Charts are especially important for those looking to profit from relatively short-term positions in financial markets using instruments such as CFDs.
Technical analysis of charts can be used for forecasting and helping to identify trading opportunities.
If we read the charts correctly, we can potentially greatly improve our chances of making successful, profitable trades.
There are various patterns that technical analysts look for when they study trading charts.
As well as the pattern of the chart itself, the volumes behind the moves also need to be studied to confirm a trend is underway.
Red candlesticks on a chart indicate price falls, while the green/blue candlesticks show increases.
The length of each candlestick indicates how far the price has moved over that particular time frame.
You can set charts to show various time intervals, including by each minute to give you a view of the intra-day price action.
Setting charts to show price changes at different price intervals can give you a fuller picture.
For instance, the price may have been falling and nearing the lower Bollinger band on a 5-minute view.
However, over using 30-minute intervals the chart may well be nearer the upper end of the Bollinger.
Bollinger bands are based on the volatility of the moving average, so there will always be an upper and lower band.
In a range driven environment, many traders will sell the asset when it reaches the upper Bollinger band and buy it when the price is around the lower band.
It´s intuitive that a downward or upward move in price that is supported by higher trading volume is more significant than one backed by relatively weak volume.
The higher volume could be a sign that big institutional investors are making buy or sell decisions.
Bullish or bearish patterns in charts supported by higher volumes are therefore likely to be more persistent, and genuinely indicative of a real underlying trend.
Reading the charts
Traders generally scan intra-day charts to look for evidence that a trend already underway will continue, strengthen or reverse altogether.
A continuation pattern means the current price direction of an asset should be expected to be maintained.
So, in the case of an asset that has been on the rise, a trader seeing a pattern of continuation in the chart may position themselves to benefit from further price appreciation.
Conversely, there could be a reversal pattern, so in this case the trader would be looking to position themselves to benefit from a price move in the opposite direction of the current trend.
Traders commonly use charts to look for signs of a breakout.
In this case, the asset price is moving through a point where there is defined support or resistance, amid increased volume.
Correctly identifying breakouts should lead to decent trading profits, as there should be a sharp move in the price.
Someone looking to profit from this scenario could take a long position after a price breaks through the resistance level or short position if the price moves beneath a support level.
They would, however, be looking for evidence that the price has moved through such levels on higher volumes, as they seek to ensure that the breakout is not a false dawn.
One of the classic patterns of that technical analysts look for is the so-called pennant.
A pennant is characterised by a large move in price that is termed as a “flagpole.” This is followed by a continuation period, eventually leading to a breakout in the same direction.
The breakout forms the second part of the flagpole.
Volume is key to defining a true pennant: the initial large price movement must be accompanied by higher volumes. The pennant phase itself, meanwhile, should be seen to have weaker volumes.
Finally, just as the initial stage was defined by higher volume, so too is the breakout phase.
Traders typically seek to profit from the pennant by implementing trades that seek to capitalise on the breakout phase.
For example, suppose you have perceived a bullish pennant pattern for bitcoin. Having observed the pattern, you could place a buy order just above the pennant´s upper trend line. Imagine bitcoin rose from $10,000 to $13,000 in a sudden rally, but then consolidated around the $11,500 mark.
A breakout then occurs at $12,000, with increased volumes confirming its veracity. The trader may choose to go long at $12,100, with a price target of $15,000.
You may also wish to implement a stop-loss order at the lowest point on the pennant. A big move down could invalidate the pattern and indicate that a reversal is on the horizon.
As well bullish pennants, the pattern can also be bearish, though this time with a vertical flagpole drop followed by a pennant phase.
With the bearish version, we would look for a breakout to the downside of the lower resistance line of the pennant.
Cup and handle
The cup and handle is a distinctive chart pattern, as can be seen from the illustration.
Lower trading volumes define the handle phase of the pattern. Early in the U-curve phase, the asset comes under pressure from profit taking.
However, this gives way to further upward momentum. Again, there is a shorter period of profit taking in the handle phase, before the asset price resumes its upward path once again.
It´s notable that the upward momentum past the handle stage is fairly steep. The cup and handle pattern is therefore a decidedly bullish one.
Crucially, and somewhat intuitively, the up price movements in the pattern are characterised by higher trading volumes while the downward moves are defined by lower volumes.
Traders typically act on the pattern by placing buy orders towards the upper end of the handle to benefit from a breakout.
A classic strategy with the cup and handle is to set a profit target using a price that is based on the distance from the bottom of the cup to the handle breakout level.
Therefore, suppose we are trading the FTSE 100 and the distance is 70 points. In this case, the trader would target a price for their long position in the index that is also 70 points above the breakout level.
A more cautious trader may look to place a stop-loss order just below the handle, while others may implement one close towards the bottom of the cup.
