The Most Reliable Chart Patterns

The Most Reliable Chart Patterns

By: George Angell

The following is an excerpt from Small Stocks, Big Profits 

In seeking a reliable chart pattern, a chart analyst will typically look to what worked best in the past.  When he finds such a pattern he will look for a similar configuration in analyzing potential stocks to buy.  As a rule, the propensity to identify tried-and-true patterns creates a sort of self-fulfilling occurrence: because a stock generates a bullish pattern, buyers rush in and the stock rises.  Therefore, if a pattern proves profitable, the investor will attempt to recreate the same model again.  He will do this until he begins to lose money.  He will then begin to look for another pattern. While there are no “sure-thing” patterns, there are commonly acceptable ones that routinely appear on price charts.  As a novice chartist, you will want to be familiar with the following widely-watched chart patterns:

• The head-and-shoulders: One of the most reliable of all patterns, the head and shoulders, as the name suggests, appears as two well-defined “shoulder” with an extended “head” on the charts.  Chartists also attempt to identify the “neckline” which runs under the shoulders.  This neckline must be penetrated for the move to begin.  Occasionally, the market will break and return to the neckline prior to the real move occurring – the so-called “return move.”  A reversal pattern, the head-and-shoulders can signal a top or bottom.  The bottom reversal pattern will have the head point down and the top reversal patterns will have the head pointing upright.  With a little experience, these patterns are easy to spot.  As a general rule, a breakout from the neckline will carry the same distance as the distance between the top of the head to the neckline.  The time to start monitoring the head-and-shoulders pattern is when it is two-thirds formed – after the completion of the head. Once the second shoulder is formed it is simply a matter of buying or selling the breakout – or waiting for the return move to the neckline to place your position.  Because most low-priced stocks are better buying candidates than selling candidates, you are probably better off looking for a head-and-shoulders bottom to a top.

• The saucer bottom: This is a compelling bottom pattern because it takes a long time to form and is easy to spot.  In a saucer formation, prices trade essentially sideway for a prolonged period, creating a gentle scoop like one would see in a soup dish.  Finally, prior to the breakout, the pattern is characterized by a “handle” formation.  The breakout from the handle is usually powerful. Saucer bottoms require the investor to be patient.  This pattern is also known as a cup-and-handle.

• Rising and falling wedges: These tend to be continuation patterns, way stations where prices hesitate prior to resuming the prior trend.  Formed in the shape of a wedge, these continuation patterns give one time to exit profitable positions or initiate a new position before the inevitable upward or downward trend continues.

• Ascending, descending and symmetrical triangles: The best way to characterize triangles is to say that they become tightly wound prior to the breakout.  In a triangle, prices are gyrating back and forth in tighter and tighter ranges as the apex is approached.  At the apex, prices break out higher or lower depending on which pattern is occurring. In the ascending triangle, prices rise up to the resistance as they approach the apex; in the descending triangle, prices trade near the support prior to breaking down; lastly, in the symmetrical triangle, prices trade in a narrow range near the middle of the triangle as they approach the apex.  The breakout signals the direction of the move.

• Double and triple bottoms and tops: These can be the most significant of all chart patterns.  A double bottom occurs when prices trade to a key support level twice.  They then bounce off that level.  The reverse is true of a double top where prices bounce down from a resistance level.  Triple tops and bottoms are even more important.  The rule is that on the third attempt to penetrate a support or a resistance, the price must go.  Otherwise, if the support or resistance holds, prices will go in the opposite direction.

• Gaps: Gaps can be a powerful pattern.  Used by so-called momentum investors, who rely on high-volume breakouts to pinpoint opportunities, gaps can signal when a stock is poised to run – or, in some instances, when a price move is exhausted.  The particular stage of the price move is reflected in the names given to gaps, such as breakaway, continuation, and exhaustion gaps.  In each of these gaps, be careful if you are planning to utilize the gap as a justification for taking a position.  Whereas the breakaway gap is often a legitimate buy signal, the exhaustion gap, as the name suggests, can be quite the opposite.