Stock Markets Guides

Author: Nishit Kumar

Trading Patterns In-Depth

Guide

A major part of your day when trading the markets involves you trying to spot trading
patterns.

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As time passes, you will get better and better at identifying trading patterns. Still, in
the initial stages of your trading, you will have to spend quite a lot of time and effort
spotting patterns so that you can open and close positions accordingly.

What patterns you choose to trade will depend on what type of trader you are and your
preferred class of patterns. However, you need to be aware of different trading
patterns.

In this post, you will learn what trading patterns are, the different types of trading
patterns that you could use, and some examples of each type of pattern.

What are Trading Patterns?

Before discussing the different types of trading patterns that you can spot and choose
from, you need to understand what patterns are why being able to spot them is
important for you as a trader.

A pattern is a distinctive formation created by movements in the price of a particular

security or stock. As a trader, you will try to identify patterns in a particular security’s
closing prices or highs and lows to predict the direction that the stock price will be
taking in the future.

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Trading patterns can easily be spotted in hindsight as you go back and look over
previous price movements; however, to profitably trade, you need to be able to spot
these patterns in real-time as and when they occur.

The real-time identification of trading patterns forms the basis for all technical
analysis, and this can happen with any security at any given point in time. There are
several types of patterns that traders can look out for depending on their trading style,
risk profile, and choice of instruments they trade.

Each trading pattern has a particular predictive capacity. The higher this predictability,
the higher the probability of a trader booking a profit if they choose to trade on this
strategy.

Trading patterns are usually formed and identified using candlestick patterns, and the
anatomy of a candlestick has been discussed below.

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How to Read a Candlestick
A candlestick is basically a type of chart, and it is the most popularly used chart among
traders. Its popularity stems from the fact that it is easy to read, and at the same time,
it provides a lot of information that traders can use to identify patterns.

In a candlestick chart, every candle represents a unit of time, and this unit can be
chosen by the trader based on their convenience and preferences. Traders use
anywhere between 1 second and 1-day as their unit of time for a single candle, as
different durations can be used to spot different trends in the stock price data and give
rise to different strategies.

Reading a candle is quite simple and involves an understanding of the anatomy of a

candle.

A candle has two parts: the body and the wicks. The body is a rectangle connecting the
open and closing prices, and the wicks above and below the body indicate the highs
and lows of the particular trading period respectively. By looking at a candle, you can
easily see the open, closing, high, and low prices for a particular trading period.

However, a candle offers much more information than this: it also indicates whether a
particular trading period was bullish, bearish, or neutral.

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This is done by coloring the body of the candle. A green-colored candle is bullish, and a
red-colored candle is bearish. Thus, market sentiments can easily be identified by
looking at a candle.

Candlestick patterns can be formed using one candle, two candles, or a large number
of candles. Each of these patterns indicates a different movement in the stock price,
and they are best understood by analyzing the sentiments and the psychology behind
these patterns. A variety of trading patterns grouped by categories have been
discussed below.

Long Term Trading Patterns

One of the ways to group trading patterns is their timeframe. This could refer to the
timeframe in which the price movements were analyzed, the timeframe in which the
position is expected to pay off, or both.

Long-term trading patterns are only undertaken by traders who have a long time
horizon and the highest levels of patience and discipline since these are crucial to the
strategy's success. Two of the most commonly used long-term trading patterns are the
cup and handle pattern and the head & shoulders pattern. Each of these has been
discussed below in detail.

Cup and Handle Pattern

The cup and handle pattern is one of the longer-term trading patterns, which is usually
formed over a period of time ranging from 7-65 weeks. The chart for this pattern
represents a cup with a handle, and it is a bullish signal.

The wider the cup is, the more reliable the signal is said to be. In this strategy, the price
first touches the resistance levels, pulls back to the support, and starts moving
upwards again towards the resistance, thereby forming a cup shape.

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This is followed by a slight bearish movement, which looks like the cup’s handle before
the stock price shoots up. There is usually a lower trading volume towards the handle,
indicating that bearish pressures on the stock are now becoming weaker.

