Most profitable chart patterns are caused by the effects of support and resistance. Double and triple tops are the result of a strong area of resistance lasting, likewise double and triple bottoms are the effect of a strong area of support holding for a long period of time. A head and shoulders reversal pattern occurs when the price briefly rises above an area of resistance, falls back to the previous area of support, and then fails to rally back to it's last high meaning the most likely place for the price to go is down since it couldn't rally above the last area of resistance; and an inverse head and shoulders pattern is the same thing in reverse. Round tops and bottoms are the result of gradually rising support followed by gradually falling resistance, or vice versa. And triangles, wedges, flags and pennants are simply just the combination of one support and one resistance line. In order to properly understand chart patterns, why they work, and exactly what they tell us you need to understand support and resistance. It's also important to trade using a sensible time frame and keep the patterns you find on the charts in perspective.
Triangles & Wedges,
A triangle is the result of one support line and one resistance line converging. Triangles typically form over several months and usually end with a sharp and sudden breakout. The direction the breakout is likely to take depends upon the type of triangle. Broadly speaking, there are three types of triangles in technical analysis, symmetrical triangles, ascending triangles and descending triangles.
A symmetrical triangle pattern is the result of rising support and falling resistance, out of all the three types of triangles is it is most difficult to predict which way a symmetrical triangle will break.
An ascending triangle pattern is the result of rising support and flat resistance showing on the trading chart. An ascending triangle is generally considered to be a bullish pattern as it usually breaks out towards the upside. It indicates that buyers are buying at increasingly higher prices; meaning that it's likely that the buyers will eventually take the price past the area where the sellers are causing resistance. When the resistance the sellers are creating has been taken out the triangle will usually end in a violent breakout.
A descending triangle pattern is the result of falling resistance and flat support showing on the trading chart. It is generally considered to be a bearish pattern since it usually breaks out on the downside. It indicates that the sellers are selling at lower and lower prices; meaning it's likely that the sellers will eventually drive the price below the flat area of resistance where the buyers are providing support. Like the ascending triangle, descending triangles usually end in sharp breakouts.
Flags & Pennants,
Flags and pennants are similar to triangles and wedges in structure; the difference between them being the type of patterns they are and the time frames that they form on. Flags and pennants are continuation patterns; they form after a large move as a result of the market temporarily consolidating before it moves again (usually) in the same direction. Flags and pennants typically form over a time period of around a day to several weeks, unlike triangles that usually take several months to form. When the support and resistance lines run in parallel the consolidation pattern is known as a flag, when the support and resistance lines are converging the consolidation pattern is known as a pennant.
A Flag: Notice the price consolidating between two parallel lines before continuing in the same direction
Pennants: Notice how the price consolidating between converging support & resistance lines before continuing in the same direction
Head and shoulders,
The head and shoulders pattern is considered by many to be the most reliable reversal pattern; a head and shoulders chart pattern unfolds in three stages –
The price rises, peaks, and then declines.
The price rises again, surpasses the former peak, and then declines again.
The price rises once more but fails to reach the heights that it rose to on the 2nd peak.
With the price failing to rally above it's last peak the most likely place the price will go next is down -
Double and Triple Tops & Bottoms,
Double and triple bottoms are bullish patterns; they are the result of a strong area of support and signal that the price is going up since it failed to fall though the support. Double and triple tops are the same thing in reverse, they are bearish patterns resulting from strong resistance and signal that the price is going down since it has failed to breakthrough the resistance. The larger the time frame of the chart these patterns appear on the stronger the support/resistance is and the more reliable the pattern.
An example of a double top - the price can't breakthrough the resistance so it falls
Round Tops & Bottoms,
Round tops occur when the trend is slowly changing direction, they are bearish chart patterns that usually form over a time period ranging from several weeks to several months. Round bottoms are the same thing in reverse, bullish patterns that occur when the trend slowly changes from bearish to bullish. They do not typically end with the violent breakouts that tend to occur with head and a shoulders and inverse head and shoulders patterns.
Summary,
Profitable chart patterns occur because of the effects of support and resistance. Strong areas of support and resistance will show on the trading charts and take the form of trade-able and easily recognisable patterns. If you understand support and resistance you will understand why the patterns appear on the charts in the way that they do.
