the risk of second-guessing such patterns it is wise to await the break of the intervening price valley in the case of a double top, or the peak for a double bottom. For triple tops and bottoms, along with head and shoulders patterns, the technique is to draw in a neckline that connects the two price valleys (or peaks) that occur as the pattern develops. A break of this neckline indicates the pattern is complete. Price targets are generated by extending the maximum ‘height’ of the pattern from its neckline, away from the move through it and in the opposite direction.

On very rare occasions, head-and-shoulders patterns can prove to be a continuation formation. This occurs when the neckline is not properly broken. Aggressive traders opening a trade as the right shoulder develops can steal a march on the market and increase the potential profit but must therefore deploy a protective stop, so that if the price breaks through the right shoulder (or trough in the case of an inverse head and shoulders bottom) and the pattern is a failure as a turning point then losses can be contained.

A protracted triple-top pattern in Admiral (ADM) presaged a steep decline in 2011 before a double bottom towards the end of the year highlighted a chance to make gains in the early months of 2012.

The long rise in Aggreko (AGK) during 2009 and 2010 was punctuated by continuation patterns. Whilst a pennant failed in May (FP) the converging edges of the shape were good guides as to where to initiate a trade. November saw a flat-bottomed pennant (P) develop after a decent rise. This was followed by a rectangle (R) while a flag (F) gave a good indication of the eventual high.

An inverse head-and-shoulders pattern in Lloyds (LLOY) completed in late 2012 as the price shot through the neckline (N). The derived target was the extension of the vertical distance between the ‘head’ low and the neckline.