How to read stock charts is one of the first skills a new trader should develop as their technical trading method, system. and plan will emerge from this foundational skill. Reading stock charts will show the trader whether a chart is in an uptrend, downtrend, in a range, or highly volatile.
Chart patterns are visual representations of the behaviors of buyers and sellers around different price levels. The importance of these levels emerge when they act as support or resistance. Chart patterns are bullish when a chart is making higher highs and higher lows, they are bearish when they are making lower highs and lower lows, and range bound when they have defined support and resistance levels and no trend.
Trading chart patterns is primarily momentum trading where a breakout of an existing pattern is the signal to enter a trade. Technical traders use the breakout of an existing trendline in a pattern to establish an entry point. After they are in, then a trade is managed to maximize a gain or minimize a loss to create a good risk/reward ratio. Chart patterns can signal breakouts, reversals, and continuations of current price action.
A trendline on a chart can be drawn to show horizontal support or resistance in a range or vertical support or resistance in an uptrend. A chart pattern emerges to show the technical buying and selling price action of traders on the chart of a stock, commodity, currency, or crypto currency.
How to Read Stock Charts:
- Identify a pattern on a chart based on the parameters of price action. The chart pattern cheat sheets below can be used as a guide.
- The more times a price support level or resistance level holds the more meaning it has.
- The longer a price range develops in on chart the greater the breakout and trend could be when it happens.
- Volume is like votes for a price at different levels. The greater the volume on a breakout the higher the chance it will work out in the direction of the momentum. The highest volume also occurs many times near chart tops and bottoms before a reversal.
- In a bullish chart pattern a buy signal is triggered on a break and follow through above a trendline of resistance of the existing price range consolidation after an upswing in price action. In a bearish chart pattern a sell short signal is triggered on a break and follow through below a trendline of support of the existing price range consolidation after a downswing in price action.
- After a trade entry a price target can be established based on previous resistance on a long term chart or overbought readings for a bullish chart or previous support on a long term chart or oversold readings for a bearish chart.
- A stop loss can be set at a reversal back through previous range support for a bullish pattern or a break back over previous range resistance for a bearish pattern.
- Position size should be conservative and not risk a big loss if the chart pattern does not follow through with a trend. 10% of total trading capital is a good general position sizing parameter for most stock trades, less if a chart is volatile, more if an index ETF is being traded. For options and futures trading it is smart to never risk more in position sizing than you are willing to lose capping risk at 1% to 2% of total trading capital on a position that can quickly go to zero.
- Chart patterns can increase the odds of success by going with the trend and flow of current price action.
Chart patterns are not predictive tools they simply show the odds of the direction a chart is likely to continue to go. When the momentum plays out and continues after a breakout then the magnitude of the profits can be many times greater than the loss that is minimized by a stop loss when the momentum does not continue. Chart patterns are ways to create great risk/reward ratios through reactive technical analysis, they are not crystal balls. Profitability comes from big wins and small losses not accuracy with a high win rate. Stock chart patterns can have big moves when the underlying company has the potential for huge growth in sales, revenue, and profits.
Long term stock trends can create more complex classic chart patterns that play out through a full cycle of accumulation, distribution, and trading price action.
For a full explanation behind the principles of these patterns check out The Ultimate Guide to Chart Patterns.