Chart patterns: recurring shapes, to be handled with caution

Chart patterns are shapes that the price draws on a chart: a double top, a head with two shoulders, a triangle. Their popularity comes from their visual appeal and the implicit promise of a "signal". But reading them is more fragile than it looks. This article presents the main patterns, how they are described, how some analysts derive a theoretical price target from them and why you should know their limits before giving them weight.

2 families

Reversal patterns describe a possible change of trend: double top, double bottom, head and shoulders and its inverse.
Continuation patterns describe a pause before the existing trend resumes: triangles, flags, pennants, rectangles.

In both cases, the pattern assumes a prior trend: without one, a reversal or a continuation has no meaning. See trends, channels and breakouts.

Reversal patterns

The double top (an "M" shape): after a rise, the price reaches a peak, falls back, rises again towards the same level without exceeding it, then falls back again. The pattern is considered complete when the price breaks down through the intermediate low (the "neckline"). The double bottom (a "W" shape) is its mirror image after a decline.

The head and shoulders: after a rise, 3 peaks, of which the middle one (the head) is the highest and the two outer ones (the shoulders) are lower and at roughly the same level. The neckline connects the two lows between the peaks. The pattern is considered complete when the price falls below that line. The inverse head and shoulders is its mirror image after a decline.

Continuation patterns

The triangle: the price moves between two converging lines. It can be ascending (horizontal resistance, ever-higher lows), descending (horizontal support, ever-lower highs) or symmetrical.
The flag and the pennant: after a rapid move (the "pole"), the flag is a short pause in a channel sloping against the move, the pennant a short pause in a small narrowing triangle.
The rectangle: the price moves in a horizontal range before moving off, generally in the direction of the previous trend, with no certainty.

A triangle or a rectangle can resolve in either direction: the usual direction is not a rule.

The theoretical price target

A common method: the height of the pattern is projected from the breakout point. Fictitious example. For a double top whose peak is at €100 and whose neckline is at €90 (height: €10), the theoretical downside target is 90 − 10 = €80.

It is a reading convention, not a forecast: the price can stop before, go further or not reach the zone. It mainly serves to compare the potential gain of a hypothesis with its risk, which points to risk management.

The role of volume

In the classic reading, volume has a typical behaviour: it decreases while the pattern forms and increases at the time of the breakout, which is judged more credible in that case. See volume and the confirmation of signals.

Why these patterns are hard to use

They are mostly recognised after the fact. A pattern is only judged complete at the time of the breakout, that is, after the move has started.
They are subjective. Two analysts do not always draw the same neckline or the same shoulders.
Many patterns do not complete or do not continue as expected. Incomplete patterns, breakouts that do not hold, shapes that never finish: the patterns that "work" are the ones we remember.
Their reliability is not robustly established. See the reliability of chart patterns and interpretation biases.
They ignore news. An earnings release or an external event can sweep away a pattern.

Key takeaways

2 families: reversal (double top, head and shoulders) and continuation (triangles, flags, rectangles).
A pattern assumes a prior trend and is only complete at the breakout.
The theoretical target (projected pattern height) is a convention, not a forecast.
Patterns are subjective, mostly spotted after the fact, and their reliability is debated.

In Earnnest, some patterns (double top, double bottom, head and shoulders and its inverse) are detected for information and description only: the direction and confidence level shown describe the shape spotted in the history; they do not constitute a recommendation.

This article is for information and education only and does not constitute personalised investment advice. The figures in the examples are fictitious and illustrative. Investing involves a risk of capital loss. Past performance is not a reliable indicator of future performance.