The trading strategy for this pattern is that a trade is opened at the resistance level
when the handle ends and the price starts moving up. A stop order is usually placed,
which means that the trade will not be executed until a specific price level.

This level is higher than the resistance, thereby protecting against a pullback. A
particular limitation of this strategy is that since it can take any amount of time to play
out, with the pattern not forming for a month, a year, or even several years, there is
always the danger of ambiguity and missing the signal.

Head and Shoulders Pattern

The head and shoulders pattern is widely considered one of the most reliable
long-term indicators for a trend reversal. Resembling the human body, the chart
pattern for this pattern is three peaks in the stock price.

However, the second peak is much higher, representing the head of the body, and the
outer two are approximately on the same level as the shoulders in the pattern. The
timeframe for this pattern is a lot shorter than it is for the cup and handle pattern, and
most o en, this pattern can be observed over a period of a few weeks.

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It indicates a bull-to-bear reversal, and the third peak (outer shoulder) is a good
opportunity to short the stock, with the take profit levels well below the base of the
pattern.

However, some risk-averse traders prefer to wait before the price touches the support
levels for the pattern and only opening a short position once they are sure it is a
breakout. While that restricts their potential gains, it is a more risk-averse strategy as it
ensures that the downside is limited.

Intraday Chart Patterns

Intraday chart patterns are very different to long-term chart patterns in a lot of ways.

For one, their timeline is a lot shorter; intraday trades are usually opened and closed
on the same day. The timeframe being considered is shorter, which limits the analysis
that can be done on the stock. Day traders commonly use these strategies, and the
successful execution of these trades requires a keen eye, fast reflexes, and good
analytical skills.

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Due to the shorter timeframe of these ideas, it is important to open and close trades at
exactly the right time, avoid being too late or too early, and get caught on the wrong
side of the trade.

Two of the most commonly used intraday chart patterns are the shooting star and the
Doji candlestick. These are single candlestick charts, which makes sense considering
the short timeframe in which these trades have to be identified, analyzed, and
executed.

Shooting Star Pattern

The shooting star candlestick represents a reversal from a bullish to a bearish trend. It
is one of the most basic trading patterns that every trader learns about and is quite
simple to understand because it is based on simple market psychology.

A shooting star pattern occurs at the end of a bullish trend, usually, a er around 3-4
continuously green candles have been spotted.

The candle can be characterized by a small body and an upper shadow that is at least
twice the length of the body. A er the shooting star pattern has been spotted, the
market turns bearish, and stock prices can fall as low as support levels.

This happens because, as bulls keep pushing up prices by buying more and more of
the stock, the price keeps rising.

At the beginning of the shooting star candle, buyers are still buying the stock and
pushing up stock prices, as indicated by the large upper shadow. However, at one
point, the smart buyers book their profits and sell their stocks, resulting in a panic
selling round as the bears gain more power and control over the market. As people
keep pulling out and selling their shares to book profits, the prices continue to fall until
the bulls come back in control of the market and begin buying again.

This is why the presence of the shooting star pattern is considered a reliable indicator
to open a short position, as long as there is secondary confirmation that to do so
would be advisable.

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Doji Candlestick Pattern

The Doji candlestick pattern is another straightforward candlestick trading pattern that
traders commonly use.

The word Doji signifies indecision, and the appearance of a Doji candlestick is usually
an indicator of a reversal in the trends. The candle looks like a cross, with a tiny body
and long shadows. Whether the reversal is bullish or bearish will depend on the
previous candlesticks; however, the Doji candlestick is a reliable indicator of a reversal.

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If a Doji candle is seen at the top of a bullish trend, it means that the prices could start
falling. On the other hand, if it is seen at the bottom of a bearish trend, it indicates the
beginning of an uptrend.

When the price opens in a Doji candle, it moves in the same direction as the trend
indicates. However, a er a point, the other side begins to gain power, and the stock
price begins to move in the opposite direction. Both sides fight as they attempt to
control the price by pushing it in opposite directions.

As a result, the stock price closes close to where it opened, with long shadows
representing the struggle between the bears and the bulls. This indicates that one side
is no longer in complete power over the market and could reverse the trend as the
other side begins consolidating its power.

