Top Five Price Action Patterns To Consider Day Trading Stocks
If you’re day trading stocks, then it’s critical to your success to recognize price action patterns. You can use price action patterns to identify support and resistance levels, trends, trend reversals, and probable trend continuation.
In short, all the things you need to know are to spot trading opportunities, low-risk market entry points, and take profit price levels.
Price action patterns fall within the realm of technical analysis and technical trading. Price action trading differs from the majority of technical trading strategies in that it doesn’t rely primarily on the use of one or more technical indicators.
Instead, it’s usually done simply by watching price action on a plain price chart and looking for recognizable patterns of price movement (although price action traders may employ a couple of simple technical indicators, such as trend lines).
There are numerous price action patterns, way too many to discuss, all of them here.
This article presents some of the most frequently reoccurring patterns that have historically been reliable indicators for predicting future price movement.
1. Reversal Patterns
The Head and Shoulders Pattern
The head and shoulders pattern is a good trend reversal pattern to know because of three reasons.
- First, it’s pretty easy to spot.
- Second, it’s among the most reliable signals of a market reversal – some backtesting studies of the head and shoulders pattern have shown it to be accurate upwards of 80% of the time.
- Third, it provides a trader with relatively low-risk market entry points.
There are four parts of the head and shoulders pattern: the left shoulder (that’s your left as you’re looking at a chart), the head, the right shoulder, and the neckline.
Here’s how the pattern unfolds during an uptrend, signaling a probable market reversal to a downtrend:
- The left shoulder is finally formed when the price hits a high for the existing trend (which will be the top of the shoulder), pulls back a bit, and then moves to a new higher high.
- Price moving to the new high but then reversing to the downside to around the pullback low level of the left shoulder creates the head part of the pattern.
- The right shoulder is created when the price pops back up a bit. That’s often to about the same price level relative to the left shoulder high, making the high of the right shoulder, but then heads back down to the left shoulder low price area.
- The pattern is only complete and considered to signal a market reversal when price action shows that price breaks significantly below the neckline. The neckline is a roughly horizontal line drawn connecting the low prices of both the left and right shoulders.
A trader can then enter a short sell order, running a stop-loss either above the high of the right shoulder (lower risk) or the high of the head (less chance of getting stopped out).
The pattern simply flipped upside down is a signal of market change from a downtrend to an uptrend. In that instance, a buy signal is generated when the price breaks above the neckline. However, the head and shoulders pattern is more frequently seen to form at the top of an uptrend rather than at the low of a downtrend.
The Pin Bar Pattern
Another commonly seen trend change signal pattern is a simple candlestick pattern referred to as a pin bar or a hammer candlestick. The key characteristics of a pin bar candlestick, which make it very easy to identify, are a very short candlestick body and a very long candlestick tail (at least 2-3 times longer than the body).
The image below shows what a bullish pin bar (signaling market change to an uptrend) and bearish pin bar, or hammer, candlestick (signaling market change to a downtrend) look like.
Many traders use the pin bar pattern as a signal to exit an existing profitable trade, but it can also be used as a market entry point to try to get in very near the beginning of a new trend.
Double Tops or Bottoms
Another of the easiest to spot and most reliable market reversal patterns is the double top or double bottom pattern. This pattern’s name makes it pretty much self-explanatory:
- A bearish pattern that signals the end of an uptrend forms when the price makes a new high and then slightly retraces to the downside. After that, it moves back up to the trend high level but without breaking significantly above it, and then turns back to the downside and continues well below the low of the previous retracement from the trend high price.
- A double bottom is just the double top in reverse: a downtrend low, small upside retracement, a re-test of the trend low, followed by price turning back to the upside and moving higher than the previous upward retracement from the trend low.
2. Continuation Patterns
Continuation patterns occur during a sustained trend that indicates that the trend is likely to extend further – that is, either an uptrend advancing to new highs or a downtrend falling to new lows.
Ascending/Descending Triangle Patterns
An ascending triangle pattern forms a continuation signal for an uptrend when the price seems to encounter a price resistance level.
It takes several attempts for the market to break above that price level. If and when it finally does, that’s the trend continuation signal.
The ascending triangle price action pattern arises when price repeatedly presses up to around the high price of the trend, then falls back down a bit – but, and this is the key to this pattern:
Each time that it falls back from the high, it doesn’t fall back as far as it previously did. Thus, as shown below, the ascending triangle is characterized by multiple roughly equal highs that are accompanied by successively higher lows.
A descending triangle pattern signaling the probable continuation of a downtrend is just an upside-down ascending triangle, featuring multiple roughly equal lows followed by upside retracements with successively lower highs.
Separating Line Pattern
The separating line pattern is a continuation pattern created by two successive candlesticks. Here’s what it looks like occurring in an uptrend, signaling a likely continuation of the trend:
- Candlestick number one opens at a price higher than the previous candlestick’s close (in other words, gaps higher at its open) but then forms a long candlestick body that closes near its low and at a price below the previous candlestick’s close.
- Candlestick number two also features a gap higher at its opening price. A gap which is usually around or even a bit above the previous candlestick’s opening price, but instead of retracing downward as the first candlestick did, it moves significantly higher, forms a long candlestick body, and closes near its high
As with other price action patterns, the bearish version of the pattern, signaling the continuation of a downtrend, is just a reverse of the bullish version of the pattern.
Gaps are a candlestick price action trading pattern that can either signal a trend reversal when the gap that forms moves price in the opposite direction of the current trend or trend continuation if the gap advances price further in the same direction as that of the existing trend.
The gap price action pattern is just what it sounds like: A candlestick gaps above or below the previous candlestick’s price action at its open, the gap remains in place (price doesn’t retrace back into the area of the previous candlestick’s price action), and price continues moving in the direction of the gap, typically forming a long candlestick body with a close near the high (with a gap up) or the low (with a gap down) of the candlestick.
The gap and go strategy is often used by traders to make profits within the first 15 minutes of trading.
Price action patterns provide clear buy and sell trading signals for stock market day traders. They can identify price levels where a buy or short sell order has a good chance of turning out to be profitable, as well as good price levels at which to take profits and exit a trade.
It’s important to keep in mind the fact that no price action pattern is a sure thing, which is one of the main reasons you should use only risk capital – money you can afford to lose – in trading. Even the most reliable price action patterns only work – meaning the market actually does what the price action pattern signals that it’s likely to do – about 60-70% of the time. Still, having a 60-70% chance of your trade being profitable is significantly better than having just a 50/50 chance (or less).
More Price Action Patterns: