TRADING FOUNDATIONS

The Most Accurate Chart Patterns

and How to Use Them

by Ed Downs
Forward
Everyone who buys a stock thinks it's going up. And
everyone who sells to those buyers thinks it's going down.
But it is the imbalance between Buyers and Sellers that
causes price to change. The larger the imbalance the bigger
the change.

Price change is seen by the market and creates more price

change, which creates patterns of human behavior that we
call Chart Patterns. Because human Buy & Sell decisions
around money are fairly consistent, these patterns can be
predictive of what the market will do next.
"Greed and Fear"
If sudden buying causes a "gap", the odds of an additional From: jrotman.wordpress.com
price rise are high because more buyers will react to the
gap and start buying. If price approaches a "support level",
buying will increase on the anticipation of a price rise,
because of the mere existence of the support level.

In this course, we will become familiar with all the

important Patterns, learn which ones to pay special
attention to, and how to profit from this knowledge.

Ed Downs
 TRADING FOUNDATIONS

Part I
Chart Patterns Defined

101: The Most Accurate Chart Patterns

and How to Use Them by Ed Downs
Part I Chart Patterns Defined
1. The Psychology of Patterns 4. Combinations of Patterns
Channels
2. Pattern Structure Cup & Handle
Head and Shoulders
Tops & Bottoms
3. The 7 Base Patterns Ranges
Support & Resistance
Trend Line
Saucer
Fibonacci Retracement
Gap
Volume Climax
Consolidation
 Part I
Section 1: The Psychology of Patterns
What is a Chart Pattern?

Patterns reflect the

psychology of a market.

Patterns can also

determine the behavior
of a market.

Patterns work because investors, traders, and fund

managers react the same emotional way to them.
Why Patterns Work
Chart Patterns work because participants react similarly based
on what happens in the chart. Each of the following patterns
causes an emotional Buy or Sell reaction.

Breakaway Gap

Breaking
Resistance

Saucer

Measured Gap

Exhaustion Gap Breaking Support

Trader Psychology & Patterns
Measured Gap indicates
more downside movement
in store.

Resistance Bounce signals

a new sell-off.
Measured
Gap
Volume Trend at the Resistance
Bounce
Bottom indicates buying
pressure.

Higher Lows confirm a new

rally. A Trend Line
Bounce indicates buying
pressure.

A Head and Shoulders

Head &
pattern indicates new Volume Shoulders
Trend Line
weakness in the market. Trend Bounce
The Fear/Greed Investor Cycle

Get ready to
Sell here.

Get ready to
Look for Bearish Buy here.
Patterns here.

Look for Bullish

Patterns here.

Investor psychology constantly moves Fear to Greed and

back in cycles. We can profit from this if we recognize
extreme Greed and Fear.
Transition from Greed to Fear, and Back

a) Market Uncertain
(support bounce)
b) Out-Performing
(breaking d Technical
resistance) c Trading
points
c) Late Arrivals
(dramatic price e
b
increase)
d) Disappointment
(breakaway gap) g
f
e) Confirmation
(measured gap)
a
f) Weakness
(Head & Shoulders
breaking down)
g) Early Optimism
(saucer pattern)
Summary
Markets Cycle between the
emotions of Greed and Fear

Chart Patterns REFLECT

these emotions.

Chart Patterns also CAUSE

these emotions to occur.

By learning to read Chart Patterns effectively, we can

stay ahead of most investors.

Buy on Bullish Patterns at the end of a FEAR cycle.

Sell on Bearish Patterns at the end of a GREED cycle.

 Part I
Section 2: Pattern Structure
Pattern Identification Structure
All Chart Patterns have
a defined structure that
enables us to identify
the Pattern. Pattern
Detected
This example shows a (Channel)
Channel, which we
identify at the lower
swing pivot, because of
the parallel line drawn
above (this is covered
in the section on
Channels)

Entry
Channel
Trade Management (Eighths Tool)
The Eighths Tool can
be used for Trade
Target
Management.
Eighths Tool set
to size of prior
We are introducing it range
here because we are
going to use it in all
our pattern examples.

Entry
Channel Stop
Trade Management (Eighths Tool)
We will study the
Eighths Tool in depth
in Part II, Section 2 Channel
Trade Management,
but let's briefly look at Exit using
how it works before we 8ths Tool
review the patterns.

As price advances, we
move the Stop up to
rungs of the tool as the
Stock Closes above a
higher rung.

Entry
The Target Rule
If the Stock closes
above its Target,
we can move the
Stop up to that
level. This can
Price closed above
Target, so we tighten result in an
the stop to the target. immediate exit
but often price
resistance will run past it.

