By Richard K.
Introduction to Trading Patterns Technical Analysis
Many people think that price action on a chart is completely random but anyone who has been trading long enough would tell you that there is a wide range of trading patterns that repeat themselves in any market and on any time frame.
The trading patterns we will be looking at in this article only focus on trading patterns that are associated with corrections i.e. patterns that develop counter-trend before the main trend continues again.
There are plenty of corrective trading patterns out there but making a serious study of only a handful of the most common ones and understanding their characteristics can seriously benefit any trader that would like to take their trading to the next level.
What is Technical Analysis?
Technical analysis describes price action interpretation using historically relevant price patterns and behavior. These past behavior patterns can help determine the potential for the future price action of a given asset.
Who Uses Technical Analysis?
Anyone investing in the stock market or other assets can use technical analysis and chart patterns to sid their trading strategy. If you have money in a position prone to price movement, technical analysis can help you better understand that price movement.
Why Are Stock Chart Patterns Important?
At their most basic level, stock patterns reveal characteristics about price action that helps traders shape their trading strategy. These patterns occur across all time frames. Whether daily, monthly, or yearly these patterns tend to repeat themselves, giving traders access to critical data that helps them formulate their strategy.
Recognizing these patterns gives you a slight competitive advantage compared to traders who ignore them. Of course, these patterns are not immune to fluctuation, but there’s no debate that technical analysis gives traders more insight into the effectiveness of their trading strategies.
Just as volume, support and resistance levels, RSI, and Fibonacci Retracements levels provide insight into your trades, so too can these chart patterns. The following chart patterns are just a few of the most common traders use to develop their trading strategy.
Essential Stock Trading Analysis Patterns
The ascending triangle is a bullish continuation pattern showing a potential breakout where the triangle lines converge. Drawing this pattern requires you to place a horizontal line (resistance) on the resistance points and to draw an ascending line (uptrend) along with the support points.
The descending triangle is the opposite of the ascending triangle, a bearish pattern that you can depict by drawing a downward trend line in opposition to the support points. You can also occasionally see descending triangles at a reversal point during upward trends. However, it is still considered a continuation pattern.
Both falling and rising wedge patterns are reversal patterns. They represent a tightening price movement between the support and resistance levels. Unlike the triangle patterns, the wedge has two upward trend lines instead of the horizontal trend line. They have either two upward trend lines or two downward trend lines.
The falling wedge depicts a potential breakthrough for the resistance and the rising wedge potentially signifies a breakthrough in support levels.
Cup and Handle
The cup and handle is one of the most notable chart patterns and it is a continuation pattern signifying a bullish market trend. You can recognize the cup and handle by identifying an extended downturn followed by a return to support levels and a subsequent slight dip. This pattern forms a cup (downward trend) and the handle, which is a potential breakout signal.
The flag forms as a sloping rectangle. This rectangle forms when support and resistance lines run parallel until a breakout point. The breakout typically occurs in the opposite direction of the established trendlines. These elements constitute a reversal pattern.
Corrective Trading Pattern Types
There are plenty of corrective patterns in the world of technical analysis and they are named by all weird and wonderful names but the only technique that I have come across that sets out to understand corrective patterns and their inner workings is known as Elliott Wave Theory (EWT).
It is true that EWT can be very subjective in nature, especially when applied to trending markets where analysts attempt to determine where a new trend may begin or an existing trend may end. When EWT is applied to corrections only, knowing that it’s underway within a trend can be very useful in understanding when such a correction might end.
We will next have a look at how corrective patterns are structured, after which I will show you a few cool techniques I use to further define them.
EWT lists 4 main categories for corrective patterns:
- Zigzags(with three variations: single, double, triple);
- Flats(with three variations: regular, expanded, running);
- Triangles(with four types: ascending, descending, symmetrical, expanding);
- Double threes and triple threes (combined structures).
I will be the first to admit that following so many types of corrections is a difficult task, so instead, I only follow the first 3 categories with the ones I consider being the most common. I highlighted them in bold and will give you a quick overview of each.
1. ZigZag Corrections
The simplest corrective pattern is a ZigZag and it unfolds in what EWT calls waves. A ZigZag has 3 main waves and they are labeled A-B-C. EWT then goes further and states that each wave, in turn, moves in smaller waves of 5-3-5 i.e. 5 waves for wave A, 3 waves for wave B, and 5 waves again to complete wave C.
Using a much smaller chart in an attempt to decipher the 5-3-5 wave structure of the larger ZigZag shows the best way to label this correction BUT this is where most people have issues with EWT as it can be very subjective and most analysts will differ in their “correct” wave labeling, especially when it comes to identifying the smaller waves.
Labeling waves in hindsight is easy, doing so in real-time is a different story! It’s for this reason that I use other tools to help me define wave structure and assist me with finding the end of these corrections more accurately. We will cover how this is done later.
There also exists a more complex ZigZag correction, which is named a Double ZigZag. This pattern is very common and can look confusing at first glance but all that is happening here is two single A-B-C ZigZags that follow in succession. They are connected by an (X) wave and the entire correction is labeled (W)-(X)-(Y).
Many analysts, including myself, believe that the decline in Gold from mid-September to mid-December 2017 was a Double ZigZag. One can be forgiven when feeling overwhelmed by this complexity but as I stated earlier, we will have a look at additional techniques to help us clear up the confusion later on.
