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Chart Patterns Forex Forex Education

How Important are Chart Patterns in Forex?

Chartist analysis in forex consists of identifying figures on the price chart, these are usually repeated historically so you can practice in their identification, also they are usually formed in different financial instruments and periods of time, and through them, it is possible to predict with some reliability where the next price movement will follow. It is perhaps the most classic form of analysis in Forex and surely one of the most effective, so your knowledge is always very advisable.

Chartist figures are formed because the market makes oscillations and leaves a “trail” which helps to detect these figures. There are chartist figures that allow confirming the changes of trend, to identify opportunities to enter the market as well as to set objectives in the prices. Chartist figures are more effective in operating in high temporality, although in short periods they usually appear more frequently, also the failures are very recurrent.

Price Pattern in Forex Technical Analysis

The analysis of price movements originated exactly when the price chart appeared. The first graphs were drawn on millimeter paper, and it was then that the first analysts noticed that there were some areas on the graph where the price made similar oscillations at different intervals of time. Traders called them price patterns because the first patterns looked similar to geometric objects, such as a triangle, a square, or a diamond. With the appearance of computer screens and the analysis of longer time periods, new patterns began to appear. Traders use chart patterns to identify trading signals, or signs of future price movements, to enter to trade at the right place.

Chart Patterns You Should Know

“Triangle”

There are several different types of triangles, however, all are based on the same principle. In classical technical analysis, the triangle is classified as a continuation pattern of the trend. This means that the trend that has been on the market before the formation of the triangle may continue after its formation is completed.

Technically, a triangle is a lateral channel of narrowing that usually emerges at the end of the trend. Basically, the triangle is resolved when the range of price fluctuation decreases to the limit, an impulse arises and the price penetrates one of the limits of the figure, moves away from the rupture. I suggest analyzing the break scenarios both upward and downward in the given example. Although the triangle is the continuation figure, it is no more than a probability, and therefore it is worth considering an alternative scenario.

When trading with a triangle pattern, it makes some sense to open a buying position when the price, having passed the resistance line of the pattern, has reached and exceeded the local highs, marked before the break of the resistance line (buy zone). Expected earnings must be set when the price passes a distance less than or equal to the amplitude of the first wave of the figure (profit zone buy). In this case, a stop loss can be placed at the local minimum level that preceded the breakpoint of the resistance line (stop zone buy).

A sales position can be opened when the price has penetrated the figure support line, reached, or pressed through the local minimum level that preceded the breakpoint of the support line (sell zone). Expected earnings should be set when the price has passed a distance less than or equal to the amplitude of the first wave of the figure (profit zone sell). A stop-loss, in this case, must be placed at the level of the local maximum that preceded the breakpoint of the support line (stop zone sell).

“Double Top”

This pattern is classified as the simplest, so the probability of its effective implementation is somewhat lower than that of other patterns. In classical technical analysis, the double vertex is classified as a trend change pattern. This means that the trend that has been on the market before the formation of the pattern may change after its formation is completed.

The figure represents two consecutive maxima, whose peaks are at approximately the same level. The pattern can be straight and inclined, in the latter case you should carefully examine the bases of the upper parts which should be parallel to the maxima.

In classical analysis, a double vertex works only if the trend is reversed and the price decreases, if the price reaches the third maximum, the formation becomes the triple vertex pattern.

A sales position can be opened when the price has penetrated the figure support line, reached, or pressed through the local minimum level that preceded the breakpoint of the support line (sell zone). Expected winnings must be set when the price has passed a distance less than or equal to the height of any vertex of the figure (profit zone).

“Head & Shoulders”

The figure represents three consecutive maxima, whose maxima are at different levels: central must be above the other two, and the first and third, in turn, must be about one height. However, there are some pattern modifications when the shoulders are at different levels. In this pattern, we must ensure that the central maximum is higher than both shoulders. Another key feature for identifying the pattern is a clear trend line, which precedes the pattern’s appearance.

