Understanding Price Action, Trendlines and Chart Patterns
In this lesson, we’ll cover three key elements of technical analysis: Price Action, Trendlines And Chart Patterns. Mastering these basics will help you better interpret market movements and identify high-probability opportunities.
Price Action:
Markets move in three distinct ways: uptrend, downtrend, and sideways (Also known as Accumulation and Distribution). In an uptrend, prices consistently make higher highs and higher lows, signaling bullish momentum. A downtrend occurs when prices form lower highs and lower lows, reflecting bearish sentiment. In a sideways movement (also called consolidation), prices trade within a range, lacking a clear direction as buyers and sellers reach equilibrium. Understanding these movements is essential for identifying trends, planning entries and exits, and adapting your trading strategy to the market’s current phase.
UpTrend – Higher Highs (HH) and Higher Lows (HL):
Uptrend: Defined by a series of higher highs and higher lows.
Behavior: Buyers dominate, pushing the price higher after each pullback.
How to Spot: Look for rising peaks (higher highs) and higher troughs (higher lows).
Example:
High: $100 → $105
Low: $95 → $100
DownTrend – Lower Lows (LL) and Lower Highs (LH):
Downtrend: Defined by a series of lower lows and lower highs.
Behavior: Sellers dominate, pushing the price lower after each rally.
How to Spot: Look for declining peaks (lower highs) followed by deeper troughs (lower lows).
Example:
High: $100 → $95
Low: $90 → $85
Sideways, also known as Accumulation and Distribution
These are critical phases in market movements that reflect the actions of institutional players and the balance between supply and demand. Price will oscillate between approximately equal highs and lows for an extended period before making its next major move.
Accumulation occurs when smart money or institutional investors are quietly building positions. During this phase, prices often move sideways as large buyers absorb supply without causing significant price increases. This phase typically precedes an uptrend, as buying pressure eventually outweighs selling.
Distribution happens when institutions are offloading their positions to retail traders at higher prices. Here, the market may again appear to move sideways, but with a gradual shift in momentum. This phase often signals the end of an uptrend and the start of a downtrend, as selling pressure begins to dominate.
Recognizing these phases is essential for aligning your trades with the market’s underlying dynamics and staying on the right side of major moves.
Reversal Criteria on Trends (How to read Change in direction)
To identify when a trend is reversing, we look for specific changes in the structure of price movements. Below are the criteria for recognizing a shift from an uptrend to a downtrend, and vice versa:
Shift from Uptrend to Downtrend
Break in Structure:
An uptrend is characterized by a series of higher highs (HH) and higher lows (HL).
A downtrend begins when this structure is broken by the price making a new low (below the previous HL).
Failure to Make a New High:
After the initial break in structure, the price attempts to rally but fails to reach a new high, resulting in the formation of the first lower High (LH)
Continuation of Lower Lows and Lower Highs:
The price makes a lower low (LL) that is even lower than the first new low.
On the next rally, the price fails to reclaim the previous support level, which now acts as resistance.
This establishes a new series of LHs and LLs, confirming the downtrend.
Shift from Downtrend to Uptrend
Break in Structure:
A downtrend is characterized by a series of lower lows (LL) and lower highs (LH).
An uptrend begins when this structure is broken by the price making a new high (above the previous LH).
Failure to Make a New Low:
After the initial break in structure, the price pulls back but fails to make a new low, resulting in formation of first new Higher Low (HL).
Continuation of Higher Highs and Higher Lows:
The price makes a higher high (HH) that is even higher than the first new high.
On the next pullback, the price holds above the previous resistance level, which now acts as support.
This establishes a new series of HHs and HLs, confirming the uptrend.
What Are Trendlines?
As we’ve just learned about trends characterized by higher highs (HH) and higher lows (HL) or lower highs (LH) and lower lows (LL), trendlines follow a similar concept—they simply connect these pivot points. A trendline is a straight line drawn on a price chart that links significant price levels, such as highs or lows. It helps visualize the direction and strength of a trend while also identifying potential support and resistance levels.
Uptrend Line: Connects two or more higher lows in an uptrend.
Downtrend Line: Connects two or more lower highs in a downtrend.