A Doji candlestick is a good indicator to open a position opposite the underlying trend.

Swing Trading Patterns

A swing trader is in the middle ground between a day trader and a long-term trader:
they trade on a timeline that spans from a few weeks to a few months at most. Their
trading patterns are longer than intraday patterns; however, they do not take as long
as the long-term trading patterns do.

Swing traders are called so because they trade on swings in the prices of securities.
These swings can take a bit of time to materialize; hence swing traders require both
disciplines as well as analytical skills: while the latter enables them to spot potential
swings, the former enables them to wait them out and ensure that they get as many
profits as they can on a potential trade.

Two of the most frequently traded chart patterns by swing traders are T-30 and Bull
Flag patterns.

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T-30 Pattern

This is one of the easier patterns to identify and trade; hence it is very widely popular
in trading circles, especially beginner traders. This pattern can be spotted using the
30-day exponential moving average if you’re using the daily candlestick charts.

The pattern occurs when a particular candle cuts through the 30-day average price
levels. While the candle that most commonly cuts through the average line is a
hammer candle, this is not essential. Another important factor that you need to look at
for this pattern is that the volume on this particular day when the slicing occurs has to
be higher than in the previous few days.

To trade this pattern, all you need to do is buy the stock when this pattern has been
observed. The stock will then proceed to go up. The reason this pattern is relied upon
by traders is because there is a confluence of multiple trading signals: the volume
indicator shows that the volume is coming back into the stock, which is a signal of a
reversal; the moving average indicator shows that the stock was previously in a bearish
trend and is ripe for a reversal.

In addition to this, the pattern is normally seen at the support levels of the stock
prices, thereby adding to the confirmation that the trend is due to be reversed.

Bull Flag Pattern

The bull flag pattern is an indicator of a pullback in the trend of the stock price. It is
named so because upon tracing the price action, the shape formed resembles a flag. A
bull flag pattern has three main features:

1. The stock price begins by moving upwards with a high volume, indicating a
strong bullish sentiment. This forms the pole of the flag in the strategy.
2. The stock price stabilizes on the top of the pole, and volumes also begin
becoming stable.
3. The price then gradually moves downwards before stopping at a point and then
reversing its direction to move upwards with an increasing volume.

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Beginners commonly use this pattern; however, one of the biggest challenges to using
this pattern is to spot this pattern in real-time, as you can only trace the flag once the
pattern has already been formed. At that point, it is already too late.

Most traders use scanners to identify bull flag patterns and make it easier for them to
trade on these patterns.

Trend Trading Patterns

Trend trading patterns can be classified into two types; reversals and continuation.
Such traders try to trade the underlying trend that a stock has been following for a
given period of time. Timeframes do not limit them. A trend trader could see gains in
his position in a minute or a year, depending on the price action.

Both types of traders, along with the tools and patterns they most commonly use, have
been discussed below.

Trend Reversal Trades

Reversal trend traders usually open trades at the top of a trend and bet against the
underlying momentum. This is done when they think that the stock has been
overbought or oversold, and they believe that the price movements indicate a reversal
of the trend as the other side of the market gains power. They have higher profit
potential as reversals in trends tend to be quite large; however, the level of risk they
undertake is also quite high since reversals are difficult to predict.

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O en, what looks like a reversal could very well be a false reversal, and the price could
continue moving in the same direction.

Reversal traders generally use indicators to show them when a stock is overbought or
oversold.

An example of such an indicator is the RSI (Relative Strength Index), which gives a
value between 0-100 depending on the market's previous price action and volatility to
indicate overbuying and overselling.

An RSI score above 80 indicates that a stock is overbought and could reverse into a
bearish market at any point. In contrast, an RSI score below 30 indicates an oversold
market ripe for a bullish reversal.

Trend Continuation Trades

On the other hand, continuation traders trade on the side of the underlying
momentum of the stock price, and they aim to ride the trend and make profits. This is
done when they are confident that the trend is expected to continue for quite a while.

