Crypto trading chart patterns: Master the basics

• Financial markets often trade in repeating patterns, which can be used as the basis of a trade setup.

• There are many different types of chart patterns, each with their own idiosyncrasies, nuances and reported efficacy.

• The degree to which any pattern is useful to a trader depends on several factors, and the use of patterns should be backed up with extensive backtesting.

Trading chart patterns are sequences of price action that can be repeatedly identified on financial charts. Traders sometimes use chart patterns as part of a trading strategy, using the different features of each pattern as a means for entry and invalidation.

This article explores:

• The value and utility of chart patterns.

• Useful tips and tools to help you trade them.

• Different types of patterns.

• What the research says about chart patterns.

Edge

The concept of “edge” in trading relates to the identification and use of non-random events in markets. Some chart patterns can offer traders an opportunity to generate risk-managed setups, with clear entries and invalidations. Identifying any repeatable pattern in markets is therefore highly valuable, as it can be backtested to determine its efficacy as a trading strategy.

Do as the professionals do

Many professional traders use chart patterns. Perhaps one of the most prominent examples of this is that of Peter Brandt, who has applied patterns in traditional markets for many years. If it works for professionals in traditional markets, then it stands to reason that it can work for other traders in crypto markets.

What is obvious

A common mantra in the world of trading is to identify what is obvious. Seeing what is obvious can help you gauge what most traders are looking at and their expectations.

This is valuable because the more obvious a chart pattern is, the more likely other traders will see it too and therefore the greater impact it might have. This applies to when chart patterns work and when they don’t.

When a chart pattern on a higher time frame has a breakout which fails (known as a ‘fakeout’, more on this below), many traders will be trapped. Even if a trader doesn’t trade the patterns themselves, they offer a means of generating a directional bias and/or informing their other trade setups, which is valuable.

Fakeouts are common

As mentioned above, a cryptocurrency’s price will often break out from a chart pattern, only to reverse course and accelerate violently in the opposite direction (this is sometimes known as a ‘throw over’). The end result of a failed breakout is that many traders find themselves trapped and forced to close their position at a loss, which in turn adds more momentum to the reversal.

Bearish patterns can breakout bullish

Bitcoin (BTC) has on a few occasions formed a bearish rising wedge, only to break out upwards (it tends to happen in bull markets). Just because a pattern is predominantly bearish, it does not mean that it will resolve in a bearish fashion, and vice versa.

Don’t risk too much on one trade

No pattern or trading strategy works 100% of the time, and losses are inevitable. What’s critical is that your average losses are significantly smaller than your average gains. The goal of a trader with regards to capital is two-fold:

1. Grow your capital - be aggressive when the market calls for it.

2. Protect your capital - be defensive when there is little to do.

It may be tempting to see a pattern and decide that you will risk all of your capital on this particular setup without any regard for the potential losses. This is a mistake that many new traders make. Every attempt to trade a pattern should be risk-managed, meaning that you are not risking an amount that would jeopardize your entire trading balance, or ability to recover should the trade fail. Some traders advocate risking no more than 1% of your entire capital on any given trade, and this can be easily achieved by:

1. Always ensuring you use a stop-loss order

2. Tailoring your position size according to your pre-determined risk.

“Plan the trade, then trade the plan” is something you might hear from various traders in the crypto sphere. In short, a trader without a carefully thought-out plan may find it difficult to be successful.

A trading plan often involves a detailed step-by-step guide with defined rules on how each setup should be traded.

These rules should be clear, objective and easy to execute. For example, let’s imagine you wanted to trade a breakdown of a descending triangle. In this scenario, you would need to know:

1. What, in terms of price action, would act as confirmation that price is in fact breaking down

2. Where you are wrong on the trade - the invalidation and what confirms that you are wrong. For example, you could place a stop at a predetermined point back inside the pattern, or you could use the same level, but stipulate that prices must close above this level to constitute an invalidation.

3. Where you will take profit on the trade if it goes in your favor.

4. The sizing of the position must be in line with your risk-management rules to minimize the impact of inevitable losses.

This is a fairly reductionist list, but it highlights how detailed a trading plan must be.

It's important to note that trading plans often delve into other aspects of successful trading, but here we focus specifically on strategy.

Trade example: the bull flag

With the above in mind, let’s imagine a scenario where you have identified a bull flag on a cryptocurrency’s price chart, and now want to trade it.

