No matter your trading style, chances are that you will find the art of reading price action patterns literally priceless. You can use these patterns to identify potential reversals, continuations, and even support/resistance levels.
In other words, this skill can help keep you one step ahead of the market, and that’s a really good thing! No?
Although price action patterns belong to the niche of technical analysis, they still can be used in combination with fundamental analysis for surer moves.
One thing there is to love about this method of analysis is that it is a bare-knuckle approach. No technical indicators are involved. Just you and the market. It’s no wonder some people simply refer to it as the “naked” or stripped approach to chart reading.
The core focus is on the movement of prices keeping in mind that stock prices are usually indicative of the different variables in play e.g., economic data, news events etc.
What Are Price Action Patterns?
As each stock is traded over time, it plots a graph. Sometimes the graph rises, and sometimes it falls. This movement over time is what is known as price action. Therefore, price action patterns are the shapes and forms created by stocks as their pricing responds to market dynamics.
If you would like to embrace this type of analysis, then you’ll need to study the movement in price over a given period of time so you gather crucial information about your favorite stock(s). This information can be in the form of:
- Potential trend continuation
- Likely reversals
- Potential Breakouts
Price action traders thrive on the notion that there is absolutely nothing new in the markets. And that in stocks, history is bound to repeat itself. You just need to look closely for some tell-tale signs so you can capitalize on the predictable moments.
Different Types of Patterns in Price Action Analysis
There are three main types of price action patterns. These are: continuation patterns, reversal patterns, and gap patterns.
1. Continuation Patterns
In most cases, the price movement of a stock can appear random and unpredictable. However, this is not always the truth. Continuation patterns do exist and when they occur they point to a possibility that a certain market behavior is likely to persist.
This is our first example of the continuation patterns in price action analysis.
Triangle patterns can either be of ascending or descending in nature. The ascending triangle price action pattern is an upward sloping triangle shape formed by joining two swing highs and two swing lows.
Typically, the highs are roughly equal but the lows tend to gradually grow higher over time suggesting a consistent upward trend. This can be a good opportunity to go long.
This shape also forms in situations where a stock falls from a high but does not retreat as low as it previously did.
Descending triangle patterns, on the other hand, are formed when the swing lows are roughly equal but the swing highs grow lower over time. This tends to suggest the continuation of a downward trend and, therefore, a good opportunity for short-selling.
Pennants are yet another example of continuation patterns in stock price movements. They are closely related to their triangle counterparts but are not exactly similar.
One key difference between them is that pennants are normally made up of less than 30 Japanese candlesticks. Also, unlike triangles, pennants tend to form a perfectly vertical flagpole made up of wide-ranging bars.
To trade pennants in an uptrend, you’ll need to place your take profit (TP) slightly above the highest swing high in the pattern and a stop loss (SL) below the lowest swing low recorded within the pattern’s framework.
The vice versa is true for downward trends.
Generally, pennants have a greater degree of success than triangles which always have the risk of breaking out upward or downward.
Separating Line Patterns
It’s very easy to observe this particular pattern as it does not require you to draw lines across the chart. Simply put, separating line patterns form when two completely different candlesticks form next to each other with the new candle opening right next to the opening position of the previous candle.
There are two kinds of separating line patterns namely bullish separating lines and bearish separating lines.
The former occurs when a new bullish candle succeeds a bearish candle but opening at its point of open. This indicates an upward trend thereby providing a good opportunity to buy that stock.
The latter occurs when a new bearish candle comes right after a bullish candle and opens at its point of opening. As this indicates a strong downward trend, it also suggests a viable opportunity to short sell that particular stock.
2. Reversal Patterns
As the name suggests, a reversal pattern is one characterized by a complete change of direction. For example, a market might reverse from a rising trend to a falling trend and vice versa. You can use such trends to correctly predict the upcoming movements especially if you know which formations you need to look out for.
Head & Shoulder Patterns
This is an example of a reversal price action pattern that’s characterized with three price peaks. Two peaks on either side are normally of roughly the same height while the mid peak towers above them.
This trend starts when a bullish trend leads to a creation of a left shoulder in a line graph. Then it retreats temporarily before another stronger bullish trend takes over creating a much higher top than the previous one.
A technical correction then takes place leading to the creation of a low that’s equal or almost equal to the low of the left shoulder.
At that point, a weaker bullish behavior takes over leading to the creation of another, third, top. This third top ends up being roughly the same height as that of the left shoulder.
As a short-seller, this is just the opportunity you need to go short. Once the right shoulder has peaked, it will naturally retreat effectively completing the missing part of the right shoulder.
Normally, the low points of all the three peaks can be connected by a straight line which is known as the neckline.
Three White Soldiers
This reversal pattern is normally associated with downtrends that are about to reverse and become uptrends. It is normally accompanied by three bullish candlesticks with short wicks.
What’s more, each candle is expected to open within the previous candle’s body. And due to the bullish nature of the reversal, the successive candlesticks are supposed to close slightly above the high of the previous candle.
In other words, each candle must open moving progressively upward in order for the three white soldiers pattern to hold.
And another thing, the three candles involved have to be of almost the same size. If one of the candles is significantly smaller then you might want to question the strength of the reversal.
Otherwise, a strong Three White Soldiers signal can be a good opportunity to buy a stock as it recovers from a downtrend.
The Engulfing Pattern
The Head & Shoulder pattern typically provides you with a bearish trading opportunity while the Three White Soldiers pattern is all about a bullish reversal. The Engulfing Pattern differs from those two as it can be bearish or bullish.
When bearish, you have two candles. The first one is normally bullish and the second one bearish. The bearish candle completely engulfs the bullish one representing the fact that the market is fully bearish and, therefore, a good opportunity to go short.
On its part, the bullish engulfing pattern comprises a first bearish candle followed by a second bullish candle that completely engulfs the first one.
The word engulfing, in this case, refers to the fact that the new candle has a higher high and a lower low than the previous one.
3. Gap Patterns
A gap in the world of stock trading occurs when there is a sudden bearish or bullish behavior coming from a stock that typically has low liquidity or when the markets open after closing for a weekend or holiday.
These tend to happen unexpectedly due to a myriad of technical and fundamental factors. That’s why folks who trade the Gap & Go strategy often use tools that silently track market behavior even during off-peak hours – that way, they are the first ones to trade when a gap opens.
Gaps patterns can either be reversal or continuation price action patterns.
It is important to remember that, trading gaps is exceptionally risky due to the extremely high levels of volatility involved. But if one is prepared with the right information and strategies, they offer sweet opportunities for some quick bucks.
And this explains why Gap and Go traders typically open and close trades within the first 15 minutes of the breakout.
There’s a lot of fun to be had when you trade with price action patterns. Above all, as this method does not involve the use of indicators or even robots, it enables you to feel the raw power of the market. It’s no wonder it is often called naked trading.
If used correctly, it can provide one with a strong foundation for a successful stock trading career.
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