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While continuation trades are considered to be much safer since the underlying
volume and momentum of the stock price favor the trader, the profit potential is quite
limited since a reversal might happen at any time.

A very commonly used continuation pattern that traders tend to use is a triangle. It is
characterized by a series of candles that are constantly fluctuating and changing
trends. However, each time, the highs keep getting lower, and the lows keep getting
higher, forming a triangle shape.

As the triangle gets closer and closer, the greater is the probability that the stock price
will breakout and pass the resistance levels to continue on its bullish trend.

Stock Trading Patterns

As you have seen above, every type of trader has their own set of patterns that they
choose to trade on. For each type, say swing trading or day trading, there are many
patterns that the trader can choose from.

Each pattern means something different in terms of what it indicates for the stock
price.

The best way to understand a stock pattern is to think about it in terms of bears and
bulls and analyze the psychology behind each segment of the market. Like what was
done above for the doji and shooting star candlestick, you should try and analyze
every candle to see what it could indicate and what it means for the future price
movements in the market.

Using Pattern Scanners and Indicators

Some patterns might be difficult to spot in real-time, which is why traders use scanners
to indicate if certain patterns are being formed.

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There are two types of scanners you can use: discretionary scanners and automatic
scanners.

Discretionary scanners will merely alert you about certain patterns formed in the
market, leaving the ultimate decision of whether or not to trade on this pattern up to
you. This leaves you in control as the final decision maker and is useful because it lets
you identify high probability trading strategies and trade only on them; however, it
might also result in wasted time and therefore cause a minimization in the profits.

On the other hand, an automatic scanner will identify a pattern and assume it fits the
criteria you have specified initially; the scanner will automatically open a position.

This is a useful tool when you are paper trading to finetune your trading strategies, as
it enables you to test your hypothesis in real-time and make adjustments to maximize
the profitability of your strategies.

However, this also has the disadvantage that you are no longer in control, and the
scanner might end up making some sub-optimal trades just because they conform to
your criteria.

High-Profit Trading Patterns

Not every trading pattern is worth trading. Certain patterns offer a higher probability of
success than others do.

As a trader, there will always be several opportunities for you to trade on; however, it is
up to you to identify the ones which yield the highest probability of success and use
that to then trade so that your capital and time are being utilized in the best way
possible.

The two ways to ensure that a particular strategy is both high-probability and highly
profitable are to check the confluence and wide-open space on the trade.

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Confluence

The confluence factor is the number of different indicators that agree on a particular
trading opportunity. Suppose your support and resistance are consistent with a doji
candlestick pattern, backed by the favorable RSI number. You know that a particular
trading opportunity has a higher likelihood of being profitable because several
patterns have a confluence on that particular point.

Wide-open space

The wide-open space refers to how much potential there is for a particular stock’s price
to move once you open a position.

The larger the wide-open space is, the higher the potential for you to be profitable.
This wide-open space is o en the distance to the next support or resistance level since
reversals are most likely to occur at this point. Hence, the wide-open space is also a
factor worth considering when deciding on what patterns to trade.

Trading Classic Chart Patterns

Identifying a chart pattern that you can trade on is not all it takes to become a
profitable trader.

What you also need in conjunction with an ability to spot trading patterns is an
established trading setup. A trading pattern is different from a setup in that the setup is
a list of conditions that need to be satisfied for the trader to go ahead with the trade.

This could include looking for confluence factors, conditions relating to the volume of
the stock, setting the stop-loss, or any number of other factors. It would be best to
have a trading setup since it will make you disciplined and enable you to trade

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optimally and consistently. Setting a proper stop loss will also ensure that you do not
risk large amounts of capital on a single trade and minimize your losses.

The ideal way to establish a trading setup is to borrow one from a more successful
trader and then adapt it over time to suit your own needs and requirements.

Lastly
In this article, you have seen various trading patterns, each of them with its own
degree of difficulty, timeline, level of certainty, and potential for profits.

Similar to this, several other patterns exist. As a trader you will have to read and
understand them based on what kind of trader you are, try to spot them while trading,
and learn to exploit these patterns to ensure your profitability in the market.

Stock Markets Guides

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