How To Read Charts Like A Hero: Common Patterns

In Summary: 

• Charts contain a tremendous amount of information for the technical trader 
• As a trader, your job is to make sure your chart analysis is on point  

What Is Chart Reading? 

Reading the market can take many shapes or forms but one thing is still a cornerstone of trading: the chart. A tremendous amount of information pours out of the markets when they are active. In turn, traders with a keen eye are able to spot buying and selling opportunities just from the price action.  

Changes in prices may tell you about investor sentiment, and whether bulls or bears dominate any given financial instrument. For your part, your job as a trader is to make sure you don’t let anything pass and digest all the chart is telling you. 

Chart reading, in and of itself, is the study of market action. It aims to identify price patterns based on the behavior of the price. And price movements are essentially a product of the collective effort of market participants.  

While traders may read into a chart too much, or too little, classical chart analysis can only be done one way. Let’s find out how. 

A Brief History Of Charting 

The first people in the US to pioneer the art of reading the chart did so near the late 1800s and early 1900s. They include Charles Dow, famous for his stock market theory, and William Hamilton, his successor as the editor of the Wall Street Journal.  

Charles Dow believed the chart contained all available information needed to make trading decisions.  Mr. Dow (who lends his name to the 30-stock Dow Jones Industrial Average index) created his theory based on technical analysis. In a sense, he became the father of all technicians as his ideas were quickly absorbed from the columns of the Wall Street Journal.  

After Charles Dow’s passing, William Hamilton took over his role at the newspaper. His editorial, “The Turn of the Tide”, contained trading principles based on price movements during the 1929 crash.  As time went on, other chartists (or chart readers) would appear and leave their mark. Some of them include Elliott, Wyckoff, Gann, and Livermore. They all were looking to find the perfect order in the way prices behave, a fascinating but challenging pursuit. 

How To Read The Chart

Markets have changed a great deal since these trading legends were active in their efforts to win big by looking at the charts. Nevertheless, technical analysis remains the same and reading charts the old-fashioned way could still get you significant profits. Whether it’s a reading of weekly, daily, hourly, or intraday charts, the rules are very similar. 

Support And Resistance

Imagine there’s a ball bouncing around in a room. It hits the ceiling and heads down to the floor, and vice versa. Support and resistance are like a floor and a ceiling. And prices are the movements of that ball, while the ball is the financial asset you’re trading.  

Correctly identifying support and resistance lines is among the first skills you need to master as a trader. Rating the strength of them will help you decide when, and how much, you could bet on any given trade. Once you understand support and resistance, you could build your strategy and include price trends and chart patterns.  

Support is essentially a price level where buying is strong enough to reverse a downtrend. The point where the trend bounces off of the support line is called an inflection point; these tend to occur at places where price might meet a previous low or continue on a downward channel and bounce from it. 

A support line is represented on the chart as a straight line connecting several bottoms. To this end, if the next bottom falls on the line, you could conclude the support has been validated.

Resistance works the other way around. Resistance is a price level where selling is strong enough to reverse an uptrend and is represented on a chart as a line connecting several tops. This said, you can expect the next top to reach the inflection point, touch and then reverse.  

How do draw these support and resistance lines? It’s fairly simple. You look for a trend, either upside or downside, and try to connect the highs, on the one hand, and the lows, on the other. Doing this would ideally give you a trendline channel. 

Further, the way you trade support and resistance is to look for price consolidation at the inflection point. If the reversal gets confirmed, price will reverse. Before, or after, (depending on your risk tolerance) you can open a trade. Also, make sure to set a protective stop in case price breaks out of the trend.  

Trend And Trading Range 

What’s the difference between a trend and a trading range? First of all, markets spend a lot more time in trading ranges than they do in trends, and in ranges, it is harder to take significant profit.

In that sense, a trend exists when prices keep rising or falling over a specified time frame. The longer the period, the stronger the trend. In an uptrend, for example, each new high should reach higher than the preceding one. An uptrend occurs when bulls are stronger than the bears and their buying keeps the price moving higher.  