The pattern can be straight and inclined, in the latter case, you should be careful to check if the bases of the upper parts are parallel to their maxima. The minimums between these maxima are connected by a trend line called the neck.

A selling position can be opened when the price has penetrated the neckline of the figure, reached, or pressed through the local minimum level that preceded the breakpoint of the neckline (sell zone). Expected earnings should be set when the price has passed a distance less than or equal to the height of the central vertex (head) of the figure (profit zone). A stop-loss, in this case, must be placed at the level of the local maximum that preceded the point of break of the neckline or at the level of the vertex of the second shoulder (stop zone).

“Wedge”

In classical technical analysis, the wedge is classified as a continuation pattern of the trend.

Technically, the wedge, like the triangle is a lateral channel constriction, but another difference between the wedge and the triangle is its size. The wedge is usually much larger than the triangle and sometimes takes months and sometimes years to form. Therefore, in classical wedge analysis, it is usually implemented in the opposite direction to the formation of the pattern itself, in other words, the trend changes. A purchase position can be opened when the price has penetrated the resistance line of the figure, reached, or pressed through the local maximum level that preceded the breakpoint of the resistance line (buy zone).

“Flag”

This price pattern is classified as the simplest, therefore its efficiency depends on numerous factors. In classical technical analysis, the flag is classified as a continuation pattern of the trend.

The pattern indicates a corrective retreat, following the strong directed movement that often looks like a channel, tilted against the prevailing trend. In classic technical analysis, the flag pattern works only if the trend continues its direction. A purchase position can be opened when the price has penetrated the resistance line of the figure, reached, or pressed through the local maximum level that preceded the breakpoint of the resistance line (buy zone). The angle formed between the predominant trend and the flag channel should not be greater than 90 degrees. The flagship channel itself should not revert in price more than half of the previous trend.

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Chart Patterns Forex Daily Topic

Chart Patterns: Ascending Triangles

Of all the bullish continuation patterns that exist, few are as sought after as the ascending triangle. Like all triangle patterns, their development and construction are dependent on two trendlines that intersect and form an apex. The two primary identifying conditions of an ascending triangle I a flat, horizontal top and an upward sloping trendline.

Ascending Triangle
Ascending Triangle

In addition to the two trendlines, there is a specific kind of behavior that the candlesticks must perform. The upper trendline and the lower trendline must be touched at least twice. Ideally, and according to Bulkowski, there should not be much open space inside the triangle. The same volume behavior that occurs in other triangles occurs here in the ascending triangle: price often breaks out in the final 2/3rds of the triangle, and volume decreases before the breakout. The psychology behind the formation of the ascending triangle is essential to understand. The pattern represents an apparent battle between longs and shorts. Short traders are under the impression that because the resistance level has been tested and has held, it will remain stronger. Long traders are under the impression that prices will move higher because of the formation of higher lows and an upward sloping trendline. Ultimately, shorts cover very quickly, just before or immediately after the breakout of the upper resistance.

Bulkowski recorded that, in equity markets, the breakout direction of an ascending triangle is upwards 64% of the time. Dahlquist and Kirkpatrick recorded that upwards breakouts occur 77% of the time. Interestingly, the performance of this pattern is roughly average across all patterns – this is contrary to the belief of many traders who self-report a high positive expectancy of upwards breakouts. Dahlquist and Kirkpatrick did warn that there are many false breakouts and that failure rates are between 11% and 13%.

As with any pattern, it is essential to pay attention to price action first and then find tools to help you filter whether an entry at the breakout is appropriate. Additionally, be wary of throwbacks as they are frequent over 50% of the time – many conservative traders wait for a retest of the breakout to confirm a valid break from the ascending triangle.


Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

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Chart Patterns

Pullbacks – How Prop Traders Manage Discounts

Pullbacks we will talk about are described as a correction candle (or bar) after a bigger, sudden price movement candle (period) on any asset chart. When you apply a technical trading system and all signals it is time to trade after a pullback, traders enter at a more favorable price. This is a great way to get more pips out of a trend although if you love this discount too much, you can easily become a discount hunter. In forex, this habit will only cut down your account. Professional traders play a very careful game with pullbacks, they are hard to gauge, and once they happen the odds are not as great as without them. The trend may not continue with the same momentum. We will address how proprietary traders manage pullbacks using their technical system and their ruleset. This example can be taken as is, although there are many ways to manage the risk of pullbacks and their psychological effect. 

Discount shoppers should not apply the same principles in forex. Entering at a better price is what we should aim for, there is a time and place for this but it does not happen often in forex. If we wait for a pullback every time, the benefits of pullbacks become a losing waiting game. Our example in this article will use technical system elements explored in previous articles to pinpoint the time and place a pullback can be used for a better price entry. With a rule addition once they happen. The element in question is the Baseline and the volatility measurements. We will also address why professional prop traders avoid them in all other circumstances. Most of the time pullbacks will not be inline with the rule set and the technical system signals, but on some occasions, they will add up and in the long term will have significance to your account. 

The pullback hunting concept is not easy to grasp for a beginner, especially if not yet accustomed to custom indicators, technical systems, and the base Moving Average element. In case you do not understand how to use pullbacks using our example, you can completely disregard this concept and move on with other strategies. Pullbacks setups do not happen often and they do not always end with benefits. Some traders will not enter a trade unless they get a pullback. This also means they miss out on 99% of other trends worth taking. But let’s see how a pullback is used in our trading system. 

Big candles happen on any currency pairs, and we are not talking about the flash crash candles like the one after the Swissy peg removal. Big candles that are unusual can be measured as the ones that break the 1.5 ATR (14) value. These candles are caused by several phenomena in the forex. Most of them are after News events, such as Non-farm payroll, GDP, rates, elections, and so on. Also, these can happen in low liquidity periods, be it brokerage, liquidity providers, or other market drivers. Stop-loss hunting by the big banks is something that happens in between these, and are more common on popular trading currency pairs. Stop-Loss hunting is deliberate price manipulation by the big banks with huge volume to trigger visible clusters around specific price levels set by traders.

This is not a conspiracy theory but a fact we can even read about in the newspapers once the fines are announced to familiar bank names. Stop hunting is not the only manipulation but this is part of forex and it is not always a bad thing. These candles are mostly in counter-trend direction and overshoot a few before it. If these movements are not caused by news, it is mostly bank dumps or a combination of both. Trends can also move like this when there is a huge trading pressure or volume but it is not that often to see it without any catalyst before. The news and big bank manipulation moves are exaggerated, and when the price is deviating so much what usually follows is a correction or a completely new trend in opposite direction – reversal. This is a point where we can take advantage of a pullback, but using elements and rules to increase our odds. 

The rules a pullback can be utilized are applied only when the price cross-closes our baseline element. This is a signal we have a good trend to enter when all other indicators agree on this. Now, we will use the ATR(14) last pip value on our target, daily chart, and see if the current candle which is about to close in a few minutes is past this ATR pip value, measured from our baseline. In MT4/5 this is quickly measured by clicking the middle mouse button or ctrl+f and dragging from the top/bottom of the candle to the baseline. The rule for pullbacks is that only trade the pullback if in the price level is back into the ATR value range from the baseline. If we do this step by step it would be like this: 

  • We use the daily chart for our trading. 
  • The candle or trading day is a few minutes before closing.
  • The price has crossed our baseline.
  • Pull up the ATR (14) indicator and see what the current pip value does it sit. 
  • Measure the range from the current price level of the candle to the baseline.
  • See if the pip range measured is higher than the ATR pip value.
  • If it is, wait for tomorrow to see if we have a pullback candle at the end of the day.
  • We measure the pullback candle current price level range from the baseline a few minutes before the day close.
  • If the measured pip range is below the current ATR pip value we enter the trade. 
  • Our system gives a trade entry signal and other rules allow for it. 

