How to use chart patterns for technical analysis when trading crypto

In Trading

Prices plotted for different cryptocurrency markets and across different time frames tend to exhibit recurring charting patterns over time, each providing an interpretation of market sentiment, along with hints on whether to go long or short.

What can make crypto chart pattern analysis challenging sometimes is that within a given chart, there can be multiple patterns (depending on the time frame inspected), some giving bullish signals, with others appearing bearish.

The more experience studying cryptocurrency charts, the more discerning one becomes in determining reliable signals from the noise.

Chart patterns can either be continuation or reversal patterns. Continuation patterns typically precede a resumption of the immediate prior trend, while reversal patterns signal a looming reversal in trend.

Common continuation patterns include Rectangle, Channel and Triangles. Reversal patterns often seen include Double/Triple Top/Bottom, and the Head and Shoulders Top/Bottom. Wedges can be either reversal or continuation patterns.

Use chart patterns along with mathematical indicators, support and resistance and a mix of technical analysis and fundamental analysis to improve your crypto trading success.

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Rectangle patterns

Rectangles are described as consolidation zones or congestion areas, and they are a type of continuation pattern that occurs during a pause in the trend. Rectangles within weekly charts can last several months, and those within daily charts can be expected last several weeks.

The more time they span, the stronger the ensuing breakout above rectangle resistance or breakdown below rectangle support. Rectangles that span less than three weeks are sometimes referred to as flags.

In the chart below, XRP/USD exhibits a series of rectangles-like patterns, where support and resistance are parallel to each other. Rectangles can also be described as horizontal channels.

A rectangle must have at least four points, with two forming the top boundary and two points defining the bottom boundary.

Even though the rectangle formation is usually categorized as a continuation pattern, it is best considered neutral, until a breakout occurs. Whichever direction the breakout takes should determine the trader’s bias.

Prior to the beginning date of the chart above (and the rectangle formations), a trader would have noted the downtrend, with the expectation for Ripple to continue its downtrend following a completion of the first rectangle.

However, to minimize risk, the trader would have avoided exiting a long position or entering a short until after completion of the rectangle (through a break below rectangle support).

One way of trading the breakdown below rectangle support would have been to place a sell stop entry order just below rectangle support so that a short position is entered only upon confirmation of the breakdown below support.

Alternatively, a sell limit situated just above rectangle support could be placed after the initial break below rectangle support on the expectation that following the break, Ripple climbs back to slightly above prior rectangle support before making a more decisive breakdown lower.

Channel patterns

A price channel is similar to a rectangle, in that the two lines that form the boundaries of the channel are generally parallel or close to being parallel. A price channel differs from a rectangle, though, by trending up or down.

The main trend line must connect at least two major highs in the case of a downtrend or two major lows within an uptrend. The “channel line” is parallel to the main trend line, and it acts as resistance in the case of an uptrend and as support within a downtrend.

In the chart above, Bitcoin (BTC/USD) can be seen trending up with the uptrend becoming progressively more steeply positively sloping in November 2017.

Channels are best traded within the price ranges they project. Within channel patterns, prices bounce from resistance to support and back to resistance, providing potential trading opportunities in either direction.

However, when trading within a downward channel, the individual may improve the risk-reward profile on potential trades by only or mainly going short.

Short positions would typically be placed near the top of the channel after a failed break above resistance creates expectations for a resumption of the down channel. The take profit buy order could be placed just above channel support.

Conversely, an upward channel is best traded by going long on bounces off the support line. Long positions would typically be entered just above support with the take profit sell order placed just below channel resistance.

Given that a market’s bounce from channel support to resistance (or from resistance to support) does not move in a straight line, traders will often close a trade earlier.

In other words, in practice, depending on each individual’s risk tolerance and profit targets, a trader may not necessarily want to target the entire move from channel support to resistance, or vice versa.

It is important to note as well that shakeouts take place quite often near channel support and resistance lines, where the market may appear to have successfully breached support or resistance, only to quickly find its way back inside the channel.

For this reason, stop loss orders are generally placed adequately far from channel support and resistance zones, allowing for false breaks in support and resistance.

Triangle patterns

A symmetrical triangle tends to signal a continuation in an existing trend, but can also lead to trend reversals. Symmetrical triangles differ from ascending and descending triangles by not sloping up or down, and are characterized by lower highs and higher lows.

A descending line connects at least two lower highs, while an ascending line joins a minimum of two higher lows. The triangle begins with the two lines fairly wide apart, reflecting a high degree of price volatility.

The market then gradually diminishes in volatility, until a breakout occurs, either to the upside or downside of the triangle.

 

In the Bitcoin (BTC/USD) chart above, the upper line of each triangle acts as resistance while the lower line of each triangle provides support. Buy stop orders are often placed just above triangle resistance and sell stop orders just below triangle support.

The initial target move on a breakout above triangle resistance can be estimated by taking the height of the triangle (difference between the highest and lowest point of the triangle) and adding it to the point of breakout above triangle resistance.

Ascending triangles are generally bullish continuation patterns in the early stages of an uptrend, where the highs are roughly equal, forming a horizontal resistance line, while the lows ascend, forming a rising support.

As with symmetrical triangles, the height of an ascending triangle can approximate the move that can be expected upon the triangle’s completion.

Descending triangles are typically bearish continuation patterns in the early stages of a downtrend, but may occasionally also signal a pending trend reversal particularly for long established downtrends. Descending triangles exhibit a series of lower highs and stable lows, and they complete when the price breaks below triangle support.