The following steps offer some insight into how this pattern might be traded:

1. A bull flag is generally regarded as a bullish continuation pattern, offering a bullish directional bias. Therefore, in this instance, you might decide that a close above the upper trend line on the hourly chart is confirmation that the asset’s price wants to move higher. This is a reasonable assumption as the pattern was originally identified on the hourly chart, so reduces the likelihood of entering prematurely.

2. The invalidation for this setup is a close below the lower trend line, as price should not go there if your thesis (that the market wants to move higher) is valid.

3. Looking at key price levels above, you spot an area of former support that may well act as resistance should price reach it, and decide to place your take-profit just below this level.

4. In this instance, price approaches the upper trendline with increasing volume, before violently breaking out upward, closing above the trend line and triggering your entry.

5. You may opt to use a crypto position size calculator to work out how much of the asset to buy at this level, taking into account your risk management rules and the loss you will realize if price reaches your stop*. You enter the long position using a market order.

6. Price continues in your favor, approaching resistance above. Seeing this, you move your stop up to a level behind the former resistance, which may well act as support should the price retrace.

7. You notice that the breakout is losing steam, volume is drying up and there are lots of upper wicks just below your desired take-profit level. Seeing this, you elect to close the trade early. While the trade didn’t quite reach the level you wanted, the market was signaling weakness, and the decision to close the trade is vindicated as price retraces the entire move shortly after.

No exchange can guarantee you will get the price you want when you enter or exit using market orders. This depends entirely on the liquidity available in the order book when the trade is executed. Violent moves in thinly-traded assets can result in a much greater loss than expected.

For this reason, when you are calculating your position size, you may want to account for slippage and fees, and reduce your size accordingly.

Use other factors as confluence

By incorporating other factors—such as indicators—into your technical analysis of chart patterns, you may find commonalities between trades that work and those that don’t. When you backtest trading certain patterns, look for events that occur alongside the patterns that make the setups more successful.

For example, you may witness that when trading falling wedges, if there is a bullish RSI divergence present prior to the breakout, the trade has a much higher strike rate. This is just one of many potential inputs you could use to improve your overall approach.

Also consider volume, which is sometimes used as a means of confirming a pattern. For example, if volume rises on the downward legs of a head and shoulders reversal pattern, this may add weight to the validity of the pattern and imply a greater chance of a breakout in the desired direction.

Broadly speaking, there are two types of chart patterns:

• Continuation patterns: these patterns form as part of a pause in the prevailing trend.

• Reversal patterns: these patterns signal a turnaround in the current trend.

The following are some patterns that are often found in crypto markets.As noted above, not all patterns resolve as expected.

Common continuation patterns

The flag

Flags can be either bullish or bearish, and form as part of a brief pause in a strong trend. A bull flag is identified by a temporary downtrend on a time frame lower than the prevailing higher-timeframe trend. They are called ‘flags’ because if you draw two trend lines - one on the top and bottom of the edges of the move - the price action and lines combined give the appearance of a flag pointing down.

The pennant

The pennant forms as a market decides which direction the market will go next. In a bullish pennant, after a move-up, price coils into a tight downward move. This sequence of price action is identifiable as a pennant by drawing two diagonal trend lines either side of the consolidation. Volume often dries up during a pennant as traders wait to jump on the breakout as it plays out. As with flags, pennants can be either bullish or bearish, forming after moves in either direction.

The symmetrical triangle

The symmetrical triangle is similar to the pennant except that it tends to be a more volatile consolidation, and therefore resembles a triangle more than it does a pennant. In the bearish case, after an established downtrend, price slows into an equilibrium, with neither buyers nor sellers able to overpower each other. As sellers eventually re-establish their dominance, the market breaks out of the triangle and continues downward. Symmetrical triangles can break out in either direction, however.

The symmetrical expanding triangle

This pattern, AKA ‘The Megaphone’ is effectively the inverse of a symmetrical triangle, with an equilibrium that expands rather than contracts.

The descending triangle

Descending triangles often form after a move down and are made up of a clear level of support (the lower, straight side of the triangle) and a series of lower highs above (which, by drawing a descending trend line, completes the descending triangle).

This pattern has been referred to as the ‘bouncing ball meme’, as it resembles how a ball bounces lower and lower as the impact of gravity takes effect. In the simplest terms, it shows how demand for an asset at a particular level of support is waning over time, before eventually breaking down. The inverse of a descending triangle is an ascending triangle.

The double top/bottom

A double top or bottom is simply a failed attempt at trend continuation and is generally easy to identify. For a double bottom, price establishes a low of support then revisits that same low shortly thereafter, failing a second time to break the same price level before moving higher.

