🔺 Chart patterns: head and shoulders, double tops, triangles, flags

🎯 In 30 seconds: Chart patterns are recurring shapes in price, like head and shoulders, double tops and bottoms, triangles, flags and the cup and handle. Each has a "trigger" level (usually a neckline or a trendline). A pattern is not complete until price closes through that level. Traders project a target by measuring the pattern's height and adding or subtracting it from the breakout. Research that tested patterns by computer found some carry a little information, but many fail, and simpler rules often did as well or better. Use patterns to plan entries, stops and targets, not as predictions.

What a chart pattern is

A chart pattern is a shape that price traces out as buyers and sellers fight over a range of prices. Patterns fall into two groups:

• Reversal patterns suggest a trend may be ending: head and shoulders, double tops and bottoms.
• Continuation patterns suggest a pause before the trend resumes: flags, pennants, many triangles, the cup and handle.

Every pattern is built from the pieces you already know: swing highs and lows (Trends) and support and resistance. A pattern is a specific arrangement of them with a specific level that confirms it.

The biggest problem with patterns is that they are easy to see after the fact and hard to define in advance. Two traders can look at the same chart and see different patterns. So for each one below, focus on the precise rules.

Head and shoulders

A head and shoulders top is a reversal pattern after an uptrend. It has three peaks:

1. Left shoulder: a peak and a pullback.
2. Head: a higher peak and a pullback to about the same level as the first pullback.
3. Right shoulder: a lower peak, roughly level with the left shoulder.

The neckline connects the two pullback lows. The pattern is only complete when price closes below the neckline. Before that, it is just three peaks in an uptrend that may continue.

Notice what the pattern is in trend terms: the right shoulder is a lower high, and the break of the neckline is a break of the last higher low. It is the trend ending, given a name.

The inverse head and shoulders is the mirror image at the bottom of a downtrend, completed by a close above the neckline.

Measured moves: how targets are calculated

Most patterns come with a measured move: take the height of the pattern and project it from the breakout point.

Worked example 1: head and shoulders (figure above, hypothetical).

Reward to risk is $7.20 / $5.80, about 1.2 to 1. That is thin: the measured move would have to work more than about 45% of the time just to break even before costs. Short selling carries extra risks, including losses that can exceed your stop if the stock gaps up, and borrowing costs. See Short selling. A trader who owns the stock might use the same pattern simply as a signal to sell.

Worked example 2: bull flag (hypothetical). A stock rallies from $40 to $50 in two weeks (the pole). It then drifts down in a tight, slightly falling channel to $47.50 over six days (the flag). It breaks out above the flag's upper line at $48.50.

Treat targets as rough guides for where to take some profit, not as forecasts. A trailing stop lets you stay in if the move runs further.

Other common patterns

Double top and double bottom. Two peaks (or troughs) at about the same price, with a pullback between them. The trigger is a close beyond the pullback point. A double bottom at $30 with a middle peak at $36 triggers on a close above $36, with a measured target of $36 + $6 = $42. Many "double bottoms" turn into triple bottoms or simply break lower, so the trigger matters more than the shape.

Triangles. Price swings narrow between two converging trendlines.

• Ascending: flat resistance on top, rising lows. Buyers keep stepping in higher. Usually read as bullish, triggered by a close above the flat top.
• Descending: flat support, falling highs. The bearish mirror.
• Symmetrical: both lines converge. No built-in direction; wait for the break.

The measured move is the height of the triangle at its widest point, projected from the breakout.

Flags and pennants. A sharp move (the pole) followed by a short, tight pause. A flag is a small channel sloping against the trend; a pennant is a small symmetrical triangle. They are continuation patterns, and they should be brief: usually days to a few weeks. A "flag" that lasts months is just a range.

Cup and handle. A rounded, U-shaped base (the cup) that recovers to near its old high, followed by a smaller, shallow pullback (the handle). The trigger is a close above the handle's high, which is usually close to the cup's rim.

Confirmation: the rules that keep you honest

• A pattern is not a pattern until it triggers. Three peaks are not a head and shoulders until the neckline breaks. Acting early is guessing.
• Use closing prices. An intraday poke through a neckline that closes back inside is a false break. See Breakouts and gaps.
• Context matters. A reversal pattern needs something to reverse; a head and shoulders "top" in the middle of a range is noise. A bull flag needs a prior uptrend.
• Volume can help. Breakouts on above-average volume are often treated as more convincing. See Volume.
• Know where you are wrong. Every pattern gives a natural stop: above the right shoulder, below the flag, below the second bottom. If that stop makes the position too small or the reward too thin, skip it.

What the evidence says about patterns

Patterns are hard to test because they are subjective. Researchers have handled that by writing computer programs that detect them with fixed rules.

• A study of U.S. stocks from 1962 to 1996 used an automated method to find patterns like head and shoulders and double bottoms. It concluded that several technical patterns "do provide incremental information and may have some practical value." Incremental information means the patterns slightly changed the distribution of later returns; it does not mean a profitable strategy after costs.
• A New York Fed study of head and shoulders in exchange rates from 1973 to 1994 found the pattern was profitable, but it was beaten by simpler rules such as moving averages and filter rules.
• A later New York Fed study of head and shoulders in 100 U.S. stocks found that trading the pattern was, on average, unprofitable. It also found unusual trading volume when the pattern completed, and price effects that faded within about two weeks.

You will see websites and books quote precise success or failure rates for each pattern. Those numbers depend heavily on how the pattern was defined, the market, the time period and whether costs were included. Treat any single figure with caution, and test your own version.

Try it

1. Write precise rules for one pattern, for example a double bottom: two lows within 3% of each other, at least 10 trading days apart, a middle peak at least 8% above the lows, triggered by a close above the middle peak.
2. Scan a year of daily charts for ten stocks from your watchlist and log every pattern that meets the rules, before checking what happened next.
3. For each one, record whether price hit the measured target or the stop first. Compute the win rate and average reward to risk.
4. Trade the next few that form in the paper portfolio and add them to your trading journal.

Sources

• NBER: Lo, Mamaysky and Wang, Foundations of Technical Analysis (Working Paper 7613; Journal of Finance, 2000)
• RePEc: Chang and Osler, Methodical Madness: Technical Analysis and the Irrationality of Exchange-Rate Forecasts (Economic Journal, 1999)
• Federal Reserve Bank of New York: Osler and Chang, Head and Shoulders: Not Just a Flaky Pattern (Staff Report 4)
• Federal Reserve Bank of New York: Osler, Identifying Noise Traders: The Head-and-Shoulders Pattern in U.S. Equities (Staff Report 42)