(The 8ths Rule

will be covered
in Part II).

support
Summary
All Chart Patterns have a
defined Structure we will
explore in the next section. Saucer Exit

In each case, we will show: Close above

Target

How the Pattern is

identified.

A basic Eighths Scale

for Trade Management

Entry and Exit

using the Eighths Scale.
 Part I
Section 3: The 7 Base Patterns
Base Patterns

The 7 Base Patterns:

1. Support & Resistance
2. Trend Line Reversal & Break
3. Saucer Formations
4. Fibonacci Retracements
5. Price Gaps
6. Volume Climax & Trend
7. Consolidations

Virtually all Chart Patterns are some

variation of these basic constructs.
1. Support / Resistance

Resistance

Support
As market approaches support, and especially as it
reverses, the market participates adding more fuel to
the fire. Support breaks can create PANIC.
Support / Resistance Structure

5
Rally off Support 4
3
Long Entry

Short Entry
5
Break Through Support 4
3
Support & Resistance
Retail Holders Trust
The 1st trade
exited on a
traversal using
the 8ths tool.

Target Exit The 2nd trade

actually hit its
8ths Exit target, so we
used the Target
Rule to Exit
Support & Resistance
Nexen, Inc.

Breakeven
using the
8ths Rule
Support & Resistance
Johnson & Johnson
2. Trend Line Break (& Reversal)

Upper Trend Line

Lower Trend Line

TR
TB
TR = Trend Line Reversal
TB = Trend Line Break

An invisible line forms as price reacts to it. This

creates a similar psychology as Support and
Resistance lines do. Breaks can create panic.
Trend Line Structures

Reversal
5
4
3
5
Long 4
Entry

3
Break
Trend Line Break
UNS - Unisource Energy Corp.

target

Target
Exit
Trend Line Break
ODFL - Old Dominion Freight Line

Target
Exit
Trend Line Break
PEP - PepsiCo, Inc.

8ths
Exit
Trend Line Break
UYG - Proshares Ultra Financials

Target

8ths
Exit

Entry
3. Saucer Patterns

50%

Saucers

Saucers usually occur at support (resistance,

occasionally). Smooth transitions in price are
noticed, causing buyers (sellers) to enter.
Saucer Pattern Structure

Distance to significant high (1.0) Distance to target (0.6)

center
5

3
Reverse:
Long Entry
Saucer Up

Break: Short Entry

Failed Support
Saucer Pattern
WIRE - Encore Wire Corp.

Current
Stop
Saucer Pattern
OCN - Ocwen Financial Corp.
Corp..

Target
Exit
Saucer Pattern
ICO - Internat Coal Group, Inc.

Current
Stop
Saucer Pattern
GM - General Motors Corp.

Current
Stop
Saucer Pattern
RGLD - Royal Gold, Inc.

Exit

Target Rule:
Set Stop here
after price
closes above
this level.
4. Fibonacci Retracements

Fibonacci
Retracements
38%
62%

50%

Markets typically reverse on eighths, especially 3/8,

4/8, and 5/8 which is 38%, 50%, and 62%. This is
an observed truth of market psychology.
Fibonacci Retracement Structure

4
50% R
Reverse 3

62% R
38% R

No Target
38% Retracement
UNT - Unit Corp.

Entry
38%
50% Retracement
SPAR - Spartan Motors, Inc.

50%

Entry

Current
Stop
50% Retracement
PTIN - Patterson
Patterson--Uti Energy, Inc.

8ths
Exit

Entry
50%
38% Retracement
FO - Fortune Brands, Inc.

38%
Entry

8ths
Exit
62% Retracement
ALGT - Alegiant Travel Co.

8ths
Exit

Entry

62%
5. Price Gaps

Gaps BG
BG = Breakaway Gap
MG = Measured Gap
EG = Exhaust Gap

MG

BG EG

Breakaway Gaps mark the beginnings of moves,

Measured Gaps mark the centers of moves, and
Exhaustion Gaps occur at the ends of moves.
Price Gap Structure
Breakaway, Measured & Exhaustion

Short Entry

Exhaustion Gap

Long Entry
5

Measured Gap
3

Long Entry

Breakaway Gap
Exhaustion and Measured Gaps
NFP - National Financial Partners

MG

Current
Exit + Stop
Entry

EG
Breakaway Gap
RFS - RPC, Inc.

Would you trade this BG

Breakaway Gap?
Why or why not?
Breakaway Gap
RFS - RPC, Inc.

BG
No. Entering on the bar
after the gap, the move
is close to our target.
Breakaway and Measured Gaps
MSFT - Microsoft Corp.

Target Exit
BG

MG

Target Exit
Breakaway Gaps
PCP - Precision Castparts Corp.