Trendlines help traders identify potential areas where the price might reverse or continue its trend.
How to Draw Trendlines
Identify Key Points:
In an uptrend, identify at least two higher lows (HL) and draw a line connecting them.
In a downtrend, identify at least two lower highs (LH) and draw a line connecting them.
The more times the price touches the trendline, the stronger and more valid it becomes.
Angle of the Trendline:
The slope of the trendline should reflect the trend’s strength. A steep trendline may indicate a strong trend but could be prone to breaking sooner. A moderate slope is often more sustainable.
Extend the Trendline:
Once drawn, extend the trendline into the future to anticipate potential support or resistance levels.
How to Ensure a Trendline Is Valid
A valid trendline is one that accurately represents the trend and provides meaningful insights. Here’s how to confirm its validity:
Multiple Touches:
A trendline becomes more valid if the price touches it at least three times. The more touches, the stronger the trendline.
Respect by Price:
The price should consistently react to the trendline (e.g., bounces off it in an uptrend or rejects it in a downtrend).
Timeframe Consistency:
Trendlines drawn on higher timeframes (e.g., daily or weekly charts) are generally more reliable than those on lower timeframes (e.g., 1-hour or 15-minute charts).
Angle and Slope:
A trendline with a moderate slope is more reliable than one that is too steep or too flat. Extremely steep trendlines are often broken quickly, while flat trendlines may not accurately reflect the trend.
Volume Confirmation:
Increased trading volume near the trendline can confirm its validity, as it shows stronger participation by traders.
What Invalidates a Trendline?
A trendline is considered invalid when it no longer accurately represents the trend or fails to provide meaningful support or resistance. Here are the main reasons a trendline can be invalidated:
Price Breaks the Trendline:
If the price closes decisively (a full candle Open High Low close) above a downtrend line or below an uptrend line, the trendline is invalidated. This could signal a potential trend reversal or a pause in the trend.
Lack of Respect:
If the price repeatedly breaks through the trendline without reacting to it (e.g., no bounces or rejections), the trendline is no longer valid.
Too Many Adjustments:
If you constantly redraw the trendline to fit the price action, it loses its reliability. A valid trendline should not require frequent adjustments.
Change in Market Structure:
If the market shifts from an uptrend to a downtrend (or vice versa), the old trendline becomes irrelevant. For example, in an uptrend, if the price forms a lower low (LL) after breaking the trendline, the uptrend line is invalidated.
Timeframe Mismatch:
If a trendline drawn on a lower timeframe conflicts with the trend on a higher timeframe, it may not be valid. Always align trendlines with the dominant trend on higher timeframes.
Practical Tips for Using Trendlines
Wait for Confirmation: Don’t assume a trendline is valid until the price reacts to it multiple times.
Combine with Other Tools: Use trendlines alongside other technical tools like moving averages, support/resistance levels, and indicators (e.g., RSI, MACD) for better accuracy.
Avoid Overfitting: Don’t force a trendline to fit the price action. If it doesn’t align naturally, it’s likely not valid.
Monitor Volume: High volume near a trendline can confirm its strength, while low volume during a break may indicate a false breakout.
Example of Trendline Invalidation
Uptrend Example:
You draw an uptrend line connecting two higher lows.
The price breaks below the trendline and forms a lower low (LL).
The uptrend line is invalidated, signaling a potential trend reversal.
Downtrend Example:
You draw a downtrend line connecting two lower highs.
The price breaks above the trendline and forms a higher high (HH).
The downtrend line is invalidated, signaling a potential trend reversal.
By understanding how to draw, validate, and interpret trendlines, you can better analyze price action and make more informed trading decisions. Always remember that trendlines are subjective tools, so use them in conjunction with other analysis techniques for the best results.
3. Chart Patterns
Chart patterns are visual formations on a price chart that indicate potential market movements. These patterns help traders anticipate where the price is likely to go next.
Common Chart Patterns:
Continuation Patterns (Trend Confirmation):
Indicate that the existing trend is likely to continue.
Examples:
Bear / Bull Flags & Pennants: Short-term consolidation before a breakout.
Ascending / Descending Triangles: A buildup of energy before a breakout in the direction of the trend.