In simple terms, a rounding bottoms pattern differs from the cup and handle formation in that there is no handle.
Rounding bottoms tend to occur at the end of a prolonged down phase and point to a trend reversal.
Following the early, down part of the U-shape, buyers come into the market to take advantage of the lower prices.
In the upward phase of the U shape, more buyers step in as momentum builds.
Finally, the formation is typically denoted by a breakout to higher price levels once the U formation has been completed.
Traders therefore typically see the U shape as a bullish signal, so potentially implement long positions from the top of the U.
Trading volumes need to be strong enough to confirm that the breakout is authentic.
Another bullish pattern to watch for is the ascending triangle. Put simply, this is a right-angled triangle formation that is created by two distinct trend lines.
A horizontal trend line represents previous resistance, with the second line plotted as an upward sloping line through the points of various trading lows.
Using an ascending triangle, traders can take long positions on breakouts from the price levels plotted along the troughs of the horizontal line.
The pattern is generally classed as a continuation trend; this could be as traders take profits at various points through what remains an upward price trend.
On the other hand, a descending triangle depicts an overall bearish trend. In the case of the descending triangle, a line is plotted through a series of peaks that steadily decline in their magnitude as the line progresses, creating a downwardly sloping trend line.
Traders tend to look for breakouts below the lower trend line on the chart, so as to enter short positions to benefit from the general bearish trend.
Like the ascending triangle, the descending version is a continuation trend, though in the opposite price direction.
A symmetrical triangle pattern is formed by two converging trendlines; the upper line of the triangle is derived from a plot of the peak points along the chart, while the lower line is taken from a plot of the troughs.
The triangle represents a period of consolidation, though with a narrowing of the distance between peaks and troughs just before a breakout occurs, either to the upside or downside.
A breakout is characterised by a sharp move above or below the triangle´s trend lines.
Once the decisive move comes, it should be accompanied by a rise in trading volumes.
A bullish flag formation points to a strong upward price trend, providing a technical signal for traders to take a long position on the asset.
As the namesake suggests, the chart pattern resembles a flag on a pole.
The pole phase represents a very sharp, vertical rise in the asset price, while the flag denotes a period of consolidation.
During the flag part of the formation, continued strong buying counteracts the usual profit taking that occurs after such a sharp upward move.
Traders often take a long position on the asset in the flag phase, though at the same time giving themselves some stop-loss protection.
A breakout upward from the flag can be just as sudden and strong as the earlier pole phase.
Traders can therefore get an idea of the upward potential in the breakout by studying the distance of the original pole.
The flag phase of the chart may not always be horizontal, but instead slope slightly downwards.
It will however be denoted by trading within a narrow range, even if there is some zig-zagging between relatively small peaks and troughs along the way.
Whether it is horizontal, or downward sloping, the peaks and troughs of the flag phase should allow you to draw a rectangle.
The flag can also be used to take a bearish position on the stock as a breakout below the lower trend line of the rectangle is a sell signal, just as a breakout above the upper line of the triangle is a sign for bulls.
As always, trading volumes will point to the veracity of either signal. Higher trading should provide you with more conviction to act.
A double top is a bearish pattern that could signal the end of an uptrend.
After rising to a peak as part of the original bullish trend, the price then pulls back.
However, the price subsequently recovers again, as the upward momentum persists. Another pullback takes place from the next peak, taking it back to the earlier level of the prior trough.
The price has peaked at around the same price level twice but was unable to move past this level, indicating that this is a point of price resistance.
A subsequent breakout below this level of resistance, or to put it another way, the low at which the price previously fell to before a substantial rally began, is a sell signal.
A breakout below this level with higher trading volume could indicate that a new bearish trend has come into being.
Traders may, therefore, seek to implement sell orders just below the lower resistance level.
A profit target for the sell trade can be worked out by applying the distance from the lower resistance level to the higher point of the double tops.
As an example, suppose we are trading Brent crude and the double tops are at a price of $69 per barrel.
If the lower resistance level is $64, then the distance is simply $5.
We could therefore choose to set a target price fall of $5 for a breakout from the lower level of resistance.
So, we would look to take profits on our short trade at around $59 per barrel.
A double bottom is the inverse of a double top, so this pattern can be used to pinpoint the end of a bearish trend.
To begin with, the price falls to a new low in a continuation of an ongoing downward trend.
Subsequently, the price moves up quite sharply but then falls back to around the same level of the prior low. However, the price then rallies yet again.
The low point marks an area of resistance as the price has been unable to fall below it on two separate occasions.
If the price can make a meaningful breakout above the prior high on increased trading volume then we could be seeing the start of a new bull trend.
Traders can therefore implement buy orders slightly above the peaks of the double bottom pattern.
A profit target can be calculated by working out the distance between the peaks and resistance levels of the formation.
So, imagine gold reached a low of $13,010 per ounce and highs of around $13,080 in the pattern, then the distance is $70.
