3 Types of Chart Patterns That Traders Should Understand
Chart patterns can be effective tools for traders and investors. They can help you decide when to buy, sell, or sit tight with an investment. But if you search “chart patterns” in Google, you’ll find hundreds of different variations. So in this guide, we’ll break them down into just three basic types: bottoming patterns, topping patterns, and compression patterns. Let’s jump in.
1. Bottoming chart patterns: when to buy an investment
In this guide, we’ll focus on understanding chart patterns – rather than memorizing them. To understand bottoming patterns, we first need to understand the psychology of investors when prices bottom out. If you’ve ever been through a crypto bear market, you’ll know exactly what I’m talking about! Fear, uncertainty, and doubt are all part of the deal.
But how do these emotions translate into bottoming patterns? More often than not, they cause the price to make two or more lows before finally trending higher. On the charts, this can look like a “W pattern”.
There’s the first low, where investor panic is usually higher, but the bravest dip buyers step in. The price then rises to give investors hope of a potential market reversal.
Then there’s the second low. This low can be lower or higher than the first low, but it gives investors more confidence that the price is finding the bottom. After this low, control begins to shift from sellers to buyers.
Of course, there are many variations of W patterns. And the inverse head and shoulders pattern is one of them. Essentially, it’s a series of W bottom patterns, with three lows instead of two. Here, the second low (the head) is the lowest.
With V-bottoms, the price only makes one low. It does this extremely fast, with massive volume traded at the low. In other words, lots of investors throw in the towel at the worst possible time. Compared to W-bottoms, V-bottoms tend to be quite rare.
2. Topping patterns: when to sell an investment
Investors experience a different set of emotions when prices are topping: euphoria and complacency. If you’ve ever been through a crypto bull market, you’ll know what this feels like.
As with bottoming charting patterns, these emotions play out in stages with the price. But this time, with “M patterns” instead of W patterns. This involves two or more peaks in the price.
In the first peak, there’s usually more euphoria among investors, with the uptrend going strong. Then the price drops unexpectedly (usually by a big amount) and the late buyers get punished. But as the price drops, investors buy the dip, thinking that the price will keep trending higher.
Then there’s the second peak. With M-topping chart patterns, this can be higher or lower than the first peak. With the second peak, investor euphoria is often replaced by complacency.
The video below explains this phenomenon in more detail, with the double top of Brent Crude oil in 2022. Note, this video is a sample from our 4.5-hour charting course, which you can learn more about here.
3. Compression patterns: when to sit tight
Compression chart patterns involve the price “compressing” into a tighter and tighter range. When that range breaks, you usually get a breakout in one direction. In other words, compression patterns can be the calm before the storm.
Compression can take many shapes, such as wedges or triangles. It can also be “messy” and not resemble a clear shape at all. But regardless of the pattern shape, it shows indecision in the market – with control ping-ponging back and forth between buyers and sellers. Then eventually, one side takes control.
Falling wedges, for example, tend to break to the upside more often than the downside. Here, sellers push the price down, but with less force each time. The price then wedges into a balance between buyers and sellers. Eventually, sellers run out of steam, and the price breaks above the wedge.
Rising wedges mean the opposite: that the buyers are losing steam. So more often than not, these tend to break to the downside.
Ascending triangles often break to the upside. And this makes sense if you think about what the pattern suggests in terms of buyer and seller strength. Here, buyers push the price up to a ceiling. And each time it hits that ceiling, sellers knock the price back down – only with less strength each time.
Eventually, sellers run out of bullets, and the price breaks higher. The more times buyers try to punch above the ceiling, the more likely they are to break through it.
Descending triangles are the opposite of ascending triangles: sellers often break the floor.
Final thoughts on chart patterns
There are hundreds of different chart patterns out there. And there are endless theories behind what each pattern might mean for the price of an investment. But instead of trying to memorize each pattern and its textbook meaning, it’s best to understand what they’re saying about investor emotions. And what those emotions might mean for the relative strength of buyer and seller pressure.
If you’d like to dig deeper into chart patterns, indicators, and other aspects of charting, check out our technical analysis course.
- The psychology behind patterns: Chart patterns are more than just shapes on a graph. They represent the collective psychology of investors. Understanding this psychology is crucial for interpreting what each pattern might indicate about future price movements.
- Three main types: While there are lots of chart patterns, they can generally be grouped into three types: bottoming patterns, topping patterns, and compression patterns.
- Understanding over memorization: Instead of trying to memorize every chart pattern, try to understand the investor emotions they represent – and what it might mean for buyer and seller behaviour.