Detecting patterns is useful in many different fields. Crime scene investigators can pick up on the tiniest clues or repetition or sameness when tracking perpetrators. Doctors and healthcare providers look for consistent symptoms and diagnostics when searching for the cause of an illness. Even the bartender at the local pub can boost her income by recognizing the drink preferences of her usual clientele.
Naturally, day traders use patterns and repetition to formulate trading ideas and strategies. When stocks move like moths near lightbulbs, detecting patterns that signal upcoming price changes can greatly boost your trading profits.
Why Day Traders Use Japanese Candlestick Charts
Pattern detection becomes much easier with stocks when using Japanese candlestick charts, which provide much more information than your typical line chart. While your basic line chart only includes the closing price on a specific day or period, Japanese candlesticks tell you the open, close, high, and low of a particular trading period all on the same digit.
Japanese candlestick charts look like, well, candlesticks. Remember in the old Looney Tunes cartoons where Wile E. Coyote would have a stick of dynamite with a fuse on both ends? (Which usually resulted in him getting himself blown up). In a candlestick chart, the dynamite stick would be pointed vertically with the tops of the fuses representing the high and low of the time period. The body of the stick comprises the range between the opening and the closing price of the time period. A red candlestick means the price closed lower than the open, while a green candlestick means the price closer higher than the open.
Candlestick charts look like they were designed with high tech day traders in mind, but their history stretches all the way back to the 1700s. A Japanese rice trader named Homma Musehisa noticed that rice prices didn’t just follow the law of supply and demand, but also the emotional slant of the traders themselves. Using candlesticks charts in day trading strategies became popular in the early 1990s following the release of Steve Nison’s book “Japanese Candlestick Charting Techniques.” Yes, clever title, I know. Candlestick charts make it easier to identify and trade key patterns that continuously appear in equities. Here are five of the most common patterns that all aspiring day traders should become familiar with.
Chart 1: Cup and Handle
Stock chart patterns are often named for the pictures they tend to telegraph when formed and the cup and handle pattern is one of the most conspicuous. The cup and handle pattern is a bullish chart formation where a long U-shaped base is formed at the end of an uptrend. The pattern is particularly noticeable due to this saucer-like base which ends with a small decline once the base reaches the previous high. This is a selling point for long-term investors, which is why the stock will pull back and form the handle. The breakout occurs once this selling pressure dies down.
Penn National Gaming (NYSE: PENN) was one of the big winners in the summer following the coronavirus crash. The stock formed a cup and handle pattern after the stock reached a new high in February. Afterward, a U-shaped cup formed, and the stock approached its previous high in June. The handle formed as the stock pulled back from that level, but the breakout occurred shortly after and the stock has nearly doubled its previous high from March.
Cup and handle patterns have a few prerequisites: the stock usually needs to be in a sustained uptrend before the cup forms and the U-shaped is crucial. V-shaped declines generally don’t form the handle afterward and can create false signals. Also, if the handle forms on heavy volume, it could signal a steeper decline ahead.
Chart 2: Triangles
Triangles can be bullish or bearish depending on their shape. When a triangle forms, it’s considered a continuation pattern; it doesn’t signal a new trend, but resparks a dormant one. The direction of the triangle points the way – an ascending triangle points toward the continuation of an uptrend while a descending triangle points toward the continuation of a downtrend.
Here’s a chart showing an ascending triangle forming in the stock of Trio-Tech International (NSDQ: TRT). The ascending triangle forms when the stock begins to hit a resistance level, but continues to make higher lows as it collides with that resistance point. The breakout occurs when the two trend lines meet, forming the triangle and signaling the entry point.
Chart 3: Flags
Also known as pennants, flags are similar to triangles in that they’re continuation patterns that can be bullish or bearish depending on their shape. The main difference between the flag and triangle pattern is the appearance of the flagpole before the pennant part of the pattern appears.
Square Inc. (NSDQ: SQ) was another of the big winners following the March 2020 crash and a nice bullish flag appeared on the chart in the middle of July.
The flagpole was a quick and forceful uptrend before coiling into a tight range which formed the rectangular pennant shape. The pennant range was maintained until July when the stock finally broke out of the upper level of the pennant and moved aggressively higher.
Remember to always confirm the trend before trading off flag or triangle patterns. Don’t go against the trend when using continuation patterns!
Chart 4: Bullish Hammer
A bullish hammer is a unique signal in that it’s only available via candlestick charts since we’re looking at a single period or session. Unlike the other chart patterns on this list, the bullish hammer is a single candlestick. The tell-tale signs of the bullish hammer are thick, square red candles with a long wick to the low and no wick to the high. The close and high are often the same price on bullish hammers, which signals a reversal.
A bullish hammer will occur at the end of a sustained downtrend. The bottom wick should be larger than the body of the candle itself and the closing price should be near or at the high. Here’s an example from the chart of American Airlines (NYSE: AAL), where a bullish hammer signaled a reversal of a downtrend.
Chart 5: Falling Wedge
Wedges may look like flags and triangles, but they’re actually reversal patterns, not continuation patterns. The falling wedge is a bullish reversal pattern that signals a downtrend is about to come to an end. The falling wedge’s common characteristics are two descending trend lines that grow closer and closer to meeting as the lows and highs become less drastic. Volume tends to dry up as the wedge gets closer to its meeting point. The breakout occurs when the price channel narrows and the stock breaks out above the upper trend line of the wedge.
Here’s another chart for Euronav NV, a Belgian oil company. Over a long time period, the stock declined and a wedge pattern began to form. The two trend lines of the wedge began to converge in November and the price falling broke above the upper trend line in December. Volume and trend confirmed the pattern and breakout was readily noticeable.
Using technical analysis isn’t a key to day trading riches, but it can increase your chances of picking winners and knowing when to cut losses with losers. Chart patterns are just a single tool in the toolbox though. Most technical patterns need to be confirmed with trend and volume before a confident trade can be entered. Once you have volume, trend, and pattern working in your favor, your odds of racking up profitable trades will be greatly enhanced.