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Stock Trading by Chart Patterns

Updated on March 20, 2013

Stock Trading by Chart Patterns: A Form of Technical Analysis

Stock trading by chart patterns is a learned skill, and it takes time to develop the “instincts” necessary to recognize a potentially profitable chart pattern. Many people debate whether or not trading by price charts even works, but I can tell you from personal experience that it works, and it works well. Trading by chart patterns falls within the field of “technical analysis”, which is a style of stock trading. What I mean by “chart patterns” is that every stock that’s currently traded on the open markets (NYSE, NASDAQ, AMEX, etc.) has a history of price activity. This price activity is simply the amount of dollars (or cents) per share a stock is fluctuating up or down on a given trading day. Any time a stock’s price doesn’t stay still, it’s a good thing for a stock trader. Those who are more well-versed in the stock market can tell you that you can make money in the stock market whether the price is going up OR down. All you really need is good price movement, and this can best be discovered by looking at a stock’s price chart.

GOOG chart image courtesy of BigCharts.com
GOOG chart image courtesy of BigCharts.com

Why Study Price Charts and Chart Patterns?

The whole point of observing price charts is to recognize common price movements that have a tendency to reoccur. Once you get good at recognizing these reoccurring patterns, you can somewhat “predict” what direction the stock’s price will move next. I say the word “predict” very cautiously, because nobody will ever know the future in advance, but just like the weather man uses averages from past data to develop a forecast, there are certain trends that you can see happening over and over again with price movement that can “foreshadow” a move in price that can be potentially profitable. These price movements take certain visual shapes on a price chart, and after some decent time and study you can identify those patterns with pretty much no problem, and know how to position yourself to profit based on the pattern that you detect.

Some Common Chart Patterns Defined

The Sideways Channel

There are several different types of chart patterns, and each one has its own “personality”. One of the most common is the “sideways channel”, also known as the “box” formation, or the “rectangle” as some call it. It looks like this…

Image courtesy of ChartPatterns.com
Image courtesy of ChartPatterns.com

The sideways channel is basically a time of hesitation in the middle of a price trend. It’s also known as a “continuation pattern”, because once prices break out of the channel, they normally tend to continue in the direction of the overall trend.

 

The Flat Top Triangle

The flat top triangle, also known as an ascending triangle, can be one of the most explosive price patterns, especially when the triangle is elongated and drawn out over a period of weeks (or even months). Check it out here…

Image courtesy of ChartPatterns.com
Image courtesy of ChartPatterns.com

Basically, a flat top triangle takes place when prices keep hitting a “barrier” on the upside, known as “resistance”, and the highs pretty much stay the same, but the lows continue to get higher. This is also a continuation pattern, and it will normally break out at its apex in the same direction as the overall trend.

The Symmetrical Triangle

Yet another continuation pattern that shows its strength particularly well in an uptrend. The symmetrical triangle differs from the flat top triangle in that with the flat top triangle, the highs stay the same. With a symmetrical triangle, the highs get lower and the lows get higher until they meet at a “tipping point” in the apex of the triangle. Normally when prices are congested in this type of pattern, prices explode out of the apex in the direction of the overall trend. Here’s a pic of a symmetrical triangle:

Image courtesy of ChartPatterns.com
Image courtesy of ChartPatterns.com

Normally the rise of the price will be in relation to the overall height of the triangle at its widest point. This is somewhat subjective, but it’s a decent rule of thumb to measure potential breakouts.

The Breakout

Speaking of which, I guess it would be a good idea to explain what a “breakout” is. Basically, any time that prices spike up and “break out” from one of the patterns mentioned above, it’s known as a…well…breakout. Hence the name. The cool thing about price breakouts from chart patterns is the fact that they tend to follow Newton’s law of physics (well, one of Newton’s laws) that objects in motion tend to stay in motion. The sheer momentum of the overall trend combined with the breakout of prices from a pattern such as the ones listed above are great environments for significant price moves to develop.

Stock Trading by Chart Patterns on YouTube

Chart Patterns: Not Infallible

Many critics of stock trading by chart patterns will say that this borders on the fringe of trying to “predict” the markets, and they say that it’s a sophisticated form of “fortune telling”, so to speak. One thing is for sure: Chart patterns have a high probability of indicating price moves, but nothing—and I mean NOTHING—is 100% guaranteed. Chart patterns are simply a way for the average investor to properly position himself for a greater probability of making a profit in this dog-eat-dog world of stock trading.

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