In a downtrend, the opposite is true: each decline falls to a lower low. A downtrend emerges when bears are stronger than the bulls and their selling pushes the price lower.  

In a trading range, the direction of the trend turns sideways. In other words, price consolidates near the same, or similar, highs and lows. During these dry spells when price is flat, it is a lot harder to make money because there is not that much movement in either direction. 

Trendlines 

Charts are a representation of the actions of bulls and bears. With this in mind, trendlines can reveal where bears flipped a trend, or where bulls increased their buying. In other words, bottoms show where bears got exhausted, while highs indicate where bulls ran out of steam. 

A trendline is basically a line connecting two or more bottoms, or two or more tops. Trendlines help you see trend formations as well as where the next inflection point might be.  

Breakouts 

Breakouts can take two forms: true and false. Traders expect prices to fluctuate in certain trends, within trendline channels. Once a trend is exhausted, price breaks out and starts seeking to form a new trend.  

Imagine an upside trend with consistent higher highs. Once the price drops to the lower side, or the bottom, it faces three possible outcomes.  

First, the price breaks out and forms a new trend (a true breakout). Generally, if a new candle opens and closes outside of a previous trend, this is considered a confirmation of a true breakout.  

Second, the price rebounds from the lower trendline and gets back into the uptrend. And third, the price slips below the trendline or breaks out, but later reverses and heads back to the upside (a false breakout).  

In your trading, pay attention to false breakouts as they tend to be quite common in financial markets. 

Chart Patterns 

The trading charts you see on your computer screen hold key patterns. In more detail, these are trails of bulls and bears, carrying a certain asset to certain price levels. In that sense, your task as a chartist would be to unveil the subtle signs visible only to those familiar with price patterns.  

An integral part of the old-fashioned chart reading, price patterns can help you decide two main trading outcomes: trend continuation and trend reversal.  

Continuation and reversal patterns include flags, pennants, and geometric formations like triangles and rectangles. A continuation pattern suggests trading in the direction of the trend. On the flip side, a reversal pattern indicates it’s time for a change in trend.  

And don’t worry, you don’t have to be a math expert to spot these on a chart.  

What you can do, however, is to get familiarized with the main chart patterns: 

1. Head and Shoulders 
2. Triangles 
3. Rectangles 
4. Flags 
5. Pennants 
6. Cup and Handle 
7. Tops and Bottoms 

 Efficient Markets, Random Walk, Or Nature’s Law? 

Efficient market theory states that nobody can beat the market because prices reflect all available information. In reality, however, this is far from the truth, because this theory fails to factor in is the emotional side of trading. People may have the knowledge about a company’s worth, but their emotions may take the share price to sky-high levels. 

Random Walk theorists defend a view in which price changes happen randomly. The randomness in the market, according to them, is the true state of price behavior. Chart observers, however, say that prices have repetitive behaviors.  

And finally, Nature’s Law states that there is a perfect order in the markets and that order makes it possible to bet on price changes. Some mystics in trading even link astrology and the movement of the planets to prices and their behavior; WD Gann, for example, is one of those mystics. Those who subscribe to the perfect order theory believe markets move like clockwork. This theory accepts that tops, bottoms, continuations, or reversals, could be predicted far into the future.  

Chart Pitfalls And What To Avoid 

Be careful not to fall into certain traps that can be costly. One of the biggest challenges in reading the charts is to make sure what you’re seeing is real.  

A Swiss psychiatrist named Hermann Rorschach designed a test for exploring a person’s mind. He would drop some ink on a sheet of paper, fold it in half, and ask the person to describe what they saw. Some people would say they saw an animal, a building, a cloud, and so on. In reality, these were only inkblots.  

Similarly, traders could see in the chart what was already on their mind. To this end, be vigilant for wishful thinking and don’t project your hopes, fears, or fantasies onto the chart.  

Summary 

Chart reading is one of the oldest ways to trade financial markets. It still holds key insights into price behaviors and is foundational for many traders worldwide. Once you uncover the subtle signs a chart offers you, your trading may be changed forever.