2. Expanded Flats
The second category of corrective patterns I follow is the Expanded Flat correction. There are 3 variations of flat corrections but I only follow this one. You will note that this correction also unfolds in 3 waves labeled A-B-C. EWT states that each wave can be sub-divided into smaller waves of 3-3-5.
Looking at a smaller time frame shows my attempt to label this correction properly with the smaller wave structure of 3-3-5. These patterns start with 3 waves down, which could be mistaken for a simple ZigZag pattern but when price moves upwards again it only does so in 3 waves which generally ends at the same level that started the correction or slightly higher before it comes crashing down again.
In our example, wave B slightly exceeded the start of the correction after which the price came down hard again with a lot of selling pressure. These are all characteristics of expanded flats and they can be notoriously difficult to trade but with some knowledge of their characteristics and the use of other techniques, we can once again find ways to help us pinpoint the end of such a violent move before the main trend resumes again.
3. Triangle Corrections
These are my absolute favorite corrections to follow as they make for high probability setups with a high winning percent ratio. The triangular nature of these corrections is easy to spot and they can form in either a symmetrical fashion or have a flat top or bottom, depending on which way the major trend is moving.
The chart above shows a Symmetrical triangle that formed a while back in AUD/USD. Symmetrical triangles form when price action moves sideways in a symmetrical fashion and they have 5 individual waves labeled as A-B-C-D-E.
Using a smaller time frame once again shows the smaller waves that create the larger waves. EWT states that each wave within the triangle can be sub-divided in 3 smaller waves labeled a-b-c.
In our example, the triangle ended with the E wave before the trend continued its upward move again. What is important to note here is that there are measurable characteristics that define triangle corrections very well, making it possible to forecast the possible end of the E wave ahead of time.
I included an example of an Ascending triangle just to show that the shape of this triangle has a flat or horizontal top instead. A descending triangle will have a flat bottom. One thing that remains constant between all triangles is that their A-C-E waves “stair steps” higher/lower. This phenomenon can be very useful when measuring the characteristics of a triangle!
Techniques That Help Define Trading Patterns
Judging by our chart examples above it should become evident that labeling these corrections like an expert Elliott Wave technician can be a very difficult task, especially in real-time and not in hindsight. I, therefore, use additional techniques to guide me in my decisions and they have proven themselves to be very accurate when determining the most likely areas where a correction might end.
I use market geometry and Fibonacci ratios to define corrective patterns without the need to be worried about the exact or right way to label corrections. Let’s next to have a look at the same chart examples above, but this time overlaid with market geometry and Fibonacci ratios.
My preferred market geometry tool is the Pitchfork and it is readily available on most trading platforms. Pitchforks work well to define future price movement or to find the likely areas where a correction might find support/resistance before reversing.
The blue lines of my pitchfork are called median lines and the red ones are called warning lines. They all run parallel to each other at equal distances. There are also various settings that can be used for a pitchfork, I prefer the Schiff setting when used with corrective patterns.
Using the high that started the correction and connecting the A and B waves to each other afterward is what projects the pitchfork lines at an angle into the future. Corrections have a high probability of ending at either the lower blue median lines or lower red warning lines.
So rather than worrying about the exact smaller EWT labeling of the waves, all I’m interested in is seeing my C wave end at, or very near to one of those lower median or warning lines. Knowing just a little bit of EWT, using this ZigZag example would have stopped you from taking an entry when the price hit the lower blue median line the first time around because it was only possible to count 3 waves into that line. Remember that wave C’s unfold in 5 waves, so when the price came down once again it reversed immediately around the lower red warning line, completing the C wave in 5 waves.
Above we have our Gold double ZigZag chart we looked at before and this time around the Schiff pitchfork became useless in finding the end of the second ZigZag.
I like to measure each ZigZag on their own rather than the entire Double ZigZag. Doing just that time the end of the complex Double ZigZag to perfection, right at the end of the (Y) wave at the lower warning line!
I very rarely use pitchforks on expanded flat corrections as these corrections tend to overshoot median lines and warning lines most of the time. I prefer to use Fibonacci extensions measured from the start of the correction to the A and C waves, therefore, projecting extensions lower.
These corrections also end in C waves and very often at or near the 1.618 or 1.786% fib extensions. In our example above we can see that price undershot the 1.786% fib but if one used a standard pitchfork in this example, then timing that low would have been easier.
Expanded flats require some skills to enter as they normally end in reversals that start just as violently as they ended. I use special entry conditions to help me with this issue but this is another topic for a different article.
When analyzing triangles I use orange trend lines to define their shapes BUT using Fibonacci retracements work perfectly well to find the ends of each individual wave that make up the triangle as a whole.
Our chart example above shows how the 0.786% Fib retracement caused the price to stop at that level before the next wave started. Knowing that a triangle has 5 waves it was possible to determine with a high degree of accuracy where the final E wave could end.
This article dealt with the corrective trading patterns that I look for and trade on a daily basis. They form an integral part of my overall strategy which aims to find the end of corrections within a trend. I like trading the end of corrections with very little risk exposure while aiming for targets that far exceed my risk when a trend resumes again.
I only touched on some of the components that I use and there are many more interesting techniques that I employ, such as:
- Multi-time frame analysis.
- Determining Trend.
- Where a correction is most likely to occur.
- Identifying a correction.
- Defining a correction.
- Specific entry condition rules.
- Trade management.
If you are interested in knowing how I combine all of these elements together with trading patterns into one powerful strategy then be sure to check out my course here.
I wish you a successful and profitable trading journey ahead!
All the best