Posted on: 09 Sep, 2019
Trading with technical analysis goes hand in hand with the identification of chart patterns due to the predictive nature of these structures. Since trading is also such a mental and emotional game, which determines, for the most part, the herd behavior we see, certain chart pattern can, therefore, act as a fantastic determiner of when such emotions may resurface to provide opportunities.
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The term charting pattern refers to the price of a particular instrument carving out a specific price formation as a recognizable arrangement of price movements, most of the times identified via the drawing of trendlines, horizontal lines and/or curves.
Chart patterns tend to play a critical role for traders that utilize technical analysis as the main approach to look for entries in the market. Traders are drawn to trade via technical analysis because through backtesting, they’ve identified that a particular pattern within a chart tends to lead to a repeatable behavior over a long enough sample of trades.
When trading charting patterns, the ultimate purpose when identifying one is to either enter into a trade in line with the perceived trend, which is what we’d call a continuation signal or alternatively, enter against the current trend, also known as a reversal signal.
In the domain of trading financial markets, we can break down chart patterns into three main categories: traditional pattern, harmonic pattern, and candlestick pattern. Just remember, there are tonnes of chart patterns out there, which is why I personally recommend a website that does an excellent job in classifying them under different categories (candle patterns and chart patterns). Thomas Bulkowski's site is the real deal. Tom has also written a few books on the subject including “The Encyclopedia of Chart Patterns.”
A harmonic pattern is characterized by the identification of structures of distinctive nature as these must align with consecutive Fibonacci ratios to get validated. The harmonic pattern is characterized by looking to trade reversals of the current momentum in the chart.
The power of harmonic patterns lies on the assumption that these structures communicate with sufficient precision the maturity of a cycle. Like any pattern, the whole point of spotting these formations is to anticipate a low-risk entry that provides an edge over a long sample of trades.
Harmonic pattern traders believe in the power of cycles as a universal law. There are cycles in everything. Human cycles (pregnancy, infancy, toddler years, childhood, puberty, older adolescence, adulthood, middle-aged, senior years). We have cycles in the formation of mountains and its respective peaks, formations in the sea via the structure of the waves, etc.
I am often reminded of the cycles from where I spend the majority of my time here in Bali. I live next to a paddy rice field, and I am always in constant exposure to the repetitive cycles the farmers go thru (land preparation, crop establishment, water use and management, nutrient management, monitoring of the crop health, harvesting, etc). Cycles in charts also exist, even if the temporality at which they get created and evolve varies much more wildly.
Find below an example of a harmonic pattern called the ‘Bat’ chart pattern.
Source: Forex Training Group
This ‘Bat’ pattern, looks like the illustration below, when looking to spot it in a chart.
Another popular pattern is what’s been dubbed the ‘Crab’ chart pattern.
Source: Forex Training Group
Which in the context of a price chart, would be represented through the following structure.
The list of harmonic patterns goes on: Butterfly, Gartley, Cypher, Deep Crab, Shark, AB=CD…
Next up I will introduce the type of patterns most commonly known by retail traders. Without a doubt, the educational material on traditional chart patterns has proliferated more than any other category due to the fact that technical analysts have used them for more than a century.
As part of the traditional patterns, we have to separate the structures that may lead to a price reversal or the ones intended to be traded for a continuation of the trend.
The reversal-type of patterns most popular out there include a Double Top, Double Bottom, Head and Shoulders, while the most common continuation patterns include Ascending Triangle, Descending Triangle, Rising Wedge, Falling Wedge, Flag and Pennant, Channel, etc.
Let’s now explore a few examples of traditional patterns. We’ll start by the configuration of price structure that may be seen as the pre-emptive signal to enter for a continuation of the trend.
A very popular one is the flag pattern. The onset of the pattern occurs when an impulsive move up or down is followed by a corrective pullback with a series of lower highs and lower lows if in the context of a bullish trend that allows us to draw a channel. In the case below a bullish flag pattern is illustrated. The impulsive move and the subsequent correction is a clue that the order flow is still favoring a follow-through continuation move. Once the price breaks to the upside of the channel with a surge in volume (ideally), it validates the bull flag entry. Note, this pattern tends to be quite tight in its range and should consist of only a few bars (up to 15-20 max).
Source: Forex Training Group
Again, in the context of a price chart, it would be displayed as follows.
Another widely used by chartists is what’s called an ascending or descending triangle pattern, which is also characterized by its continuation dynamics. It’s best when it occurs in established trends. Its initial setting comprises a double top (ascending triangle) or bottom (descending triangle), followed by a series of higher lows, which in order flow terms, it translates into buyers adding further upside pressure by compressing price into a narrower upper range. On the flip side, if a double bottom is followed by a series of lower highs, that means sellers are taking control for an eventual breakout. In both cases, the pattern validates when the price break out, with an increase in volume ideal.