Double tops therefore commonly mark reversals as buyers run out of buying power, and price rolls over, breaking market structure to the downside. A triple top simply has one more failed attempt to break resistance.

The wedge - reversal edition

Wedges can and often do signal reversals of a trend. The primary factor is how price enters the wedge when it’s formed. If price is trending down before forming a wedge, but breaks out to the upside, that would be deemed a bullish falling wedge. As with regular wedges, expanding wedges can also be used to mark the end of a trend.

The head and shoulders

This classic pattern marks the end of a trend with a failure to form a higher high. The result is a pattern with a left shoulder (a high), followed by the head (a higher high) and then finally the right shoulder (a lower high). A break of the neckline - the major support level beneath the head and shoulders - can be used as a trigger to enter a trade. An inverse head and shoulders can mark the end of a downtrend.

The following is a list of patterns that print far less frequently:

The cup and handle

This reversal pattern is generally well-known, but clear examples are few and far between. In the bullish case, price forms a rounded cup-like bottom before accelerating to a former resistance level. Here, the market then prints a bull flag (marking the handle; a short, stunted retracement) before resuming the trend and continuing higher. The end result is a pattern that loosely resembles a cup and handle.

Wyckoff distribution and accumulation

Perhaps the most detailed example of a chart pattern is that of Richard Wycoff’s accumulation and distribution patterns. The bullish version, or accumulation, marks the bottom of a downtrend and a reversal to the upside (the asset is accumulated before demand eventually overcomes supply).

Each pattern has multiple phases and features, meaning that identifying them may not be straightforward. In short though, the accumulation pattern is a range that forms after a downtrend, but fails to break down.

After one final sweep of the range low (known as ‘The Spring’), price moves aggressively up to and through the range high, before breaking out higher.

The diamond top/bottom

This very rare reversal pattern may be hard to spot, but looks vaguely similar to a compressed head and shoulders pattern, with one additional shoulder. If we look at a diamond top, what enables a trader to draw a diamond around it is a higher high (as part of an established uptrend) immediately followed by a break of structure to form a low.

This is what creates the pointed top and bottom of the diamond. After this new low, price consolidates, creating the right-hand side of the diamond, before breaking down, completing the pattern.

It's important to remember that how patterns are drawn will vary from trader to trader. The identification of chart patterns is subjective, but here are some basic guidelines that may help:

1. Be consistent: Some traders use the wicks to mark the edges, while some traders use the candle bodies. Whatever you decide to do, be consistent.

2. Patterns are imperfect: despite what you see in most visual guides, technical analysis is often an inexact science, and patterns do not always print perfectly. Sometimes you may have candles that deviate slightly outside the pattern identified, and this can be ok. The lines you use to draw the patterns should be considered a ‘line of best fit.’ Price action is often a messy affair.

3. Know when to abandon a pattern: If after drawing a pattern you notice that price does not behave as expected, then perhaps your interpretation is wrong or the market is simply not interested in respecting the pattern. As author and trading psychologist Mark Douglas once wrote, “Anything can happen.”

There is relatively little rigorous empirical data published on the efficacy of chart patterns (particularly with respect to crypto markets), but what does exist strongly suggests that they can act as the foundation for a successful strategy.

• One attempt to determine the success rate of chart patterns found that several patterns ‘...have no statistical edge’, and said that they should not be used in isolation. Combined with support and resistance, the study showed that the patterns were markedly more reliable. Note that this study was not published in a peer-reviewed journal.

• In Thomas Bulkowski’s Encyclopedia of Chart Patterns, the author conducted a large-scale study using nearly thirty years of stock market price data. Bulkowski clearly demonstrated that:

  • Patterns do play out reliably with statistical significance.

  • The reliability of each pattern varies wildly.

• One study showed that seven commonly identifiable chart patterns were successful more than 50% of the time across numerous trials.

Exercise

Using the Kraken Pro platform, see if you can find the following real-world examples of chart patterns that have previously formed on cryptocurrency price charts:

• ETHBTC: Inverted head and shoulders, visible on the monthly time frame in 2021.

  • Clue: The neckline is around 0.04000.

• BTCUSD: Descending triangle, visible on the weekly time frame in 2018.

  • Clue: Price broke down from the key support level at $6,000.

In summary, chart patterns offer traders and investors the foundation for a successful approach to crypto markets, and this is supported by research showing that they can have predictive value.

By extensive backtesting of what factors impact on the success rate of chart patterns, their overall utility may be enhanced.

Now that you understand common chart patterns that can appear on a cryptocurrency’s price chart, why not sign up for a free Kraken Pro account today and see if you can identify these formations.