Tens of thousands of CFD and stock market traders love using chart patterns to determine the best entry points into the market. Whilst some chart patterns perform brilliantly (especially on short term Contracts for Difference markets), others leave you frustrated and angry.
Today we'll take a closer look at the top 6 chart patterns and the best way to position yourself when they occur. Always remember the best course of action is to be educated on each pattern so you can instinctively know the best way to react.
Rounding tops and V formations can signal the end of an up trend. An ascending wedge is likely to break down and a descending triangle can also break towards the downside. We will have a look at two new patterns to watch out for as well the double top and the head and shoulders pattern. Being able to identify these patterns can better enable you to define when to exit from a trade.
The rounding top is the reverse of the rounding bottom. It shows a gradual shift in sentiment from the buyers to the sellers and can lead to rapid drops in the share price. The rounding top is an uncommon pattern however is reliable when found. Look for a slowing down in the rise of the share price and then the share falling more quickly to the downside.
Wedges normally give no clear direction as to which way the share will break and as a guide the wedge would normally breakout in the direction of the major trend. There is one special exception to this rule known as a rising wedge, which will normally break to the downside.
The share price moves higher and higher but is unable to break out of the squeeze pattern. The sellers are drawing the few remaining buyers to part with their shares at slightly higher prices and volume normally drops away. There comes a point when the buyers are no longer willing to buy and the sellers drop the price to sell their shares. The breakout is usually accompanied by an increase in volume.
The descending triangle is an upside down version of an ascending triangle. With this being the case you would expect the share price to break to the downside, however this pattern is not as reliable as the ascending triangle. If the support is strong enough then the share may rebound off support and break up.
The best way to trade the descending triangle is to use a conditional order and get in only on the confirmed break. Alternatively you can set alerts for the break and trade it that way. Always be careful of a snap back into support.
After a rapid increase in price expect the share to pull back. It is only natural that a strong rise in the share price leads to a reversal as traders take their profits. If you had made a 100% profit in a week would you sell your shares? Most people would and this selling off drives the share price back down. Watch these patterns carefully and use trailing stop losses in order to maximise your opportunities in either direction.
Double tops are commonly found when a share cannot push higher. The share price rises up and forms the first peak. It then drops away and rebounds back towards the peak. The price cannot push any higher and can then fall away rapidly.
Buying a CFD as a double top forms can result in a losing trade and if you own a CFD when a double top forms it can be time to exit from the trade. The NASDAQ correction in 2000 when all the technology shares fell over was characterised by a double top pattern forming in the market as a whole and in many technology shares.
Head and Shoulders
The head and shoulders pattern is formed by the share price creating a peak, the first shoulder followed by a higher peak, the head. The share price then fails to regain the level that it reached previously and forms the second shoulder. When the share breaks through the neckline expect a strong fall in the price. The fall will often be the same distance below the neckline that the head is above the neckline. The head and shoulders can mark the end of an up trend and the beginning of a new trend.
Using the tips suggested above will ensure you get the most out of each of your trades. Good luck and as always Trade Smart.