The world of trading presents very difficult as well as tricky puzzles that traders are required to solve. Now, traders who don’t know how to solve those puzzles far more than often end up losing their money. Conversely, the gurus and master puzzle solvers can accumulate loads of money. So, how can you solve those puzzles? Price action patterns. Yes, price action patterns help you analyze the price action and make good trading decisions.
Price action patterns, in fact, are the lifeblood of successful trading. Whether you are a stock trader, forex trader, or trade on something else, you cannot survive without learning these price action patterns. Because, these specific patterns help you in solving puzzles like trends, support and resistance levels, trend continuation, and trend reversal. In other words, you need to know these price action patterns to spot profitable trading opportunities, best entry points, and take profit levels.
Have you ever heard about trading based on technical analysis? Price action patterns also belong to the toolbelt of technical analysis. However, it is different from various other technical analysis techniques because it doesn’t rely on technical indicators. Instead, technical analysis based on price action patterns is conducted by simply looking at price charts.
Understanding price action patterns is, however, as complicated as it is important for perfect trading decisions. Therefore, we decided to help you understand price action patterns and how they develop. Our guide includes everything you need to know regarding the topic. So, let’s dive into it.
What is a candlestick?
A candlestick is basically the smallest unit you find on a price chart. It is a measurement unit that helps you understand different aspects of price movement. Although there are other different types of charts such as bar, line, or Renko charts. However, the majority of modern traders choose candlesticks. That means candlesticks are building blocks of a price chart and price action pattern.
So, what is the reason behind such popularity of candlesticks? It is pretty obvious. Visual hints – candlesticks are popular for how they provide visual hints to traders. These visual hints help traders understand price action patterns and thus make good trading decisions. Having said that, we should be very grateful for Homma, the great rice trader from Japan. Because he is credited with candlestick development. It is obvious that his trading rules were developed and refined. And eventually, the modern candlestick and candlestick charts evolved that we use today.
Candlesticks represent a flow of price on price charts and also indicate timeframes. A single candlestick, as we know, is the basic unit of the larger picture we see on the price chart. Thus, several candlesticks construct a larger structure that traders use for price action pattern analysis. The phenomenon is very similar to languages. Words combine to make a sentence and sentences combine to make a paragraph. In short, the following are key aspects of price chart patterns.
- Candlestick – the basic unit of price measures on a price chart
- Candlestick patterns – similarly, groups of candlesticks, typically consisting of one to three candles, construct a specific pattern. That pattern represents the overall direction of the chart.
- Price swings – the groups of candlestick patterns, typically consisting of three to five candlesticks. It shows a larger price movement.
- Price action patterns – a group of swings combine to shape a price action pattern. This pattern then represents bearish, bullish, reversal, or continuation.
- Trend channels and range – again, price action patterns eventually form a trend channel or a range. The angles of the channels, in fact, indicate whether the price is going up, down, or sideways. A trend channel always moves up or down. Whereas, a range always moves sideways.
The basics of candlesticks
A candlestick is either a bullish candlestick or a bearish candlestick.
- Price closing higher than where it started forms a bullish candle. A bullish candlestick is white by default or green.
- On the other hand, price closing below where it started forms a bearish candle. A bearish candle is always black by default or red.
On the other hand, if we talk about the structure of a candlestick, it consists of;
- The body – a box that is formed by the movement of the prices.
- Shadow, tails, or wicks – the highest or the lowest point of the price movement within a particular time frame are called shadows, tails, or wicks.
- The nose – a small part of a candlestick.
Moreover, the structure of a candlestick always remains the same irrespective of timeframes or financial instruments.
As we have highlighted the basics of the candlesticks you need to know, let’s head back to our main topic.
Price action patterns explained
The following 7 price action patterns are considered the most reliable price action patterns.
