Despite the constant advances in technical analysis, including the invention of new indicators and ways of analyzing charts, pattern analysis remains one of the basic concepts that a trader can apply to try and predict future price movements. Patterns generally break down into two types – those that signal an end to a trend, and change of direction, called reversal patterns; and those that are seen in the context of a trend, marking a pause in the price movement, but are continuation patterns following which the trend will continue.
It is not enough to find a recognizable pattern in order to trade. You need to check other factors and indicators, and the volume of trading, in order to check how likely it is that the price action suggested by the pattern will occur. For instance, one of the well known price patterns is called the head-and-shoulders, which is basically three peaks in the price with the middle one, the ‘head’, slightly higher. This is normally taken to be a reversal pattern, but can also be a continuation pattern, and this depends on the prevailing trend and other factors.
When trading CFDs in particular, you want to be able to find the best entry point so that you do not have to bear swings against you, with the possibility of margin calls. For the head-and-shoulders pattern you would wait until the price had clearly dropped under the neckline rather than taking a trade when the pattern was first noticed. If the price comes back up to the neckline, the pattern has clearly failed, so that is the stop loss position. The target price would be as far below the neckline as the head was above it.
Other reversal patterns include the double and triple top and bottom, and you can also get ‘complex’ versions of the head-and-shoulders, with additional parts, such as a second head. One of the confirming factors for these patterns is that the volume reduces on each successive peak, signalling a failure of the trend.
Continuation patterns are often shorter term than reversals, and they mark consolidations in a trend. For the most part, trends continue rather than reverse, so you will see more continuation patterns than reversals.
Triangle patterns are frequently continuations, and the triangle means that the price is squeezed into a reducing space, which limits the amount of time the pattern continues before it is finally resolved. In effect, you are looking for a breakout from the pattern to confirm the move, and usually it will be in the original direction.
Other continuation patterns include the flag and the pennant, both of which usually come after a steep price move, and are therefore just resting places in a strong trend. Trading using patterns to spot and predict possible future price movements is one of the fundamental techniques of analysis, and in combination with other indications can be very effective in determining and confirming the price trends to come.