It looks like this when trading the price structure in a candlestick chart:
Now, when it comes to traditional patterns with reversal characteristics, I’d dare to say the most popular to report by mainstream media, as far as my memory goes, is probably the double top/bottom as it creates the prospects for a rather attractive risk-reward.
The double top is formed after price retests a previous high and fails to break as long as the interval between the first and the second test of the high has a minimal separation in between. The double bottom is created when two lows by a minimal separation are created. In the case of the double top, once the low in between the first and second high gives in, that’s when we find the confirmation needed to enter into a short. As usual, a breakout of high volume will increase the chances that the pattern becomes more reliable for further follow-through continuation.
Below, in a candlestick chart, a double bottom is also illustrated.
A second reversal-type pattern that may offer sufficient conviction to be traded to those having done their due diligence in backtesting it includes the Head and Shoulder. The pattern receives its name from the similarity of the pattern to a head and shoulder. For the pattern to complete, we need two separate leg high (the shoulders) with a higher high (the head) in between. The H&S pattern is a bullish reversal pattern, while the inverted head and shoulders pattern corresponds to the bearish reversal pattern, characterized by two low legs with another lower low in between. In both instances, when the breakout of the 2nd shoulder is confirmed, which as part of the pattern terminology, we’ll call it ‘the neckline’, that’s when the pattern is ratified.
The chart below shows a symmetrical head and shoulder pattern with an entry at the circle.
Time to delve into the last category of chart patterns, which in the realm of technical analysis is referred to as candlestick patterns. The idea is to trade certain standalone candlestick formations in anticipation that the pattern can help us predict a particular market movement.
Steve Nison is the foremost leader in exporting this type of candlestick charting from Japan to the West as an analysis tool to study the markets. The number of candlestick patterns that exists is overwhelming, in the hundreds, so I will just focus on a handful of the most popular.
The first one that comes to mind is what’s called a pin bar. It’s a candle pattern that consists of a long wick or tail (shadow) with the body smaller in comparison. If the body closes bearish, as the image below, with losses after the candle period is concluded, it’s referred to as a bearish pin bar. If the rejection off the high is substantial yet the body still closes bullish, while not ideal, it can still be considered a bullish pin bar under the condition that the wick or tail is large enough. The more volume that the pin bar carries, the more credence.
See below an example in the chart graph:
Another powerful candlestick pattern is the engulfing candle. This candle pattern is characterized by the formation of two candles, each of different colours, with the body of the second fully engulfing the body and tail of the first one. The close of the second candle should be on the last third as a sign of conviction by the side creating the reversal. When an engulfing candle pattern occurs, it means there has been a sudden shift in order flow, and it communicates that the prospects of a reversal in favor of the direction of the engulfing candle are on the rise, if other factors also agree. The more volume in the formation of the pattern, the better.
Note, as part of a candlestick pattern playbook, when one thinks of an engulfing pattern, the sister version is what we call the outside candlestick pattern. This candle pattern has a lot of similarities to the engulfing pattern as said, with the subtle difference that the second candle must have a higher high and a lower low than the first candle. The close of the second candle, as in the case of the engulfing, should be on the last third of the bar as a rule of thumb. When an outside bar occurs, an aggressive shift in order flow ensued, also known as an order book sweep. The more volume in the formation of the pattern, the more involvement by large capital.
Last but not least, we have the inside bar candlestick pattern, which is made up of a minimum of two candles. The first candle must engulf the second, which must be smaller and within the delimitations of the first candle. The high of the first candle is higher than then high of the second candle, and the low of the first candle is lower than the low of the second candle. This pattern means a period of equilibrium or consolidation in the market. Inside bars are great patterns to play for a follow-up move in line with the dominant trend. They tend to be validated by the breakout of the low or high of the first candle, often referred to as the mother candle.
Not yet satiated with the above price action chart patterns? Check this cool cheatsheet put together by www.jbmarwood.com
Trading with technical analysis goes hand in hand with the identification of chart patterns due to the predictive nature of these structures. Traders (the humankind and not robots) tend to be visual creatures, which is why price chart patterns attract plenty of interest, as we feel comfortable engaging in routine activities, which when extrapolated to trading, it means each one of us can adopt an exploitable chart pattern strategy that suits us. Since trading is also such a mental and emotional game, which determines, for the most part, the herd behavior we see, certain chart pattern can, therefore, act as a fantastic determiner of when such emotions may resurface to provide opportunities. By trading chart patterns, you are looking to decipher the current trading psychology of the market and that’s very valuable.
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