This procedure may look complicated but it is easy after a few times. Some tools which can be downloaded for free from the MQL5 market can draw the ATR range channel on the chart making it easy to see if the pullback has qualified for entry, no need to measure the distance. 

Now we will give a few pullback examples using MT4 included indicators. In the picture below we have the EURUSD pair on the daily timeframe, 20 period SMA as our baseline example, Chaikin Money Flow indicator as our trend confirmation indicator, and the ATR on the default settings (14 periods). 

Notice the big candle in the middle of the picture that close-crossed our 20 SMA baseline colored yellow. Below, our confirmation indicator signals the long trade as it is above the horizontal zero line. The ATR below the Chaikin Money Flow gives us a value of 1005 points (100 pips) when we hover over the line (take the decimal number as a whole). 

When we measure the price level distance from our baseline, we get 101 pips – bigger than our ATR value so we do not take this trade (see picture below). 

If you want to be precise, you can hove over the candle and the baseline to see the values and calculate the pip distance, although when you trade real time this precision is not important unless it is hard to tell. The next candle pulled back. Our confirmation indicator is still signaling the long trade, the closing price level is now inside the ATR range from the baseline – 33 pips.

So now we are entering this trade at a discount, 68 pips better price entry does matter plus we have a better risk as our Take Profit point is lower. Pullback situations like this are not common, but you should be ready once they do. Remember that the one candle rule is applied here. If the next candle is not in the ATR-Baseline zone you do not take that trade. We do not count later candles and qualify them as pullbacks, only the first after a big candle. Interestingly, this one candle rule is applied to some lagging indicators to give them a chance to catch up with the rest of the system, however, this is just one example of a trading system used by a prop trader. The picture below shows price action we do not qualify as a pullback, the second candle after the exaggerated one is not a correction while the third is not accountable. 

On some occasions, your confirmation indicators may be lagging so you do not catch a baseline crossing candle or the one after. If this happens and the price is already past the ATR range from the baseline, you pass on that trade. There is no waiting for any kind of a pullback. The baseline element cannot play its role if you take trades too far from it. The baseline is there to show the “balance” point to which the price comes back to after deviations. Entering a trade in the middle of the deviation decreases the odds it will continue to move away. The baseline element is also a protective function from losses. Of course, you can try other ATR settings or levels for this rule if it proves to be more effective in the testing. 

The ATR range rule is applied to normal trading signals too in our system example. Any deviation which is too far away once the baseline is crossed does not qualify for an entry. There is one exception though – when you encounter continuation trades. More on these situations is presented in another article. 

Pullbacks can work well, so well it can make you skip the rules you have set. The hype of success can lead you to seek pullbacks wherever you can, adjusting the system to only catch them as much as it can. This change will lead you into a losing spiral not only to your account but to your morale too. It is easy to get into the pullback hype and much harder to get out of it. There are no indicators that predict pullbacks and even less the ones that predict trends after it. You may rely on your hunches whenever you see a big candle, and this is a dangerous practice for your account. When your ATR is just one pip lower to qualify a pullback, there is no tolerance, you pass on that trade.

The rule discipline will get you out of the losing trades and, more importantly, you will not wait for pullbacks and miss out on winner trends just because the price kept going. These winners are what make a difference to your account after everything, missing them out is not an option. The choice between five 300 pip winners per year and one 350 pip winner with a pullback entry is very easy to make, but the hype of getting a discount cloud our judgment. Discount shopper patience does not apply to forex when it comes to pullbacks. Waiting for a high-percentage trade is not similar. Here, you are missing out on a signal from your system and your rulebook just because you want a better price to enter after a pullback. Do not mix this with high-percentage trading which is actually what you should do all the time. 

