Finding the right time to enter a trade is as important as risk management and technical analysis. Missing a few candles can sometimes change the whole game and greatly impact your PL. Therefore, a good trader needs to learn how to identify core price patterns and react to them quickly. Trend continuation and reversal patterns are exactly what you need to look for, and in this article, we’ll cover the figures that can help you decide whether to enter a position or not.
Support and resistance level trading
Traders around the world are typically divided into three different categories, depending on how they make decisions: some operate on rumors, some base their decisions on solid facts (fundamental analysis), and others base their commitments on reading the graphs (technical analysis).
“The most successful class of traders are those who work on supply and demand, or simply read the graphs.”
The first thing many traders consider when making trading decisions is the supply and demand, or support and resistance levels. These represent the levels where high volumes of buying or selling are concentrated for a specific asset. Let’s have a look at the graph below: $8.2K represents the BTC supply (resistance), whereas $7.6K represents the current BTC demand (support).
In other words, the support and resistance levels are the levels where the price tends to stop growing or declining and reverses. There are several criteria that traders need to take into consideration when analyzing the support and demand:
- Number of touches
The more times the price touches a level, the more significant it becomes.
- The previous price action
If the price move that precedes the support or resistance zone is steep, the zone is more significant. Fast upswings or downtrends are usually met with higher enthusiasm by market participants, so in this case, support and resistance levels are likely to not yet be formed or be in low volumes that are broken.
The more buying or selling that happens at a specific level, the more significant it becomes. Some graphs allow traders to examine the volumes that are currently being put out as limit orders at a certain level, such as Xena Market Barometer’s Printline.
Analyzing the supply and demand levels is necessary for many trading decisions. It allows for trading within a channel or putting limit orders at levels above or below the support and resistance levels to enter a position once the bulls or bears beat this significant level. Furthermore, many traders put stop loss orders below or above these lines to protect their position.
The core price patterns: continuation and reversal
The power of history in trading can hardly be undervalued: price movements tend to go in circles, and analysts have identified some patterns that indicate whether a trend will continue or change. Basically, a price pattern is a recognizable configuration of a price movement that is identified by a series of trend lines. Experienced traders can identify patterns with a quick glance and check their intuition with the help of other technical indicators. So, let’s have a closer look at what figures indicate that a trend will continue.
Trend continuation patterns
Trend continuation patterns consist of the following:
- Pennants, constructed with two converging trend lines
- Flags, constructed with two parallel trend lines
- Wedges, constructed with two converging trend lines, where both are angled either up or down
Pennants are drawn with two trend lines that eventually converge. The key thing to note about pennants is that they contain trend lines moving in two directions — a downward trend line and an upward trend line. Quite often, the volume decreases during the formation of the pennant, followed by an increase when the price eventually breaks out.
Flags are constructed by two parallel trend lines in a narrow range after a sharp move up or down. They can be angled up or down or be absolutely flat. Usually, a new movement up is precedented by a flag that goes sideways or is slightly angled down. The important thing to remember is that the flag needs to emerge after a sharp move, nearly vertical, to serve as a trend continuation pattern.
Wedges are pretty similar to pennants, as they are drawn using two converging trend lines; however, a wedge is characterized by both trend lines moving in the same direction, either up or down. A wedge that is angled down is an indicator of a pause in an uptrend, and similarly, an upward-angled wedge is a sign of an interruption during a falling market. As with pennants and flags, volumes typically taper off during the formation of the pattern, only to increase once the price breaks above or below the wedge pattern.
Triangles are among the most popular chart patterns, since they occur more frequently compared to the other patterns. Triangles are divided into three groups:
- Symmetrical triangles occur when there are two trend lines moving toward each other. The only signal they give is that a breakout is likely to occur, but they do not indicate the direction.
- Ascending triangles are characterized by a flat upper trend line and a rising lower trend line and suggest an upward breakout is likely to occur.
- Descending triangles have a flat lower trend line and a descending upper trend line, which suggests a downward break is likely to occur.
The magnitude of breaks up or down is typically the same as the height of the left vertical side of the triangle. Triangle patterns can last anywhere from a couple weeks to several months.
Cups and Handles
The cup and handle is a bullish continuation pattern that occurs when an upward trend has paused and will continue as soon as the cup and handle pattern is confirmed.
The “cup” part of the pattern is a “U” shape that resembles a round bowl rather than a “V” shape with equal highs on both sides of the cup. The “handle” forms on the right side of the cup, resembling a flag or pennant that is not preceded by a strong move. Once the handle is complete, the asset is likely to break out to new highs and resume the trend upward.
A closer look at reversal patterns
Reversal patterns indicate a change in the prevailing trend, a period when either the bulls or bears have run out of steam. Reversals that occur at market maximums are also referred to as distribution patterns: These are points where a given asset is more actively sold than bought. Reversals at the bottom of the chart are known as accumulation patterns.
As with continuation patterns, the longer a pattern takes to develop, and the larger the price movement within the pattern, and the larger the expected move once the price breaks out.
There are three main reversal patterns:
- Head and shoulders, which consists of two smaller price movements surrounding one larger movement.
- Double tops, which represent a short-term swing up, followed by a failed attempt to break above the same resistance level.
- Double bottoms, which represent a short-term swing down, followed by a failed attempt to break below the same support level.
Head and Shoulders
Head and shoulders patterns appear at the top or bottom of the market as a series of three pushes: an initial peak or trough, followed by a second and larger one, and finally a third push similar to the first. For example, if the market is trending up and a head and shoulders top pattern occurs, the price is likely to reverse and turn into a downtrend.
Double tops and bottoms
Double tops and bottoms are areas where the market has attempted twice to break through a support or resistance level. In practice, a double top looks like the letter M, and a double bottom looks like the letter W.
Triple tops and bottoms are reversal patterns that aren’t as prevalent as head and shoulders or double tops or bottoms. However, they act in a similar fashion and can be a powerful trading signal for a trend reversal. These patterns occur when the price tests the same support or resistance level three times and is unable to break through.
Price patterns, as you can see from the examples, are pretty logical. They form when the price movement pauses and volumes decrease. These price patterns are easy to find, which makes them a perfect choice in primary technical analysis, when you check the patterns’ signals with the help of other technical indicators, such as moving average, MACD, RSI, etc. So, study up, learn to find patterns on historical data, and then trade at low volumes to test your fresh knowledge!