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Interpreting Chart Patterns - Technical Analysis on L1



This post is part of our mini-series on technical analysis on the Level 1 CFA exam.

We've previously covered the 4 major charts used in technical analysis--line, bar, candlestick, and point-and figure. This post picks up where that one left off and talks about the major types of patterns that technical analysts interpret within these charts.

After all, while we’ve shown several key types of charts, the art or science of technical analysis is in interpreting the patterns shown on the charts to try to predict future prices.

The Major Technical (Chart) Patterns on L1 

Expect 1-2 questions that ask about these patterns and be able to identify the size of an expected move off of a pattern. This last point is important. Calculating the size of a move from a given chart pattern is the most likely quantitative question you will find within this entire section.

There are two major classifications for patterns. Broadly speaking, they either:

  • Indicate a reversal of a past trend or
  • Confirm the continuation of that trend.

Within this classification, key patterns include:

  • Reversal Patterns
    • Head and Shoulders Pattern
    • Double and Triple Top Patterns
  • Continuation Patterns
    • Triangles
    • Rectangles
    • Flags
    • Pendants 

Let's cover all of these.

Reversal Patterns

Head and Shoulders Chart Pattern

Generally a head and shoulders pattern occurs during an uptrend period and serves as a bearish indicator. A head and shoulder development has three parts:

  • The Left Shoulder reflects a local high point (peak) of the current trend. It’s basically an upside down parabola, where we see a price decline from the top to the initial price level of the shoulder (called the neckline)
  • The Head starts at the low-point of the left shoulder and generally shows a steep price uptrend to a new high, however, this trend is accompanied by lower volume than the uptrend in the shoulder. The head then declines again to the neckline marking the first sign of a reversal.
  • The Right Shoulder is essentially a mirror image of the left shoulder, formed when prices rise from the head, but again it will have even lower volume (reflecting lower demand)

Head and Shoulders Pattern - CFA L1 Technical Analysis

Calculating a Price Target/Level from a Head and Shoulders Pattern

The height of the head and shoulders pattern is often used to predict the extent of the subsequent downturn (we predict it declining by the height itself). This could easily be tested.

So in the graph above, if the top of the head is at 100 and the neckline is at 70, we say the size of the pattern is 30. We would expect the decline to go from the neckline down by the sie of the move. So the target would be 40 (=70 – 30).

Double and Triple Top Patterns

Both these patterns also indicate the breakdown of a bullish trend. Basically the uptrend hits a resistance line, decreases, and then approaches it again on lower volume (once or twice). We can also use the size of the top to predict the extent of the subsequent decline.

A triple top shows greater likelihood of the trend reversing than a double top, i.e. it is a more significant pattern. Both patterns are more significant the greater the time period over which they form. The price targets we calculate for these patterns follow the same mechanism as the head and shoulders pattern (subtract the height of the top from the neckline).

Note that with head and shoulders and double-top/triple-top patterns they can all also be inverted to mark the reversal of a downtrend as well (as shown in the graph below).[1]

Double and Triple Top Patterns - CFA L1

Continuation Patterns

Continuation patterns are patterns that suggest a pause rather than reversal of an existing pattern. In a market context we often call these “healthy corrections.”

Most continuation patterns are formed with triangles, which occur graphically when we start seeing lower highs and higher lows over a period. This compression reflects a balance between buying and selling pressure/demand. Triangle patterns can form in both up and down trends, and are shown by connecting the high prices and low prices with two different trend lines.

Here too, the longer the time period over which the pattern forms the more pronounced the trend is expected to be. Note the height of the triangle is called the measuring implication and is used to forecast the price rise/fall.

Triangles can be:

  • Symmetrical – buyers are becoming more bullish and sellers more bearish
  • Ascending – a bullish signal, will have flat trendline on high prices and an upward sloping trendline connecting the low prices[1]
  • Descending – a bearish signal, will have flat trendline on the low prices and a descending trendline connecting the high prices

Another major continuation pattern are rectangles. Rectangles occur when trading is confined between support and resistance levels, i.e. it occurs between two parallel lines.[2] Note we sell when the price closes below resistance and buy when it closes above.

As a continuation pattern a rectangle is bullish if it follows an uptrend and bearish if it comes after a downtrend.

Summarizing Triangles and Rectangles

Rectangle and Triangle Stock Patterns - CFA L1

Flags and Pennants

These are both considered minor continuation patterns because they form over short time periods, and are essentially short-term rectangles and triangles respectively.

If you'd like to continue with our mini-series, the next blog post covers technical indicators including:

  • Price-based indicators
  • Momentum oscillators
  • Sentiment indicators
  • Flow-of-funds indicators

Footnotes

[3] The flat trendline on the high prices show that sellers are taking profits at around the same level.

[2] http://www.onlinetradingconcepts.com/TechnicalAnalysis/ClassicCharting/Triangles.html

[1] http://www.stocks-for-beginners.com/stock-chart-patterns.html. These are called double-bottom, triple-bottom, and inverse head and shoulder patterns.