Chart Patterns 101: The Algorithmic Way in Algo Trading Charts

Decoding Chart Patterns: A Systematic Approach to Advanced Technical Analysis

Welcome to the world of technical analysis, where Chart Patterns play a pivotal role in shaping trading strategies. This is an ultimate guide designed to help users objectively identify the existence of Chart Patterns, define the characteristics and classify them.

Understanding Chart Patterns

Chart patterns are visual representations of price movements on a chart, which can help traders identify potential trading opportunities. These patterns are formed by the interaction between supply and demand in the market and can indicate the continuation or reversal of a trend.

There are various types of chart patterns, including:

Trend Continuation Patterns: These patterns suggest that the current trend is likely to continue in the same direction. Examples include the flag pattern, pennant pattern, and triangle pattern and all other trendline pair based patterns that we are going to discuss today
Consolidation Patterns: These patterns suggest a period of indecision in the market, where the price is range-bound. Examples include the rectangle pattern, symmetrical triangle pattern, and ascending/descending triangle pattern.
Trend Reversal Patterns: These patterns indicate that the current trend is likely to reverse. Examples include the head and shoulders pattern, double top pattern, and double bottom pattern. These patterns also include rising and falling wedge type of patterns that are based on trendline pairs

Instruments and Timeframes for Applying Chart Patterns

Chart patterns can be applied to a wide range of financial instruments and timeframes. Here are some considerations for applying chart patterns:

Instruments:

Stocks
Forex (Currency Pairs)
Commodity and metals
Indices
Cryptocurrencies

Timeframes:

Intraday (e.g., 1-minute, 5-minute, 15-minute)
Short-term (e.g., hourly, 4-hourly)
Medium-term (e.g., daily, weekly)
Long-term (e.g., monthly, quarterly)

It is important to note that the effectiveness of chart patterns may vary depending on the instrument and timeframe. Traders should consider the characteristics such as market volatility, price movements of the specific instrument and choose the appropriate timeframe for their trading strategy. Proper risk management is also crucial for any trading strategy in order to limit potential losses.

Basic Principle of Identifying the Chart Patterns

It is crucial to apply a definitive set of rules when identifying chart patterns to avoid biases or fitting them to our opinions. To understand the risks of overfitting chart patterns to our bias, please visit our other blog post on overfitting chart patterns.

To objectively identify chart patterns, it is important to establish ground rules or follow a well-defined technique. Here is the technique we employ to identify chart patterns.

Step 1 - Apply Zigzag indicator on the chart

Tradingview has plenty of free community scripts for Zigzag indicator. For this demonstration, we are going to use our Recursive Zigzag implementation.

Find Recursive Zigzag Indicator On Tradingview

Once the indicator is loaded on the chart, goto indicator settings and perform these modifications.

Disable the Labels : The Labels contain information that is needed for this exercise.
Set the Highlight level to 1 or 0 : We can iteratively increase the level and check next levels on the go.

You can also adjust Zigzag Length and Depth Parameters.

Update Recursive Zigzag Indicator Settings

Step 2 - On each level, mark the last 5 zigzag pivots.

For example, in today's BTCUSDT 1h chart, level 0 zigzag of Length 5 is displayed as below where we have marked last 5 Zigzag pivots.

Mark 5 Zigzag Pivot Points on the Chart

Step 3: Draw trendlines

As part of this step, draw two trendlines.

The first trendline will join pivots 1 and 5 marked in the previous step.
The second trendline will join pivots 2 and 4 marked in the previous step.

Draw Trendlines joining the Upper and Lower Pivots

Step 4: Inspect and identify if there is a Chart Pattern

On visual inspection, this looks like a Diverging Triangle Chart Pattern. However, the only issue is that pivot (3) is nowhere near the trendline. This makes the upper trendline not reliable, and so is the derived Chart Pattern.

Check the connectivity of the trendlines to pivot points

Step 5: Repeat the process on next zigzag levels

You may not find any Chart Patterns on the base zigzag level. However, repeat the process on next zigzag levels.

On further inspection, we identified a valid Chart Pattern on the level 3 zigzag.

Example of a valid trendline pair creating a Chart Pattern

From visual inspection, this can be either a "Ranging Channel Chart Pattern" or "Uptrend Channel Chart Pattern" or "Expanding Rising Wedge Chart Pattern". You can apply further rules on the trendline slopes to determine which category the Chart Pattern falls into.

Please note that Pivot (3) may not touch the trendline at the exact point. Keep certain threshold to allow minor deviations.

Using Last 6 Pivots

Above is the demonstration of using last 5 pivots for scanning the Chart Patterns. Similarly, we can also use last 6 pivots. Using 6 pivots will yield lesser number of Chart Patterns and also geometrically more accurate Chart Patterns.

When using 6 Pivots, we need to inspect both pivot 3 and 4 are part of the opposing trendlines. In short, Pivots 1, 3, 5 should form a trendline where no candles should violate them. It is fine if the candles touch the trendlines. But, they should not fall outside the trendline pairs. Similarly, Pivots 2, 4, 6 should form a trendline, where not candles are violating them.