1. Head and Shoulders Patterns
Head and Shoulders patterns are among the most reliable price action patterns. They can be both, bullish and bearish. These patterns are also quite easy to spot. Additionally, Head and Shoulders patterns also enable traders to enter the market at the best point.
Three consecutive rounding tops form a Head and Shoulders pattern after a bullish trend. These rounding tops include the head and two shoulders. Shoulder tops flank higher than the head top. Moreover, the prices at the rounded tops may also vary. Similar prices aren’t the prerequisite to this pattern. However, the signal is stronger if the prices are close to each other. Similarly, prices at the lowest points may also vary. Furthermore, the lowest points may not necessarily form a horizontal straight line.
On the other hand, an Inverted Head and Shoulder forms after a bearish trend in the market. However, this Inverted pattern consists of three rounded bottoms instead of rounded tops. Again, three rounded bottoms include two flanks and ahead. Both of the bottoms flank lower than the head. Moreover, prices at the bottom of the flanks may vary. However, the signal is more powerful if the prices remain close to each other. In contrast to Head and Shoulders patterns, Inverted Head and Shoulders patterns’ flanks are typically slopped instead of being horizontal.
2. Triangle Patterns
Triangle patterns are also important to price action patterns. They are continuation patterns. Triangle patterns are formed when upper and lower trendlines ultimately converge at the right side to form a triangle. Moreover, there are also two forms of these patterns Ascending Triangle patterns and Descending Triangle patterns.
Ascending Triangle patterns develop during a bullish trend. A series of higher lows follow an uptrend move. In these patterns, highs typically remain identical and form a horizontal upper trendline line. Conversely, the lower trendline remains ascending as rising lows make them do so. Moreover, if the price breaks above the upper trendline, the Ascending Triangle pattern is successful.
On the other hand, the Descending Triangle pattern develops during a bearish trend. A series of lower highs form this pattern. Moreover, the lower trend lines remain horizontal as the lows are almost identical. Whereas, the upper trendline descends because of falling highs. Eventually, both trend lines meet on the right side to make a triangle. The pattern is successful if the price breaks below the triangle.
3. Rectangle Patterns
Another price action pattern that you need to know is Rectangle patterns. These patterns have horizontal trend lines without any slopes. Thus, Rectangle patterns are channel patterns. Moreover, these patterns are also of two types: Bullish Rectangle Patterns and Bearish Rectangle Patterns.
Bullish Rectangle patterns are formed, during an ongoing uptrend, by a series of two or more consecutive highs and lows. These highs and lows are nearly identical as well. Thus, identical highs and lows form two horizontal trendlines. Eventually, the price breaks above the upper trendline. Bullish Rectangle patterns are successful when the distance of the price breakout is the same as the width of the rectangle.
On the other hand, Bearish Rectangle patterns are also formed, during an ongoing downtrend, by a series of two or more consecutive highs and lows. Again, these highs and lows are near identical as well. Therefore, identical highs and lows form two horizontally parallel trendlines. Finally, the price breaks below the lower trendline. Bearish Rectangle patterns are successful when the distance of the price breakout is the same as the width of the rectangle.
4. Channel Patterns
Channel patterns are also very important among price action patterns. These patterns are also among the highly reliable patterns because of longer timeframes. Again, Channel patterns can also develop during both uptrend and downtrend.
Ascending Channel patterns develop during an uptrend. These patterns are formed by a series of lower highs and lower lows during a longer consolidation period. Thus, both upper and lower trend lines run parallel to each other but in a downward slope. Ascending Channel patterns are successful when the price breaks above the upper trendline. Moreover, the price keeps moving above to cover as much distance as the distance of the initial bullish trend.
Descending Channel patterns, on the other hand, develop during a downtrend. These patterns are also formed by a series of higher highs and higher lows during a longer consolidation period. Thus, both upper and lower trend lines run parallel to each other but in an upward slope. Descending Channel patterns are successful when the price breaks below the lower trendline. Moreover, the price keeps moving below to cover as much distance as the distance o the initial bearish trend.
