Education > Forex - Step9

[SECTION 3.3]

Technical analysis: price patterns

Traders vote with their pocketbooks. If they think a currency pair is going to go higher, they will buy that pair. If they think a currency pair is going to go down, they will sell that pair. When it's their money on the table, they will do whatever they have to do to make profit. Frequently, the actions of these necessarily selfish traders cause price patterns on the chart.

Price patterns are chart formations that provide clues as to how forex traders feel about the market at various price levels. Recognising various price patterns gives you the upper hand on traders who rely only on fundamentals or technical indicators.

Imagine you are able to precisely identify trade entry points as a currency pair breaks out in tandem with the ability to accurately project where a currency pair is going to move to once it has broken out and starting moving. This is precisely what price patterns do.

Price patterns are divided into the following two categories:

1. Continuation patterns [SECTION 3.3.1]
2. Reversal patterns [SECTION 3.3.2]

[SECTION 3.3.1]

Continuation patterns

"Is this trend sustainable?"

This is a question that forex traders will always ask. The point of entering a new trade in the middle of a trend or exiting the trade you are currently in so that you can take your profits is a difficult decision to make. You probably feel that you can never be sure whether a currency pair is about to turn around and start moving in the opposite direction. You can learn how to eliminate a lot of the doubt however, if you learn how to make continuous patterns a critical part of your decision-making process.

Continuation patterns can alert you as to when a currency pair is likely to resume its trend after a short consolidation period and how far the currency pair is likely to go in that direction. And, while they are not fireproof, continuation patterns do help to stack the odds in your favour.

Take some time to become acquainted with the following price continuation patterns:

1. Pennants [SECTION 3.3.1.1]
2. Flags [SECTION 3.3.1.2]
3. Wedges [SECTION 3.3.1.3]
4. Triangles [SECTION 3.3.1.4]

[SECTION 3.3.1.1]

Pennants

Pennants are continuation patterns that develop as the price of a currency pair moves into a tighter and tighter consolidation range. Pennants can be bullish or bearish, depending on what the trend was prior to the development of the pennant. If a currency pair was in an up trend before the pennant began to form, it is a bullish continuation pattern. If a pair was in a down trend before the pennant began to form, it is a bearish continuation pattern. Pennants usually develop over shorter periods of time.

Pennants all have the following five characteristics (see figure 1):

1. Resistance level (A): This is a down-trending level of resistance that is converging with the support level.

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1. Support level (B): This is an up-trending level of support that is converging with the resistance level.

1. Flag pole (C): This is the trend preceding the emergence of the pennant. The flag pole covers either the distance from the outset of the trend to the highest point of the pennant (bullish pennant), or the gap from the outset of the trend to the lowest point of the pennant (bearish pennant).

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1. Breakout point (D): This is the point where the currency pair breaks up either above the down-trending level of resistance (bullish pennant) or below the up-trending level of support (bearish pennant).

1. Price projection (E): This is the price to which the currency pair will either �probably fall after it has broken out of the pennant formation (bearish pennant), or rise after it has broken out of the pennant formation (bullish pennant). The distance the currency pair is projected to move is the same as the height of the flag pole.

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Figure 1-Pennant

[SECTION 3.3.1.2]

Flags

Flags are continuation patterns which develop when the price of a currency pair retreats from the prevalent trend in a parallel channel. Flags can be either bullish or bearish, depending on what the trend was prior to the flag's formation. If a currency pair was in an up trend before the flag began to emerge, it is a bullish continuation pattern. If a currency pair was in a down trend before the flag began to emerge, it is a bearish continuation pattern. Flags usually develop over shorter periods of time.

Flags all have the following five characteristics (see figure 2):

1. Resistance level (A): This is the down-trending level of resistance that is parallel to the support level (bullish flag), or an up-trending level of resistance that is parallel to the support level (bearish flag).

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1. Support level (B): This is the down-trending level of support parallel to the resistance level (bullish flag), or an up-trending level of support that is parallel to the resistance level (bearish flag).

1. Flag pole (C): This is the trend that precedes the development of the flag. The flag pole either spans the distance from the outset of the trend to the top of the flag (bullish flag) or the distance from the outset of the trend to the bottom of the flag (bearish flag).