Reversal Patterns:
Indicate a potential trend change.
Examples:
Head & Shoulders / Inverse Head & Shoulders: Predicts a reversal from Key levels and Supply and Demand zones.
Double Top / Double Bottom: Indicates a reversal at key levels.
Rising Wedge:
A bearish reversal pattern where the price consolidates upward, with the range narrowing.
Typically occurs during an uptrend and signals a potential breakdown from a supply zone or a key level of resistance.
Falling Wedge:
A bullish reversal pattern where the price consolidates downward, with the range narrowing.
Typically occurs during a downtrend and signals a potential breakout from a demand zone or key level of support.
Neutral Patterns:
Can lead to a breakout in either direction and usually do not have an initial dominating leg.
Example:
Symmetrical Triangle: Price compresses and shows Lower Highs and Higher Lows and eventually breaks out, This pattern must take out previous pivot and hold price for continuation in the direction of breakout. If it resists at previous pivot after initial breakout then it is highly likely a false breakout and price reverse to the opposite side.
Trend Continuation Patterns
Trend Reversal Patterns and Measured Targets
Chart patterns are widely used by traders, but only a few understand their precise application. When applied correctly, these patterns achieve their target levels with a 90% success rate. By following supply and demand principles, marking key levels accurately, and recognizing trend reversals through candle formations, traders can effectively use two primary pattern groups:
- Head & Shoulders / Inverse Head & Shoulders
- Cup & Handle / Inverse Cup & Handle
Except for rare events like economic news causing sharp V-shaped moves, price action typically follows this structured method for trend changes. The key advantage is the ability to predict price targets in advance and let trades unfold naturally. Properly measuring targets for these patterns across the correct time frames helps traders set realistic expectations and refine their strategies for consistent success.
Head and Shoulders Pattern
Description:
The head and shoulders pattern is a bearish reversal pattern that occurs after an uptrend. It consists of three peaks: a higher peak (the head) flanked by two lower peaks (the shoulders). The neckline, which connects the lows of the shoulders, serves as the breakout level.
Measured Target:
To calculate the measured target:
Measure the vertical distance between the highest point of the head and Lowest on the neckline.
Subtract this distance from the neckline at the breakout point.
Example:
Head: $505
Neckline: $490
Distance Between Head and Neckline: $505 – $490 =15
Measured Target: $490 – $15 = $475
Inverse Head and Shoulders Pattern
Description:
The inverse head and shoulders is a bullish reversal pattern that forms after a downtrend. It is the mirror image of the head and shoulders pattern, consisting of three troughs: a lower trough (the head) flanked by two higher troughs (the shoulders). The neckline connects the highs of the shoulders.
Measured Target:
To calculate the measured target:
Measure the vertical distance between the lowest point of the head and the neckline.
Add this distance to the neckline at the breakout point.
Example:
Head: $34.35
Neckline: $38.7
Distance Between Head and Neckline: $38.7 – $34.35 = $4.35
Measured Target: $38.7 + $4.35 = $43.05
Cup and Handle Pattern
Description:
The cup and handle is a bullish continuation pattern. It resembles a rounding bottom (the “cup”) followed by a consolidation phase (the “handle”). The breakout typically occurs when the price breaks above the resistance level of the cup.
Measured Target:
To calculate the measured target:
Measure the vertical distance between the bottom of the cup and the resistance line (the top of the cup).
Add this distance to the breakout point.
Example:
Bottom of Cup: $20556
Resistance: $20628
distance between the bottom of the cup and the resistance line: $20628 – $20556 = $72
Measured Target: $20628 + $72 = $20700
Inverse Cup and Handle Pattern
Description:
The inverse cup and handle is a bearish continuation pattern. It resembles an inverted rounding top (the “cup”) followed by a consolidation phase (the “handle”). The breakdown typically occurs when the price breaks below the support level of the cup.
Measured Target:
To calculate the measured target:
-
Measure the vertical distance between the top of the cup and the support line (the bottom of the cup).
-
Subtract this distance from the breakout point.
Example:
-
Top of Cup: $22075
-
Support: $21895
distance between the top of the cup and the support line: $22075 – $21895 = $180
-
Measured Target: $21895 – $21715= $180
