Technical analysis is a commonly used tool by stock traders to help them make informed investment decisions. In its simplest form, technical analysis studies past price movements to identify patterns and forecast future price behaviour. While many different price patterns can be studied, this article will focus on three of the most popular. By understanding how to recognise these patterns and what they mean for a stock’s chart, traders can use technical analysis as one piece of their overall trading strategy to help improve their chances of success in the market.
What is technical analysis, and what are price patterns?
Technical analysis studies past price movements to identify patterns and forecast future price behaviour. Price patterns are recurring formations or shapes observed on a stock’s price chart. These patterns can provide clues about a stock’s future direction and help traders make better-informed decisions about when to buy or sell.
There are different types of price patterns that technical analysts study. Still, three of the most popular are support and resistance levels, head and shoulders patterns, and double tops and bottoms.
Support and resistance levels
One of the most commonly used concepts in technical analysis is support and resistance levels. Simply put, these are price points where a stock has trouble breaking below (resistance) or above (support). Resistance levels typically form when a stock hits a specific price and starts to pull back, as the buyers are no longer willing to pay that high price. Similarly, support levels occur when a stock reaches a specific price and starts to rebound, as the sellers will no longer be willing to sell at that low price.
These levels can be found by looking at a stock’s past price action and identifying where it had trouble breaking through in the past. Once these levels are identified, traders can use them to help make informed decisions about future price movements. If a stock trades at a resistance level, the trader may expect it to start pulling back soon. On the other hand, if a stock is trading at a support level, the trader may expect it to start moving higher.
Head and shoulders patterns
It is one of the technical analysis’s most reliable and easy-to-identify price patterns. This pattern typically forms after a stock has had a sustained uptrend and starts to experience weakness. The pattern is made up of three distinct peaks, with the middle peak (the ‘head’) being the highest and the two outside peaks (the ‘shoulders’) being lower. The neckline is formed by connecting the lows of the two outside peaks.
This pattern is considered very bearish, as it suggests that the stock’s uptrend is coming to an end. Traders will often use the neckline as a potential sell point, as a break below this level could signal further weakness in the stock.
Double tops and bottoms
Another popular price pattern is the double top or bottom. This pattern typically forms after a stock has made a significant move in one direction and reverses course. The pattern is made up of two distinct peaks (in the case of a double top) or troughs (in the case of a double bottom), with the second peak or trough being lower than the first.
The double top is considered to be a bearish reversal pattern, as it suggests that the stock’s uptrend may be coming to an end. In contrast, the double bottom is considered a bullish reversal pattern, as it suggests that the stock’s downtrend may end. Traders will often use the peaks or troughs of these patterns as potential entry or exit points.
How to trade using price patterns
Now that we’ve covered the most popular price patterns, let’s look at how traders can use them in their trading strategies. There are two main ways to trade price patterns: breakout and reversal.
Breakout trading involves taking a position in a stock when it breaks out above a resistance level or below a support level. This type of trade is often considered high-risk, as there is no guarantee that the stock will continue moving in the desired direction. However, breakout trades can also be very lucrative if timed correctly.
Reversal trading, on the other hand, involves taking a position in a stock when it reverses course after forming a head and shoulders pattern or a double top/bottom. This type of trade is often considered lower-risk, as the trader enters the trade after the stock has already made a significant move in one direction. Click here to find out more on share dealing.