We therefore expect gold to reach a high of about $13,150 following the breakout and can set a price target to exit our long position a little below this level.
Wedges are indicative of a reversal either to the upside or downside.
The wedge shape is formed by two converging trendlines, indicating a narrowing of the peaks and troughs on a chart.
This narrowing is a sign that the current trend is nearing a reversal. Once, the price breaks through the trend lines, there is scope for a sharp price move.
Crucially, the breakout tends to come in the opposite direction to where the wedge is pointed.
So, in the case of a falling wedge, a breakout to the upside on higher trading volume represents a buying opportunity as a new bullish trend gets underway.
We could place a long trade at a price marginally above the upper trend line at the pointed end of the wedge.
The triple bottom can detect a reversal of a bearish trend, highlighting opportunities to go long on an upwards price breakout.
As the namesake suggests, three troughs are created at around the same price level.
When the price rises a third time off the level represented by the troughs, this is viewed as a bullish signal that the bear trend has come to an end.
However, traders look for the price to actually rise above the upper resistance level as represented by the peaks of the zig zag pattern.
A long trade could therefore be implemented slightly above this upper level, though as always it´s important to look for higher trading volume at this point to confirm that a new trend is genuinely beginning.
A price gap is an empty space between candlesticks on a chart; the price has significantly changed but with no trading in between the two points.
If substantial price gaps do occur, in most cases this is due to changes between the close and open of a market.
There are various different types of price gap: common, breakaway, runaway, exhaustion and island reversal.
Understanding the different types of gaps can help uncover whether a price trend is beginning, coming to an end or picking up.
Common gaps tend to be relatively small and occur fairly frequently, so should not be used for analytical purposes.
For instance, if General Motors stock price opens at $40.08 on Wednesday after closing at $40.06 on Tuesday, the gap is liable to correct itself over the following trading sessions.
While common price gaps are normal for stocks between the end and beginning of trading days during the week, in currency markets price gaps are more likely to occur after trading ends for the weekend.
A breakaway gap on the other hand can be a sign of changing investor sentiment, especially in the aftermath of significant news.
As the term suggests, a breakaway gap applies to a gap that brings the asset price out of a given trading range, possibly starting a new price trend in a different direction.
Suppose a major announcement on Brexit was made on a Sunday lunchtime when GBP/USD currency markets are not trading.
Theresa May declares that the UK will stay in the current customs union with the EU following a transition period, though will remain outside the single market.
The pound opens at $151 at the start of the trading day, having traded at just $139 at the close of the session on the previous Friday.
Breakaway gaps can occur to either the upside or downside, though as they often mark the beginning of a new trend, traders can expect the direction of travel to be relatively persistent.
As would be expected, breakaway gaps are associated with a significant pick up in trading volumes.
Runaway gaps refer to a gap that occurs in an existing trend, as more traders take positions in line with the overall price trend.
The gap that results may encourage yet others to enter the trade, so could be taken as either a buying or selling signal, depending on the direction of travel.
Referring to the earlier example, suppose the rally for sterling continues to gather steam into the next weekend.
At market close on Friday evening sterling trades at $153 but opens on the following Monday at $154.
Again, a runaway gap could be a signal to take either a long or short position, so long as it is in line with the existing trend.
At the same time, traders will likely set a lower profit target for this type of gap as compared to a breakaway gap situation.
An exhaustion gap can come towards the end of a trend. For instance, a stock that has been rallying strongly may suddenly open at a significantly lower point on the next trading day.
As the namesake indicates, the exhaustion gap is a sign that the trend is unwinding as fewer buyers are coming into the market than previously.
Unlike a breakaway gap, an exhaustion gap may signal that the trend is drawing to close, rather than already at an end.
The asset may therefore continue in the same direction as before for longer, though it could well be that the trend is at the beginning of an end.
An island emerges from two price gaps that occur in opposing directions and is a strong sign of trend reversal.
Firstly, there is a price gap in the direction of the current trend followed by trading within a relatively narrow range.
Another price gap subsequently occurs, but in the opposite direction to the trend.
In the case of an asset that is moving from a bullish to a bearish trend, the island pattern can be a signal for traders to adopt short positions in the asset.
Those who traded in the area of the narrow trading range that followed the initial price gap are effectively stranded on an island.
Studying chart patterns can unlock some important technical insights for traders, though by no means should they be used in isolation.
As highlighted throughout this article, traders need to look at volumes to gauge the strength of such patterns to help them decide whether they should act on them.
When acting on a given formation, it´s worth setting some kind of profit target as well as initiating a stop loss should the trade not go as we would like.
Chart patterns can be used in conjunction with other technical indicators such as Bollinger bands.
Lastly, such patterns can also be analysed in combination with fundamental analysis, which may provide further rationale as to why a given formation is occurring.