Using 6 Pivots to Find Chart Patterns based on Trendline Pairs

Classification of Chart Patterns

Once the Chart Patterns are identified, they need to be classified into different types. We need to apply predetermined rules to objectively classify Chart Patterns into what they are. Everyone can build their own rules.

Properties of Derived trendlines

Before classifying the trendlines, we need to understand below properties of the derived trendlines.

Direction of Individual trendlines

Both the trendlines needs to be individually classified among these categories

Rising - trendline is sharply rising up.
Falling - trendline is sharply falling down.
Flat - trendline is flat across the pivots.
Bi-Directional - trendlines are moving in opposite directions

Please note that, it is less probable for trendline to absolutely flat. Hence, allow angle to have certain degree of threshold to be considered as flat. For example, +- 10 degrees can be considered as flat.

Also, the angle of the trendline can further subjective based on how compressed the chart is. It is recommended to use either log/auto-scale or a specific formula based on ATR to identify the angle.

Characteristic of the trendline Pairs

This parameter defines how both trendlines are aligned with respect to each other. Possible options are:

Converging - trendlines are converging and when extended towards the right will intersect at a visible distance.
Diverging - Diverging trendlines leads to broadening formation. This forms the diverging pattern. When extended towards the left the trendlines should intersect at a visible distance.
Parallel - trendlines are almost parallel to each other and may not intersect to either right or to left at a visible distance.

To objectively identify the intersection distance, we further need to use some standard. Here are few options

Fixed Number of Bars: If the trendlines do not intersect to either left or right within X bars (Lets say 100), they can be considered as parallel. Otherwise, they can be classified as converging or diverging based on which side the intersection happens.
Relative to the Length of the Chart Pattern: If the length of longest trendline is X bars. The trendlines should converge within 1–2 times the X bars to be considered as converging or diverging. Or else, it can be termed as parallel channels.

Geometrical Shapes Classification

Following are the main geometrical classifications

Channels - trendlines are parallel to each other. And hence they both move in the same directions.
Wedges - trendlines are either converging or diverging from each other. However, both trendlines move in the same direction. Both trendlines will be either up or down.
Triangles - trendlines are either converging or diverging from each other. But, unlike wedges, upper and lower trendlines will have different direction.

Types of Chart Patterns

Once we identify the direction and characteristics of trendlines, we can go on and classify the Chart Pattern in following categories. Each pattern has its own generic bias. For example, Rising Wedge patterns are considered bearish whereas Ascending Triangle Patterns are considered bullish. However, Converging Triangle and channels are considered bilateral patterns. However we will not discuss the trade directions as part of this article.

Rising Wedge Chart Pattern(Contracting)

Rules for Contracting Rising Wedge Chart Pattern are as follows:

Both trendlines are Rising
trendlines are converging.

Example of Contracting Rising Wedge

Rising Wedge Chart Pattern(Expanding)

Rules for the Expanding Rising Wedge Chart Pattern are as follows:

Both trendlines are rising
trendlines are diverging.

Example of Expanding Rising Wedge

Falling Wedge Chart Pattern (Contracting)

Rules for the Contracting Falling Wedge Chart Pattern are as follows:

Both trendlines are falling
trendlines are contracting.

Example of Contracting Falling Wedge

Falling Wedge Chart Pattern (Expanding)

Rules for the Expanding Falling Wedge Chart Pattern are as follows:

Both trendlines are falling
trendlines are diverging.

Example of Expanding Falling Wedge

Contracting/Converging Triangle Chart Pattern

Rules for the Converging Triangle Chart Pattern are as follows

The upper trendline is falling
The lower trendline is rising
Naturally, the trendlines are converging.

Example of Converging Triangle

Ascending Triangle Chart Pattern(Contracting)

The rules for the Contracting Ascending Triangle Chart Pattern are as follows

The upper trendline is flat
The lower trendline is rising
Naturally, the trendlines are converging towards each other

Example of Contracting Ascending Triangle

Descending Triangle Chart Pattern(Contracting)

The rules for the Contracting Descending Triangle Chart Pattern are as follows

The upper trendline is falling
The lower trendline is flat
Naturally, the trendlines are converging towards each other

Expanding/Diverging Triangle Chart Pattern

Rules for the Diverging Triangle Chart Pattern are as follows

The upper trendline is rising
The lower trendline is falling
Naturally, the trendlines are diverging from each other.

Example of Diverging Triangle or Expanding Triangle

Ascending Triangle Chart Pattern(Expanding)

The rules for the Expanding Ascending Triangle Chart Pattern are as follows

The upper trendline is rising
The lower trendline is flat
Naturally, the trendlines are diverging from each other

$Example of Expanding Ascending Triangle$

Descending Triangle Chart Pattern (Expanding)

The rules for the Expanding Descending Triangle Chart Pattern are as follows

The upper trendline is flat
The lower trendline is falling
Naturally, the trendlines are diverging from each other

Example of Expanding Descending Triangle

Ascending/Uptrend Channel Chart Pattern

Rules for the Uptrend Channel Chart Pattern are as follows

Both trendlines are rising
trendlines are parallel to each other

Example of Ascending Channel

Descending/Downtrend Channel Chart Pattern

Rules for the Downtrend Channel Chart Pattern are as follows

Both trendlines are falling
trendlines are parallel to each other