Prior move
used for
measurement
BG

BG
Target
Exit
6. Volume Climax & Trend

Volume VT = Volume Trend

VC = Volume Climax

VC
VC VT VT

Climaxes form powerful patterns, indicating an

exhaustion of supply or demand. If the market
does not reverse, it becomes a trend indication.
Volume Climax & Trend Structures

Short Entry

5
Long Entry
4
Short Entry
3

Long
VC VC VT
VC
Volume Climax and Trend
RES - RPC, Inc.

VC VT
Volume Climax
MMM - 3M Co.

Shows why it is
important to let
the trade work.
Current
Stop

VC
Volume Climax
ABK - Ambac Financial Group

Current
Stop

VC
Volume Climax
FL - Foot Locker, Inc.

Current
Stop

VC
7. Consolidations

Consolidations
C
E
D

F
B

A AB=BC, BD=DC, CE=EF

Consolidations are the most powerful pattern. There are

many different forms (ascending, rectangle, etc.), but a
consolidation is any tight trading range with an Anchor.
Consolidation Structure Aggressive
(Symmetrical Triangle shown) (Profit Stop)
Conservative
Target *

Long Entry

Break: 5
Continuation
4

Reverse: 3
Failure
Short Entry

width width width

Anchor

* In our examples, we will use the Conservative Target.

But note how often the Aggressive Target is reached!
Consolidation
TRW - TRW Automotive Holdings

Entry

Project
Consolidation
WNR - Western Refining, Inc.

Hit Target

Entry

A
Consolidation
IMMR - Immersion Corp.

Target

Entry

A
Hit Target
Consolidation
UNS - Unisource Energy Corp.

Entry

Hit Target
Consolidation
C - Citigroup, Inc.

Nice move, but

we are already at
the Target.

Target
Consolidation
SSO - Ultra S&P 500 Proshares

Hit Target

Entry

A
Consolidation
EXPE - Expedia, Inc.

Entry

Hit Target
 Part I
Section 4: Combinations of Patterns
Combinations of Patterns

The following
patterns are
Cup & Handle
combinations of
Base Patterns.

8. Channels
9. Cup & Handle
Saucer
10. Head and Shoulders
11. Tops & Bottoms Consolidation

12. Ranges Two patterns combine to

create a new combination.
8. Channels

Channels

S = Best Place to Short

Channels are formed by 2 parallel Trend Lines. The

objective is to Buy near the lows of an up-sloping Channel
and Sell at the highs of a down-sloping one.
Channel Structure

It is generally best to a
F
take profits at the c Short
target, but an eighths Entry
scale can be used. D

5 b
4
E
B 3 Long
Entry d

Formed Channel: Forming Channel:

Project point F based Project point d based
on BDF | | ACE on bd | | ac.
Channels
ABV Compania de Bebidas
Channels can be
narrow or wide. Here
Channel Boundary Exit is a wide Channel
formed on ABV.

Eighths Tool Exit In this case, volatility

in the middle of the
channel caused the
8ths Tool to exit.

A strategy on Channels
is to hold the Fixed
Loss Stop at the base
and a Profit Stop at the
Target, without using
the 8ths tool.
Channels
BHI Baker Hughes

BHI showing Channel Exit using 8ths

Construction using
the 3 Point Method.
D
Point "D" is projected
from "C" as parallel
to line AB. C
Channels often break
out the top as this B Entry
one did.

A
Channel
GDXJ Market Vectors Goldminers
GDXJ formed a
very nice
Exit
channel that was
actionable at
D two points.
Exit
The trade from
b to d only
d lasted 5 days
and made 3%.
Entry
C B
The trade from
B to D lasted 7
b Entry days and made
10%.

A
Channels
AIG American International Group
AIG also has 2
trades in the
same channel.
Exit
The Entries
Exit
D happen on the
Open of the bar
d after the lower
pivot is formed
C (point b and B)
B Entry

The Exits
happen on the
b Entry bar AFTER the
A upper line is
reached.
9. Cup & Handle

Cup and Handle

Handle
(Consolidation)

Cup
(Saucer)

A Cup and Handle is a curved price formation (Saucer

Pattern) followed by a Consolidation. Its power comes
from the Consolidation Break.
Cup & Handle Structure

Curvature
B
5
4
3
Long
Entry
A

Projecting a Target:
A is at Center of Cup Pattern
B is at Center of Consolidation
C is projected target, equal to AB in Price & Time
Cup & Handle
CI - Cigna

Sometimes,
these patterns
are very small
and quick.

