FORMATIONS TUTORIAL

Formations are powerful indicators of future price moves. They have been used be traders for many years and play a vital role in technical analysis.

The two most important concepts to understand when looking at graph formations is to be able to identify supports and resistances."

In essence, a support line is a trend line identified on a graph that the share price approaches and then bounces off. A support line is classified after several points displaying this behavior and is comprised of at least two of these points. The easiest way to become familiar with this is through looking at examples which can be seen below.

Similar to the support line is the resistance line. The resistance line is also a trend line however this line represents a barrier that the share price approaches, slows to a halt, and then backs away. It is classified in the same way as the support line in that it is comprised of several points that when linked together form this line. The minimum number of points required is two. The examples below will help to make the concept more familiar.

The Head and Shoulders formation is one of the most used and reliable pattern formations. It is a bearish formation which indicates that the share price is going to move down. It consists of a left shoulder, head, and right shoulder which can be seen in the figure. The shoulders should be relatively equal is size with a larger head in the middle. The base of the Head and Shoulders is called the neck line. This neck line is a support line on which the Head and Shoulders is based. The actual neck line does not have to be horizontal but can be at a slight to moderate angle which is shown in the examples below.

A Head and Shoulders formation target is triggered when the right shoulder finishes forming and breaks the support line. The Head and Shoulders target is worked out by taking the height of the head from its support line and subtracting this from the support line.

The second example shows a further characteristic that is possible with a Head and Shoulders pattern. This is that the pattern can also be comprised of multiple shoulders as long as the shoulders that follow are below the highs of the shoulders directly aside the main head.

In the third example one can see the share price coming back to the support and breaking the support. This happens on occasion with Head and Shoulders patterns. This does not mean that the pattern is discarded. The target is only removed if the share price moves above the right shoulder level.

The Inverse Head and Shoulders pattern follows the same pattern as the regular Head and Shoulders, with a left shoulder, head, and a right shoulder but is flipped about the neckline which can be seen in the diagram below. The Inverse Head and Shoulders is thus a bullish formation

This formation is formed between an ascending support trend line and a descending resistance trend line which forms a triangle shape. The pattern can be either bullish or bearish depending on the breakout point. An example can be seen below. How the triangle formation works is that the share price is bound by the support and resistance and moves between them, at the instance where the share price breaks through either the support or resistance line the target method is applied. If the share price breaks through the resistance trend line the target is bullish. If the share price breaks through the support the target is bearish.

Using the example shown below, the targeting methods will be explained. What is clear is that the share price broke the support line, triggering the bearish target. If it had broken the resistance, the bullish target would have been triggered."
The first method that will be discussed is the triangle height method. How this method works is you move to the starting point of the trend line (either the support or resistance line) that is furthest right, thus in the case of the example it is the resistance line, and you take the vertical distance between the support and resistance line at this point and either add it to the resistance line break out point or subtract it from the support line breakout point depending if it is a bullish or bearish breakout. If the share has broken the resistance line then it is added to the break out point. If the share price has broken the support line then the distance is subtracted from this point

The second method is the parallel line theorem. This is a slightly more technical method but once understood is very easy to implement. Firstly the break out needs to be identified - either bullish or bearish. If the beak out is bullish, a line parallel to the support is drawn from the starting point of the furthest right trend line in the same way that was done for the first method. If the breakout is bearish, as seen in the example, a line parallel to the resistance line is drawn. A vertical line is drawn from the breakout point to this parallel line and the point at which they intersect is the target

This is a triangle formation where the resistance is a horizontal line and the support is an increasing bullish trend line. The share price moves between these two lines until it either breaks through the support or the resistance. This formation is a bullish formation and a break of the resistance will trigger upward movement."
The target method for this type of formation is as depicted in method 1 under the symmetrical triangle formation tab. As this example is a bullish breakout, the vertical distance from the furthest right trend line, in this case the resistance line to the support line, was taken and added to the breakout point of the resistance line. The target was then reached.

This is a triangle formation where the resistance is a descending gradient bearish trend line and the support is a horizontal trend line. The share price moves between these two lines until it either breaks through the support or the resistance. This formation is a bearish formation and a break of the support will trigger downward movement. 

The target method for this type of formation is as depicted in method 1 under the symmetrical triangle formation tab. The vertical distance from the furthest right trend line, in this case the resistance line to the support line, was taken and subtracted from the breakout point of the support line. The target was then reached.

The ascending channel is when the share price moves between a support and resistance line, both with an increasing trend line. Once the support and resistance entities have been established, traders can make use of this technique to trade between the support and resistance bounds. Instances when the share price approached the support triggered stock purchases and instances when the share price approached the resistance triggered stock sells. An example can be seen below, where this methodology would have worked well.

The descending channel is when the share price moves between a support and resistance line, both with an decreasing trend line. Once support and resistance entities have been established, traders can make use of this technique to trade between the support and resistance bounds. Instances when the share price approached the support triggered buys, and when the share price approached the resistance triggered sells. An example can be seen below where this methodology would have worked well.

A falling wedge is a bullish reversal pattern. It can be described as a cone like shape with a resistance and support line with a negative gradient that converge on one another. The share price moves between the support and resistance lines and if the share price breaks through the top resistance line the formation target is triggered. The target method is very simple as it is to the start of the resistance line, this can be seen in the figure below.

A rising wedge is a bearish reversal pattern. It can be described as a cone like shape with a resistance and support line with a positive gradient that converge on one another. The share price moves between the support and resistance lines and if the share price breaks through the bottom support line the formation target is triggered. The target method is very simple as it is to the start of the support line, this can be seen in the figure below.