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1. Breakout point (D): This is the point at which the currency pair either breaks up above the down-trending level of resistance (bullish flag) or breaks down below the up-trending level of support (bearish flag).

1. Price projection (E); This is the price to which the currency pair will either probably fall after it has broken out of a bearish flag formation or probably climb to once it has broken out of a bullish flag formation. The distance the currency pair is projected to move is the same as the height of the flag pole.

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Figure 2-Flag

[SECTION 3.3.1.3]

Wedges

Wedges are continuation patterns that emerge when the price of a currency pair retreats from the prevalent trend and moves into a tighter and tighter consolidation range. Wedges can be bullish or bearish. Which it is depends on the trend in existence prior to the wedge's development. If a currency pair was in an up trend before the wedge began to form, it is a bullish continuation pattern. If a currency pair was in a down trend prior to the wedge's development, it is a bearish continuation pattern. Wedges tend to emerge over shorter periods of time.

Wedges all have the following five characteristics (see figure 3):

1. Resistance level (A): This is either the down-trending level of resistance converging with the support level (bullish wedge) or an up-trending level of resistance that converges with the support level (bearish wedge).

1. Support level (B): This is either the down-trending level of support (bullish wedge) �or an up-trending level of support (bearish wedge). that converges with the resistance level

1. Flag pole (C): This is the trend in place before the wedge emerges. The flag pole is either the distance from the beginning of the trend to the top of the wedge (bullish wedge) or to the bottom of the wedge (bearish wedge).

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1. Breakout point (D): This is either the point at which the currency pair breaks up above the down-trending level of resistance (bullish wedge), or breaks down below the up-trending level of support (bearish wedge).

1. Price projection (E): This is either the price to which the currency pair will probably fall after it has broken out of the wedge formation (bearish wedge) or probably rise after it has broken out of the wedge formation (bullish wedge). The distance the currency pair is projected to move is the same as the height of the flag pole.

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Figure 3-Wedge

�[SECTION 3.3.1.4]

Triangles

Triangles are continuation patterns that emerge as the price of a currency pair hits a flat level of support or resistance and commences moving into a tighter and tighter consolidation range. Triangles can be either bullish or bearish. Which it is depends on the trend that was in existence before the wedge began to emerge. If a currency pair was in an up trend before the triangle began to form, it is a bullish continuation pattern. If a currency pair was in a down trend before the triangle began to form, it is a bearish continuation pattern. Triangles usually form over longer periods of time.

Triangles all have the following five characteristics (see figure 4):

1. Resistance level (A): This is either the horizontal level of resistance (bullish, or ascending triangle) or a down-trending level of resistance that converges with the support level (bearish or descending triangle).

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1. Support level (B): This is either the up-trending level of support that converges with the resistance level (bullish or ascending triangle) or a horizontal level of support (bearish or descending triangle).

1. Flag pole (C): This is the trend in place prior to the emergence of the triangle. The flag pole either covers the distance from the trend's outset to the highest point of the triangle (bullish, or ascending triangle) or the distance from the outset of the trend to the lowest point of the triangle (bearish or descending triangle).

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1. Breakout point (D): This is either the point at which the currency pair breaks up above the horizontal level of resistance (bullish, or ascending triangle) or at which it breaks down below the horizontal level of support (bearish or descending triangle).

1. Price projection (E): This is either the price to which the currency pair will probably drop once it has broken out of the triangle formation (bearish, or descending triangle) or will probably climb once it has broken out of the triangle formation (bullish or ascending triangle). The distance the currency pair is projected to move is the same as the height of the flag pole.

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Figure 4-Triangle

[SECTION 3.3.2]

Reversal patterns

We've already discussed the difficulties in determining whether a trend can be sustained. Just like continuation patterns, reversal patterns can be an invaluable tool if you can successfully assimilate them into your analysis.

While they offer no guarantees, they can take some of the guesswork out of your decision-making process.

Take some time to become acquainted with the following price reversal patterns:

1. Double tops/bottoms [SECTION 3.3.2.1]
2. Triple tops/bottoms [SECTION 3.3.2.2]
3. Head-and-shoulders top/bottoms [SECTION 3.3.2.3]

[SECTION 3.3.2.1]

Double tops/bottoms

Double tops/bottoms are reversal patterns that emerge as the price of a currency pair hits a support or resistance level twice before the currency pair turns and retreats in the opposite direction. Double tops are bearish reversal patterns and double bottoms are bullish reversal patterns. If a currency pair is in an up trend, then a double top will form. If a pair is in a down trend, �a double bottom will be the outcome. Double tops/bottoms usually develop over longer periods of time.

