Price patterns are a lot like the brake lights on the cars around you when you are driving in traffic. When you see the brake lights come on in the car in front of you, you know that the car is slowing down and that you need to slow down too unless you want to crash into it. What you don’t know is whether the car is going to accelerate and continue moving in the same direction after it slows down, or if the car is going to come to a complete stop and change direction.
[VIDEO] Understanding Price Patterns
When you see a price pattern starting to form on a stock chart, you know the stock is starting to slow down, or consolidate, and that you need to slow down, take a step back and evaluate what may happen to it. What you don’t know, is whether the stock is going to breakout and continue moving in the same direction after it slows down, or if the stock is going to turn around and change direction.
Price patterns are an underutilized and extremely valuable tool in your stock-trading arsenal. It may take a little while to get comfortable with dealing with the subtle nuances and occasional ambiguity that are a part of price patterns, but once you do, you will feel like you are able to see into the future.
Price patterns are visual representations of market psychology. They tell you when traders in the market are excited and moving, when they need to take a moment and catch their breath and regroup and when they are ready to get moving again.
Attributes of Price Patterns
All price patterns are made of the following four pieces:
- Old trend: the trend that the stock is in as it starts to form the price pattern
- Consolidation zone: a constrained area defined by set support and resistance levels where the trend is undefined or channeling
- Breakout point: the point which the stock breaks the consolidation zone
- New trend: the trend the stock enters coming out of the consolidation zone
Types of Price Patterns
Price patterns are divided into two major categories: continuation patterns and reversal patterns.
Continuation patterns tell you that the new trend is going to continue in the same direction that the old trend was moving. [Learn more about continuation patterns here.]
Reversal patterns tell you that the new trend is going to reverse directions and move in the opposite direction that the old trend was moving. [Learn more about reversal patterns here.]
The only real difference between continuation patterns and reversal patterns is which direction the new trend is moving. Both types of patterns have an old trend, a consolidation zone, a breakout point and a new trend.
Image courtesy makdune.