The capital markets are constantly moving as traders engage in currency trading, generating supply and demand for assets. The movements create a framework that makes patterns that provide insight into the future trends of a currency pair. Chart patterns are part of technical analysis, which is the study of past price movements to determine the future direction of an asset. The analysis of a pattern can gauge where the markets are heading, however they’re not a guarantee of price movement, as past performance is never indicative of future performance. Some of the more popular trading patterns are continuation patterns and reversal patterns.
What are Patterns?
A chart pattern is a recognizable picture that you can use to create a forecast. You can use these patterns to help you with short-term movements or long-term changes to an asset price. You can use all types of data, including monthly, weekly, daily, and intra-day data. Chart patterns can focus on an exchange rate over a couple of days or multiple weeks. One of your goals is to determine if a pattern is forming in the middle of a trend or if the movement is on its last legs and is about to reverse.
Different Types of Patterns
The concept behind technical analysis is that history may continue to repeat. The study of past price movements focuses on how human beings react in similar ways when faced with specific circumstances. For example, when you stick your head out in a crosswalk to see if a car is coming, you will likely either pull back if one is on the way or stay put or move forward if the coast is clear. People react the same way when they see price action move in a specific way. But again, what actually happens in the markets is anyone’s guess.
Fear and greed also play an essential role in the way people view price movements. Upward trends are usually smooth and provide complacency. Downward movements are generally sharp and generate fear. An uptrend shows that bulls are in control as demand outstrips supply. In a downtrend, bears are in control as supply overwhelms demand.
Most of the patterns that exist fall into two categories: continuation patterns and reversal patterns. A continuation pattern indicates a period of consolidation before the market refreshes in the direction of a trend. A reversal pattern usually indicates when prices are forming a top or a bottom.
What is a Continuation Pattern?
A continuation pattern is a pause that refreshes in the direction of the current trend. Two popular continuation patterns are the flag and the pennant. The difference between the two is very slight. You will generally see a sharp move higher or lower, followed by a consolidation. A pennant pattern usually moves sideways of the move higher or lower, while the flag pattern consolidates in a range moving more downward. After a significant move higher or lower, traders begin to jockey for position. Some are taking profits after the initial move, while others enter new trades, hoping to catch the following action higher or lower. You can see that the consolidation of the EUR/USD that, after a significant move higher, the exchange rate moved sideways before it refreshed and started to climb higher. Other continuation patterns also include triangles. Prices will consolidate and form a tighter and tighter range before either breaking out or breaking down. Generally, a triangle will move in the direction of the trend.
What is a Reversal Pattern?
A reversal pattern helps you determine if prices or an exchange rate will form a top or a bottom. Generally, a reversal pattern will take time to develop and, in certain instances, can include some continuation patterns. One of the most popular reversal patterns is the head and shoulder reversal pattern. This type of pattern is recognizable before you have a left shoulder formation, followed by the appearance of price action that looks like a head and a right shoulder. Usually, the left shoulder is part of a continuation pattern. The head and shoulder pattern forms a neckline, which is below the two-shoulders and the head. When the exchange rate of a currency pair breaks below the neckline, the reversal pattern is complete, and the exchange rate usually reverses lower.
When an exchange rate forms a bottom, it can generate a head and shoulder reversal pattern. This pattern is similar to the head and shoulder, but in reverse. Both shoulders and the head are upside down. When prices break above the reverse neckline, prices will complete a bottoming formation and start to rally. There are similar reversal patterns called double tops and triple tops. Instead of the prices forming two shoulders and a head, they form matching tops or bottoms. After testing higher levels multiple times, the exchange rate will test lower (or higher) levels and break out or down in the opposite direction of the tops or bottoms.
The Bottom Line
Patterns are naturally occurring and reflect the movements of a currency trading rate. Most patterns can be categorized as either reversal patterns or continuation patterns. A continuation pattern is a pause that refreshes, while a reversal pattern forms a top or a bottom. Patterns are part of your technical analysis arsenal. By evaluating patterns, you may be able to help yourself determine the next potential market trend. Just remember that, while patterns are helpful to gain insight, they’re never a guarant