The downside target can be estimated by subtracting the height of the triangle from where support breaks.

As with the Ethereum (ETH/USD) example above, using the height of triangles to estimate the magnitude of a move upon triangle completion is not necessarily helpful.

The other method of arriving at a target price from the point of breakout on a triangle involves drawing a line parallel to triangle support from the highest point of the triangle (in the case of an upside triangle resistance breakout).

The price reached by the right end of this parallel line is the price target. As with most target estimates provided by charting patterns, neither of the two methods described for triangles suggests a timeline during which the target prices can be expected.

Wedge patterns

The falling or descending wedge that follows an uptrend/rally typically reverses higher at its completion, signaling a continuation of a prior uptrend. A falling wedge is similar in shape to a descending triangle, except that with a falling wedge, both its support and resistance lines point down.

With the descending triangle, steady support is provided by roughly equal lows (until the triangle completes with a break below triangle support or above resistance).

Because a falling wedge exhibits a support line with less negative slope than its resistance line, it reflects a gradual decrease in bearish sentiment, hinting at a turn in trend.

When the highs and lows of the descending wedge (following a prior uptrend/rally) converge such that wedge support and resistance lines almost meet, the market is likely to breakout to the upside.

A rising (or ascending) wedge works in a similar manner to the falling (descending) wedge, except that its signal is typically bearish when it follows a downtrend. A rising wedge, through its series of higher highs and higher lows, often provides a pause in a downtrend.

Flag/pennant patterns

Flags and pennants are usually considered continuation patterns, providing a temporary pause in an uptrend or downtrend, and are really shorter term versions of triangles, wedges and rectangles.

Flags are price patterns shaped like a flag, where the shape as defined by the pattern’s highs and lows is rectangular. Pennants are triangular shaped. After a price rally, a flag generally slopes down, while a pennant usually remains fairly neutral.

Unlike triangles and rectangles, flags and pennants generally last only 1-4 weeks. Longer-term flags (exceeding 12 weeks) are more commonly known as rectangles, while pennant patterns of similar duration are referred to as triangles or wedges.

In the chart below, for sake of illustrating the resemblance of flags and pennants to triangles, wedges and rectangles, disregard the time periods involved.

Note that the price estimates for each flag/pennant are arrived at by adding (in the case of an uptrend) and subtracting (in the case of a downtrend) the length of the flag/pennant’s pole from the point of breakout (from each flag pattern).

Double/triple top/bottom

Double and triple tops are two or three consecutive major highs that hint at a bearish reversal towards the end of a price trend as it nears exhaustion.

Triple tops start off as double tops, and should be considered neutral until their patterns are complete, as they are sometimes merely rectangular continuation patterns reflecting the digestion of a strong trend move prior to a resumption of the trend.

The double or triple top completes its pattern when the price breaks below support (as defined as the base of the two or three major highs). A triple top generally provides more of a bearish reversal signal than does a double top.

A price target for a double or triple top is generally estimated by subtracting from the support break, the distance between the resistance and support (as defined by the double or triple top).

As with any other pattern, the rule of thumb is that the longer a pattern takes to develop, the more reliable the trading signal that is generated.

Most double or triple tops (on a daily chart) take months to develop, and they should have highs that are roughly equal and spaced well apart.

Head and shoulders top/bottom patterns

A head and shoulders top pattern behaves much like a head and shoulders bottom, except that it provides a typically bearish signal. An initial price peak (left shoulder), is followed by the uptrend’s highest high (head), before forming a lower high (right shoulder). The lower high is typically bearish, and signals a potential trend reversal.

This bearish reversal pattern is confirmed when the price continues falling, breaking below the neckline support. The neckline is an imaginary line that connects the base of the left shoulder, head and right shoulder.

Necklines can be upward or downward sloping, or nearly horizontal. Downward sloping necklines signal more bearishness than horizontal or upward sloping necklines.

Properly interpreting long-term chart patterns (as with the roughly 4-month long head and shoulders in the chart above) not only aids with short-term trading, as it provides a directional bias, but is also clearly critical to the performance of longer-term fund managers, research analysts and retail investors.

When a more aggressive trader spots the right shoulder of a head and shoulders pattern, a short may be initiated as soon as the lower major high is defined by the right shoulder, while more conservative traders may wait for the neckline support break, followed by a failed test to reclaim the support line, before going short.

A head and shoulders bottom, also known as an inverse head and shoulders pattern, generally signals a trend reversal. As with double/triple bottoms, the head and shoulders bottom is typically bullish.

This pattern derives its name from its resemblance to the head and shoulder outline of a person, turned upside down. The neckline is the resistance line drawn by connecting the left shoulder, the head and the right shoulder.

This reversal pattern completes once the price breaks above the neckline. The more upward sloping the neckline, the more bullish.

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This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.

WRITTEN BY

Darren Chu, CFA

Darren Chu, CFA, is the founder of Tradable Patterns, publisher of daily technical analysis on Bloomberg, Thomson Reuters, Factset, Interactive Brokers, Inside Futures, and other partner websites. Before the launch of Tradable Patterns, Darren served as IntercontinentalExchange | NYSE Liffe's country manager for Australia, India, and the UAE, expanding his role to look after Liffe business development in APAC ex-Japan/Korea until his departure mid April 2014. Previously, Darren was with the TMX Group | Montreal Exchange, marketing Canadian futures and options across North America, London, Singapore and Hong Kong. Darren also launched and managed CMC Markets Canada's Chinese marketing and sales team, along with educational offering. Visit www.tradablepatterns.com for more information.