The rally after

Hit Target this Cup &
Handle formed
hit its target on
the 2nd day.
Cup & Handle
WAG - Walgreens

Curvature was Hit Target

slight on WAG in
the summer, but
the Consolidation
Antipicatory
was clear. Entry
Cup & Handle
WDC - Western Digital

Curvature was
less noticeable
on WDC.
Hit Target
The
Consolidation
is the key
feature in this
pattern.
Cup & Handle
RIG - Transocean

Consolidation
on RIG was
Hit Target easy to miss,
but there
definitely was a
range formed in
Feb after the
very clear
Saucer pattern.
10. Head & Shoulders

Head & Shoulders

A Head and Shoulders Pattern is formed by a High (or Low)

(the Head) followed by a Trend Line Break (Neck).
Head & Shoulders Structure
B

C
h
A
5
4
3
Short h
Entry

For a Bearish Head & Shoulders:

A and C are lower than B
Drawing a Trend Line through the "Neck" forms the Signal
Projected Target "D" is the height of the Head (or "h")
Head & Shoulders
AEO American Eagle

Inverted HS:

AEO showed a
classic higher
Hit Target
low before
rallying.

Both an
inverted Head
& Shoulders
AND a
Consolidation
Higher were present.
Low
Head & Shoulders
COH Coach Inc.

Inverted HS:

COH shows a
very nice higher
Exceeded low in a classic
Target inverted Head &
Shoulders.

The Bullish
sentiment on
COH was strong
enough to send it
further than the
Target.
Head & Shoulders
CSCO Cisco Systems, Inc.

Bearish HS:

Cisco falls hard

Lower as the lower
High neckline of this
well-formed
Head &
Shoulders is
violated.

Since we exceede
the target, we
should apply the
Exceeded Target 8ths tool now.
Head & Shoulders
DECK Deckers Outdoor

Bearish HS:

Deck generates a
Lower Short after the
High Lower High of
the Bearish Head
& Shoulders.

Hit
Target
11. Tops & Bottoms

Tops & Bottoms

Wide

Tops and Bottoms are Support and Resistance Reversals,

Reversals
with a wide price range leading up to the reversal.
Top & Bottom Structure

Double Top
Short
Entry

5
4
3

Long
Entry

Double Bottom Triple Bottom

Wide ranges create solid Double and Triple Tops and

Bottoms. A good place for an initial Target is the 50%
point, though a more aggressive Target can be
established at 7/8 of the range.
Double Bottom
IGT International Game Technology

This wide range

Double Bottom on
IGT led to a
spectacular rally.
Double Top
MSFT - Microsoft Corporation

Microsoft failed
to get past its
prior high of
31.5 in the
Spring of 2010,
leading to a
dramatic selloff
of 30% of its
value.
Triple Bottom
AMGN Amgen Inc.

AMGN formed a
classic Triple
Bottom in
September 2010.
Triple Top
NRG NRG Energy

Triple Top patterns

are rare. In fact, it
was hard to find
this one on NRG,

This example is
more of a Range
Breakout because
the range of the
pattern is small.
12. Range Breakouts

Ranges

Ranges are Consolidations without a defined

reference for target projection. We look for
Range Breaks on the side with the most touches.
Range Breakout

A Range is
formed by at
least 3 points
(A, B, and C)
A C Long 5
Entry
4
No obvious 3
Anchor
T

Ranges are like Consolidations except they do not have an

Anchor (see Consolidations). They are generally smaller
patterns than traditional Tops and Bottoms (i.e., they look
like Consolidations without an Anchor.)
Range Breakout
ADP Automatic Data Processing, Inc.

ADP formed a
range in the
Summer of 2011,
from Support at 51
to Resistance at 55.

In August, Support
gave way and the
stock dropped fast.
Range Breakout
TEG Integrys Energy Group, Inc.

TEG forms a classic

3 point range and
breaks out to gain
5% in a few weeks.

(the Eighths tool

caused us to stop out
at breakeven)
Range Breakout
KMB Kimberly Clark Corp.

Is it a Triple Top
or a Range
Breakout?

Doesn't matter;
the principle is
the same. Clear
Resistance is
broken leading to
a move.

(in this case the

8ths tool stopped
out for a loss)
Range Breakout
MRO Marathon Oil

MRO formed a
subtle range
before breaking
Resistance.
Summary for Part I
We reviewed 12 Patterns:
1. Support & Resistance
2. Trend Line
3. Saucer Consolidation
4. Fibonacci Retracement
5. Gap Trend Line

6. Volume Climax
7. Consolidation
8. Channels
Range
9. Cup & Handle
10. Head and Shoulders
11. Tops & Bottoms Volume
12. Ranges Climax

Which ones are most accurate? See Part II for the answer.