As you may have noticed, this example is based on measurements, indicators, and strict rules in conjunction with them. It is a technical system that may not be an appropriate way of trading for everyone. Some traders trade without any indicators, or as they might describe – secondary technical indicators. The primary indicator for them is Price Action. What they see on the chart is the base for their decision making. Identifying pullbacks is not exact practice, they might wait for a pullback every time with pending orders or wait for a Price Action pattern to unfold before making an entry. However, these skills are unique to them and cannot be replicated in any technical system. On the other side, by having something you can measure, you have an easy-going decision-making system ready for anyone who can just follow their signals to be successful.

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Chart Patterns

Forex Chart Patterns Might Be an Illusion

If you are new to forex trading, chart patterns are likely to attract your attention quickly because the trader community is full of praises for this kind of trading. They will certainly seem appealing due to habits developed from a young age when our parents used different shapes and forms to keep us entertained and amused. Nowadays, the entire toy industry and children based video games are based on shapes and forms used to provide preschool education to toddlers and children. Our brains are naturally wired to see patterns in every abstract form, be it star constellations or forex charts. We give meaning to randomness. Therefore, who could blame you for jumping on the chart pattern bandwagon once you enter the world of forex trading?

Indeed, some pattern names will easily trigger childhood memories that instantly attract you to explore more about pattern trading: triangle, wedge, rectangle, flag, and pennant. Some of them are appealing enough, such as head-n-shoulders or cup-n-handle. It just sounds like fun and games, and why not have some of it while trading. To make things more serious, most traders will tell you that it works and they will provide you with an abundance of examples. But the question is: have you learned to lose fun games when you were a kid?

The question is posed because there is not much information available on when chart patterns are not working. In reality, chart patterns supporters will show you examples when chart patterns have already worked but will rarely share the failed stories on using patterns that have completely misled them. The first instance would obviously create an image of a prominent trader, while the latter would discredit them and portray them as a showoff. Therefore, psychology plays a significant role in chart pattern trading as the availability of successful examples plays hand in hand with the trader’s inclination and ability to boost self-confidence. Reliance on the limited information that is available to the narrow circle of traders and a strong belief in skills that provide an advantage over the competition will eventually lead to overconfidence. Such a mindset represents a perfect stage for doubtless use of chart patterns as successful examples visible only in the aftermath is seen as an actual confirmation of self-confidence and perceived ingenuity. This fact is your first red flag when considering chart patterns as your go-to strategy in forex trading. 

It is also important to keep in mind that the overwhelming majority of traders are impressed by chart patterns, which is why new traders are attracted to this kind of trading. It is a classic example of social learning theory that can be summarized as the acquisition of new behaviors by noticing and imitating the behavior of others in the group. That same theory is proven in social experiments in which a random person not aware of the experiment is acting the same way as the group participating in the experiment, without even knowing the reasons for such behavior and regardless of how ridiculous that behavior may be. Simply put, chart patterns should not be utilized without any doubts just because the overwhelming majority is doing so, according to the contrarian traders’ opinion. This resonates as the second red flag especially if you put in the perspective that the majority of traders are on the losing end of the forex market. 

As a beginner, it is not easy to spot a forming shape when looking at charts. In fact, you have to draw it yourself and there are no clear instructions on how to do it. Line drawing can cause a lot of frustration, consume much of the precious time, and requires plenty of creativity. You are bound to make mistakes, redraw numerous lines and shapes and it still does not guarantee success. A good example that demonstrates drawing patterns is a matter of frustration rather than efficiency is drawing trend lines. As you may know already, traders analyze charts in numerous different manners and therefore see trend lines arising at different points. Therefore, your decision on breakouts and entry points will differ from other traders and chances are that the same is applicable to drawing chart patterns. There is simply no consistency in drawing patterns. When the first red flag is added to the equation, the fact that chart patterns work perfectly for others makes us question our own abilities and we quickly start blaming ourselves when the drawn patterns are not giving results.

