What do chart patterns tell us?

Learn about the relevance of chart patterns for trading.

The transcript of the above video is below.


Welcome to another video of the Byte-sized Tradeducation series by Researchfin.ai. Here we share essential trading concepts in 5 minutes or less. These are for educational purposes only, and these are not investment advice.

In this video, we will talk about, chart patterns.

What are chart patterns? Chart patterns are an essential component of the technical analysis toolkit that many retail traders use.

They are simply the shapes that help explain the price action of the stocks. Think of the price action as the flow of a river, and the market environment as the natural landscape. Then, just as the river tends to take the path of least resistance to flow through the landscapes, the stocks too, take the path of least resistance, to flow through the market environments. Resistance is offered by the buying pressure or selling pressure. Stocks tend to move in the direction which offers less pressure, that is, less resistance. And whenever the pressure shifts either from buying to selling or vice-versa, the stock trend changes direction.

For easy recognizability, traders have mapped the common paths that most stocks take, to various, named chart patterns.

Why are chart patterns relevant? As we discussed in the last video on swing trading, the key to identifying trade setups is looking for entry points when the price breaks out, or breaks down, after reaching equilibrium, between buyers and sellers, which is shown by compression in volatility and reduction in volume.

While the equilibrium point is an important marker, the price action that the stock demonstrates, before reaching the equilibrium, carries a lot of information, that can help determine, how likely the stock will trend in the direction, of the breakout or breakdown. A trader can significantly increase their win-rate, as well as the reward risk ratio, by understanding this price action. And, chart patterns, help understand price action, better.

What are the different types of chart patterns? There are two main categories of chart patterns — continuation patterns, and reversal patterns.

Continuation patterns help traders identify setups, that are likely to push the price to continue, in the direction of the trend. A bullish continuation pattern is seen when the price is in an uptrend. A bearish continuation pattern is seen when the price is in a downtrend. Typically stocks don’t go up or down in a linear way. They take brief pauses, that is, the short-term consolidation, and pull-backs, due to profit-taking, before continuing the move, in the direction of the trend. When a stock breaks out or down from these pauses, they offer great entry points, and are identified by the chart patterns like the cup and handle, pennant, rising or falling channels, ascending or descending triangles, bullish or bearish flags, etc.

Reversal patterns help traders identify setups, which confirm the change in the direction of the trend. These typically occur at the top of the uptrend, or the bottom of the downtrend, when the stock reaches the exhaustion point, of buying or selling, and is ready to move in the opposite direction. These are identified by the chart patterns like the double bottom or double top, head and shoulders or the inverse head and shoulders, falling or rising wedge, etc.

Are chart patterns sufficient for trade setups? While the chart patterns carry some good information, on the price action of the stock, however, they alone are not sufficient, to qualify as a trade setup. A trader has to look at several other characteristics of the stock, to identify valid setups, especially indicators that determine, who among the buyers, or sellers has the upper hand, at any given point in time. Combining this information, with the metrics to identify, the stock fundamentals, the general market environment, the sector, and the industry group behavior, among other things, helps identify good trade setups.

The Researchfin.ai app uses state-of-the-art AI, and machine learning, to automatically identify valid trade setups from within chart patterns, techno-fundamental data, and market environment data. To learn more, visit us at www.researchfin.ai. You can download the app, from App Store or Play Store, and try it out for free for 30 days. Please give it a spin, and let us know your feedback at hello@researchfin.ai

Hope you found this video useful. See you in the next video! Goodbye!