Along with fundamental analysis, technical analysis is the primary method traders use to analyze the forex marketplace and decide when to enter and exit trades, as well as where to place stop limits and take profits. The basic theory behind technical analysis trading is that market movements tend to repeat themselves over time, and that by correctly identifying trends, a trader can accurately predict when they will occur again.
In addition to the many technical indicators available to retail forex traders, including Bollinger Bands, Stochastics, Moving Averages and Relative Strength Index, which can be used to identify trends, reversals and the momentum of a financial asset, there are also a number of established patterns that can be used to determine how and when to execute a trade. In this article, we will be going over how to recognize these patterns and use them to improve your trading. It is very important to remember not to place any trades before a pattern completes itself. The forex market can be extremely volatile, meaning that even if a pattern looks like it’s forming, there is still a strong possibility that the price will radically change directions.
In technical analysis, it is a commonly held assumption that after the price of an asset repeatedly tests a particular support or resistance line, that asset will either reverse or extend its trend. Reversal or continuation patterns signal exactly what their names suggest; either the trend will reverse or continue. Knowing how to identify which of these will occur is key to becoming a successful technical trader. We will now look at several reversal and continuation patterns that are easily identifiable and can prove very useful to forex traders.
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The Head and Shoulders pattern is an excellent way for traders to identify either an upcoming bearish or bullish trend reversal. The Head and Shoulders Top pattern indicates that the price of an asset is about to turn bearish. It takes place in the middle of an uptrend, and consists of the price of an asset peaking and dropping to its support line (the first shoulder), after which it peaks again at a higher point and drops down its support line (the head), and then peaking again to around the same area of the first shoulder and dropping back to the support line (the second shoulder).
After the second shoulder completes its formation, traders can take this as a sign that a reversal has taken place and that the price will turn bearish. Let’s look at an example:
Notice how after the second shoulder reaches the support line, the price continues moving downward, giving traders an excellent opportunity to profit on a sell position.
The Head and Shoulders Bottom pattern is the mirror opposite of the example above, and can be used to identify an upcoming bullish reversal. Instead of the price peaking at a certain point and falling to its support line, it bottoms out and then moves back up to a resistance line. Of course, the same pattern (just upside down) needs to complete itself before a bullish correction is likely to take place. That means that one shoulder has to form, followed by the head, and then the second shoulder which bottoms out at roughly the same area as the first one. When this takes place, traders can take it as a sign to open a buy position.
The Double Top or Bottom patterns are very effective ways of predicting trend reversals, with the Top pattern indicating a bearish reversal and the Bottom pattern indicating a bullish reversal.
A Double Top pattern has formed when the price of an asset that is in a bullish trend touches a resistance line, sees a modest drop, moves back up to the resistance line and then proceeds to fall back to, and breaks through a key support level. Once this pattern completes itself, it can be taken as a sign that a bearish correction is about to take place, meaning traders may want to open up sell positions. Let’s look at an example:
A Double Bottom pattern is the mirror opposite of the Double Top, and can be used to identify an impending bullish reversal. Instead of the price hitting a resistance level twice before turning bearish, it will hit a support line, see a modest bullish correction, hit the support line again, and then continue upward. When this formation occurs, traders can take it as a sign that the price of the asset is going to reverse and turn bullish, meaning this may be a good time to open a buy position.
The Cup and Handle pattern, while sometimes difficult to identify, can be very effective at signaling to traders that a bullish trend will extend itself. What is important to remember is that for this formation to occur, the asset must already be in an upward trend. The price of the asset will then move downward to a support line, where it will range trade for some time before moving back up to the point where it originally dropped. This pattern will form a ‘U’ shape, which will signify the cup in the pattern. It is important that the pattern form a ‘U’ and not a ‘V’, which would indicate that the price has risen and fallen too quickly.
After returning back to the point where it originally dropped to form the cup shape, prices will see another smaller drop and increase, which signifies the handle in our pattern. After the handle is formed, traders can take it as a sign that the bullish will extend itself, meaning it may be a good time to open a buy position. Let’s look at an example:
There is also such a thing as a reverse Cup and Handle pattern, which takes place in the middle of a bearish trend, and signifies an extension of that trend. The price of the asset will move down before reversing to hit a resistance line, range trade and then move back down to form an upside down cup.
Both the Flag and Pennant formations are great ways to forecast a short-term continuation of trends. Both patterns are categorized by either a sharp bearish or bullish move, a period of sideways or range trading, and finally a resumption of the original bullish or bearish trend.
With Flag formations, the asset will range trade with parallel trend lines, as can be seen in the chart below. After the asset moves above the upper trend line, the original trend resumes.
The Pennant formation is very similar, with the only difference being that while range trading, the asset’s trend lines will converge before the original trend resumes.
In both formations, the pair breaks out of its sideways trend when the price moves above the upper trend line. Once this happens, it may be a smart choice for traders to open a buy position, as the bullish trend is likely to resume.