Pattern recognition software is a broad name for programs that use mathematical algorithms and artificial intelligence to identify specific graphic patterns in price movement. This type of software is used by traders in tandem with charting software to inform their trading strategy, timing, and position. Using AI, pattern recognition software scans price action charts for specific breakout patterns that are commonly understood as indicators of market change, thereby alerting traders to possible profit opportunities and helping them manage risk.
In order for pattern recognition software to be useful, traders must understand what a given pattern indicates from a strategic standpoint. Once they know what position to take when that pattern manifests, they can use pattern recognition software to alert them or trigger preestablished pending orders.
Interpreting Four Popular Forex Chart Patterns
Pattern recognition software exists for a variety of potential price action patterns. We’ve outlined four price patterns that traders commonly use pattern recognition software to identify and how to interpret them.
Support and Resistance Trendlines
Support and resistance lines are a widely used trading tool. They can be drawn on price action charts in a rudimentary way or created with more precision using pattern recognition software. Resistance lines are placed along price peaks, and support lines are placed along price gullies, creating a banded price range. In an uptrend or downtrend, support and resistance lines should form a stair-like pattern in the direction of the current trend, with higher highs or lower lows shifting support and resistance lines in an incremental fashion, as illustrated in the diagram shown.
If price is oscillating in a sideways fashion, support and resistance lines will remain stationary until a breakout occurs and a new trend manifests. As a general rule, when price moves close to the support threshold, it’s seen as a bullish, or buy, signal. Likewise, when price moves close to the resistance line without traversing it, it’s typically seen as a bearish, or sell, signal. When price moves outside of this established support and resistance range, new support and resistance levels are established based on the direction of the breakout. For example, if an uptrend manifests (price surpasses the current resistance line), the previous resistance threshold becomes the new support baseline, as illustrated by the next graph.
Pattern recognition software can be used to recognize support and resistance levels and draw lines to help identify potential breakouts and buy/sell signals.
Double Top and Double Bottom Patterns
This chart pattern manifests in price action as an “M” or a “W” shape, with two relatively equal peaks (double top) or dips (double bottom). Double top and double bottom patterns are powerful indicators because they typically precede a trend breakout or reversal.
In an uptrend, a double top indicates that the trend is losing momentum because price is unable to form a higher high. The fact that the two peaks of the “M” formation are evenly positioned serves to confirm the resistance level established by the first peak and suggests that a trend reversal is imminent. On the flip side, during a downtrend, a double bottom formation is understood to mean that the trend will reverse to the upside.
Pattern recognition software can help traders identify double top and double bottom patterns, thereby alerting them to potential high-profit opportunities. When a double top or bottom is identified, a trader may enter into a bearish position directly below the new resistance line (placing a stop-loss order just above this line) or wait for price to continue to drop below the current support threshold, thereby making this line the new resistance level.
Doji patterns are price bars that are so compressed in length that the price bar and candlestick are relatively equal in size. The most common doji pattern resembles a plus sign, with the bar serving as the vertical “line” of the plus and the candlestick serving as the horizontal line. This plus-shape manifests when opening and closing prices are exceptionally close together, which in itself is a sign of market uncertainty. Recognizing doji patterns is most useful in trending markets (as opposed to volatile markets) because these patterns suggest that traders are losing confidence in the prevailing trend and typically foreshadow a reversal.
There are different types of doji patterns, the most widely recognized being the neutral doji, which resembles a plus sign. There are also long-legged, dragonfly, and gravestone dojis (see illustration).
Both neutral and long-legged dojis are signs of market indecision. Gravestone and dragonfly dojis form when an asset’s closing price is equal to its entry price, which typically occurs immediately before a reversal. In the next image, you can see a gravestone doji manifest at the market turning point.
Because doji patterns appear at these pivotal market turning points, traders often use them to confirm reversal signals from other indicators and pinpoint ideal entry and exit points.
Three Strikes Pattern
This pattern manifests during a strong, well-established trend. As such, it’s commonly used to confirm trend direction, momentum, and strength. This is especially helpful when determining entry points and positioning following a market reversal or when deciding how long to remain in a trade to maximize profit and minimize risk. This pattern is less common than the other three and can be either bullish or bearish.
Somewhat counterintuitively, a three strikes pattern consists of four candlesticks: three white, one black. In this pattern, the first three (white) candles continue the current trend, opening and closing at incrementally higher (uptrend) or lower (downtrend) levels. The fourth (black) candlestick opens at a higher price than the third and closest candlestick to it, but then closes at a value below the first candlestick, creating a longer body. This pattern indicates a short-term pullback that typically occurs in trending markets as traders choose to lock in profits. After this pullback has occurred, the trend continues on in the same direction.
No matter what pattern recognition software you use, remember that no one indicator alone should dictate your trading strategy. Pattern recognition software should be used like any other technical indicator in your tool kit—that is, as part of a well-rounded trading strategy with the appropriate checks and balances. To effectively balance risk and reward, make sure to confirm signals across a variety of indicators.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.