Basics part 3: Classic patterns

Technical analysis is all about understanding the shifting balance of supply and demand for a given stock or exchange traded fund (ETF) in the market. Over many years, traders have come to rely on technical analysis as a tool to help identify trends, possible reversals of trends, support and resistance levels as well as provide an indication of possible target prices. There are a variety of technical patterns and indicators in common use today. In this article, we'll highlight three types of classic price patterns that should be understood by technical traders.

Classic patterns are among the best-known types of technical analysis events. These patterns gain their names from the unique shapes they form on a price chart. Classic patterns are in some ways the most actionable type of technical events for investors since their occurrence can also provide a target price based on the shape or height of the pattern.

The head and shoulders is among the best-known patterns in technical analysis. The pattern can be either bullish or bearish depending on the context. The bearish pattern is known as the head and shoulders top and occurs at the conclusion of an established uptrend. The head and shoulders top is characterized by three successive highs with the middle one (the head) being slightly higher than the other two. A horizontal level of support known as the neckline is formed where the price is supported at the bottom of each price swing. The head and shoulders top is confirmed when the price breaks downward below the neckline, indicating the start of a new bearish trend. The bullish counterpart of this pattern is the head and shoulders bottom.

Triangle patterns are quite common in technical analysis and can be either bullish or bearish. Triangles can also be reversal patterns (indicating the previous trend is likely to reverse) or continuation patterns (indicating the previous trend is likely to continue) — it all depends on the context. All triangles share a key characteristic: They're formed when levels of support and resistance in the market for a stock begin to converge, thereby indicating closer and closer agreement between buyers and sellers. Eventually, the price will break out either above or below the triangle, indicating the start of a new trend.

Flags and pennants are also common patterns which are very useful for active traders. A flag or pennant is formed when the price of a stock undergoes a consolidation period after a strong run-up or decline. These patterns can be useful to determine an opportunity to enter a position in a stock that has already experienced a strong price movement. The strong run-up or decline preceding the flag pattern is called the “flagpole.” Flags and pennants are differentiated by the subtle difference in the shape of the pattern. Pennants have converging lines of support and resistance, much like a triangle, whereas these levels are approximately parallel in the case of a flag.

Unlike other technical analysis events, such as bar or candlestick patterns, classic chart patterns have an added advantage in that they can also provide the investor or trader with an approximate target price. A standard technique in technical analysis is to the derive the target price for a pattern by measuring the height of the pattern and adding this to the confirmation price for the event. This technique provides an “expected move” — a rough guide for where we expect the price to go based on the occurrence of the pattern.

Technical traders use classic patterns along with a variety of other types of patterns and events beyond those that are highlighted in this article. Identifying and using these types of events in your trading can be a time-consuming task. Fortunately, there are online tools available to help investors in this process, including Technical Insight, a software technical analysis tool from Trading Central. You can find this tool on the CIBC Investor’s Edge trading platform in the Technical Analysis tab in Market Centre under Quotes and Research.

Technical Insight automates the standard practices of technical analysis, making it easy to identify new trade ideas or evaluate the technical perspective for a given stock or ETF. All the classic patterns described in this article are automatically detected by Technical Insight on an end-of-day basis.

Technical Insight users can look up a stock or ETF of interest and see all the active patterns and technical indicators which are currently active. The Featured Ideas module highlights 10 trade ideas per day based on what is poised to move from a technical perspective. Users can also search for trade ideas in a given sector or based on a specific technical pattern (like a flag or head and shoulders) using the Technical Event screener. Finally, users can stay on top of their positions and tune in to signs of weakness using the email alerts functionality.