Double tops/bottoms all have the following four characteristics (see figure 5):

1. Resistance level (A): This is a horizontal or slightly angled level of resistance.

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1. Support level (B): This is a horizontal or slightly angled level of support.

1. Breakout point (C): This is either the point at which the currency pair breaks up above the horizontal level of resistance (double bottom) or breaks down below the horizontal level of support (double top).

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1. Price projection (D): This is either the price to which the currency pair will probably slip or probably climb once it breaks out of the double-top formation. The distance the pair is expected to move is equal to the distance between the support and resistance levels.

Figure 5-Double top

[SECTION 3.3.2.2]

Triple tops/bottoms

Triple tops/bottoms are reversal patterns which form as the price of a currency pair hits a support or resistance level three times before the currency pair turns and retreats. Triple tops are bearish reversal patterns and triple bottoms are bullish reversal patterns. If a currency pair is in an up trend, a triple top will emerge. If a pair is in a down trend a triple bottom will be the outcome. Triple tops/bottoms tend to form over longer periods of time.

Triple tops/bottoms all have the following four characteristics (see figure 6):

1. Resistance level (A): This is a horizontal or slightly angled level of resistance.
2. Support level (B): This is a horizontal or slightly angled level of support.

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1. Breakout point (C): This is either the point at which the currency pair breaks up above the horizontal level of resistance (triple bottom) or breaks down below the horizontal level of support (triple top).

1. Price projection (D): This is either the price to which the currency pair will probably drop after it breaks out of the triple-top formation or climb after it breaks out of the triple-bottom formation. The distance the currency pair is estimated to move is equal to the gap spanning the support and resistance levels.

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Figure 6-Triple top

[SECTION 3.3.2.3]

Head-and-shoulders tops/bottoms

Head-and-shoulders tops are reversal patterns which emerge as the price of a currency pair gets to a resistance level (forming the first shoulder) then breaks through that resistance level to hit a higher resistance level (forming the head). Subsequently, it then retreats to the first resistance level (forming the second shoulder).

Head-and-shoulders bottoms are reversal patterns which develop as the price of a currency pair reaches a support level (forming the first shoulder) before breaking through the first support level to reach a lower support level (forming the head). Subsequently, it then retreats to the first support level (forming the second shoulder).

Head-and-shoulders tops are bearish reversal patterns. It follows then that head-and-shoulders bottoms are bullish reversal patterns. If a currency pair is in an up trend, a head-and-shoulders top will emerge. If a currency pair is in a down trend, a head-and-shoulders bottom will develop. Head-and-shoulders tops/bottoms tend to develop over long periods of time.

Head-and-shoulders tops/bottoms all have the following five characteristics (see figure 7):

1. Left shoulder (A): This is a horizontal or slightly angled level of resistance (head-and-shoulders top), or a horizontal or slightly angled level of support (head-and-shoulders bottom).

1. Head (B): This is a higher horizontal or slightly angled level of resistance (head-and-shoulders top), or a lower horizontal or slightly angled level of support (head-and-shoulders bottom).

1. Right shoulder (C): This is a horizontal or slightly angled level of resistance that aligns with the left shoulder (head-and-shoulders top), or a horizontal or slightly angled level of support that aligns with the left shoulder (head-and-shoulders bottom).

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1. Neckline (D): This is a horizontal or slightly angled level of support (head-and-shoulders top), or a horizontal or slightly angled level of resistance (head-and-shoulders bottom).

1. Breakout point (E): This is either the point where the currency pair breaks up above the neckline (head-and-shoulders bottom) or breaks down below the neckline (head-and-shoulders top).

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1. Price projection (F): This is either the price to which the currency pair will probably fall once it breaks out of the head-and-shoulders top formation or rise once it is clear of the head-and-shoulders bottom formation. The distance the currency pair is expected to move is the same as the gap spanning the head and the neckline.

Figure 7-Head-and-shoulders top