5. Double Top/Bottom Patterns
Double Top/Bottom Patterns are also crucial for price action analysis. These price action patterns are in fact reversal patterns.
Firstly, there are Double Top patterns. These price action patterns start developing when a rounding top appears after an ongoing uptrend. After the first rounding top, another rounding top also appears. Thus, the development forms a swing low in between the two rounding tops. Moreover, the highs of the tops also are almost identical. In fact, the pattern appears just like the letter “M”. The signal is stronger when the distance in between is wider. The price continuously keeps declining and eventually breaks below the swing low. Double Top patterns are successful when the distance of the fall in prices is nearly equal to the distance between the tops and swing low.
Secondly, there are Double Bottom patterns. These price action patterns start developing when a rounding bottom appears after an ongoing downtrend. After the first rounding bottom, another rounding bottom also appears. Thus, the development forms a swing high in between the two rounding bottoms. Again, the lows of the bottoms also are almost identical. Thus, the pattern appears just like the letter “W” as compared to M formed by Double Top patterns. The signal is stronger when the distance in between is wider. The price keeps increasing until it breaks above the swing high. Double Bottom patterns are successful when the distance of the rise in prices is nearly equal to the distance between the bottoms and swing high.
6. Triple Top/Bottom Patterns
Triple Top patterns start developing during an ongoing uptrend. A double top pattern appears first and then a third rounding top also follows with an almost similar high. Similarly, the second swing low also has the same swing low as the first swing low. The price continues to decline and eventually breaks below the swing lows. Triple Top patterns are successful when the distance of the price decline is almost equal to the distance between the third top to the second swing low.
Whereas, Triple Bottom patterns start developing during an ongoing downtrend. A double bottom pattern appears first and then a third rounding bottom also follows with an almost similar low. Similarly, the second swing high also has the same swing high as the first swing high. The price continues to increase and eventually breaks above the swing highs. Triple Bottom patterns are successful when the distance of the increase in price is almost equal to the distance between the third bottom to the second swing high.
7. Flag Patterns
Flag patterns are also worth mentioning among the most important price action patterns. These are continuation patterns and are similar to Channel price action patterns. However, there are a couple of differences. Firstly, Flag patterns have a pole. Secondly, these patterns develop in a shorter time frame. Moreover, Flag patterns can also develop during both uptrend and downtrend.
Bullish Flag patterns develop during an ongoing uptrend. First of all, a strong upward price movement forms a flagpole. Then, a period of consolidation occurs in which the price instantly moves against the uptrend. Thus, a series of lower highs, typically consisting of five to twenty candlesticks, appears. Moreover, the upper and lower trend lines run parallel to each other. Additionally, the lower trendline must not be above the midpoint of the flagpole. Bullish Flag patterns are successful when the price eventually breaks above the upper trendline. Moreover, the rise in price must also cover as much distance as the flagpole.
Conversely, Bearish Flag patterns develop during an ongoing downtrend. Firstly, a strong downward price movement forms a flagpole. Then, a period of consolidation occurs in which the price instantly moves against the downtrend. Thus, a series of higher lows, typically consisting of five to twenty candlesticks, appears. Moreover, the upper and lower trend lines run parallel to each other. Additionally, the upper trendline must be below the midpoint of the flagpole. Bearish Flag patterns are successful when the price eventually breaks below the lower trendline. Moreover, the decline in price must also cover as much distance as the flagpole.
Price action patterns – the wrap-up
The price action patterns are very important to cope with the precarious market. Traders can identify the best entry and exit points using these patterns. However, it is also a fact these price action patterns are not always successful. In fact, price action patterns don’t ensure that the market will behave in an expected way. If we talk about it in terms of percentage, several studies indicate that even the most reliable price action patterns are successful only up to 60-70%. Still, using price action patterns is better than anticipation and baseless predictions.