Finally, it is not shapes and forms that move the prices but the big banks reacting to the retail traders. None of them are putting effort into creating triangles and wedges on the charts. On the contrary, they are bound to form eventually as a natural process of market movements. Their natural formation is not a clear indicator that prices are going to take a direction predicted by the pattern, despite the time amount invested in identifying the pattern. The reality is that the prices still have even odds of going one way or another, and there are more systematic ways to connect the dots that give us a higher chance of success than chart patterns.

Forex trading is not universal science and many different strategies and approaches could be used – and even developed – by traders. Those who develop unique trading systems based on evidence that demonstrate consistent results are more likely to achieve success, simply because they start to trust the process over time. In the process of building their exclusive trading system, traders develop a greater understanding of arising issues and use distinctive rationale thus dealing with market obscurities more effectively. Such traders do not waste time identifying and drawing shapes nor do they adjust their skills and knowledge to the chart pattern system that has not been empirically proven.

Although chart patterns are not supported by practical evidence that would confirm their (in)famous reputation, the red flags pointed out in this article represent just one school of thought. There is no need to change the system heavily relying on chart patterns that yield profits, as it certainly is a powerful tool for those traders who found the winning formula. Such traders may have a strong argument on using chart patterns; however, they cannot draw the lines and shapes for all the traders who just can’t get it right. And it is no surprise overwhelming majority struggles with chart patterns since there is more evidence available on why chart patterns do not work in practice. Once caught in its web, it is difficult for traders to break away from the habit of identifying shapes on the chart. Moreover, they tend to modify their systems and overthink when they spot a shape on the horizon. In an effort to avoid this trap, any trader should eventually pose the same question when getting lost with chart patterns: would I rather trust my own work and judgment or follow the signs along the way?

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Chart Patterns

How to Use Continuation Chart Patterns to Set a Trading Strategy

Introduction

In our previous educational article, we presented a set of trend reversal patterns, which allowed the investor to participate from the beginning of a new trend. Sometimes, however, for various reasons, the investor doesn’t join the latest trend. When this situation occurs, a continuation pattern may present an opportunity for the investor to join and make an entry to the trend in progress.

In this educational article, we’ll present a set of continuation patterns that help traders to time new trades in the direction of the established trend.

Triangles

There are three basic types of triangles: symmetrical, ascending, and descending. A triangle pattern must contain at least two peaks and two valleys; however, considering the odds of a false breakout, in conservative trading, the investor should wait for the third peak (or valley) to complete and be able to recognize two valleys (or peaks) in the pattern.

The symmetrical triangle is characterized by having two converging trend lines. In a bull market, a buy-side position will trigger once the price breaks and closes above the upper trend line. The confirmation of this setup is given by a close above the last peak preceding the breakout.

On the ascending triangle, the upper trendline is horizontal and represents a short-term resistance, while the baseline is an ascending dynamic support. A market entry will be activated once the price breaks and closes above the horizontal guideline.

The descending triangle is a bearish continuation pattern in which the base guideline is short-term support, and the descending upper trendline acts as a dynamic resistance. A sell-side signal will rise once the price break and closes below the horizontal guideline.

The initial profit target corresponds to the range of the bigger height of the triangle pattern projected from the breakout level in the trend direction.

Rectangle Pattern

The rectangle formation generally acts as a continuation pattern; however, it can sometimes act as a reversal pattern when the price action develops a triple top or bottom structure. The next figure represents the rectangle pattern breakout.

A buy-side signal will arise if the price breaks and closes above the resistance, in a bear market, a sell-side signal will trigger once the price breaks and closes below the support of the sideways formation. An initial profit target level will be the amplitude of the rectangle pattern. Investors should be alert for false breakouts and set propper stop-loss levels and breakout confirmation rules.

Broadening Formation

The broadening pattern is a complex formation difficult to trade due to its divergent guidelines expands across time as an expanding triangle. The following figure illustrates the broadening pattern.

In a conservative market positioning, the investor should consider that this formation tends to appear at the end of a trend. On the other hand, investors should also wait for the completion of three peaks or valleys, and then the breakout and close above or below the previous high or low. Reward/risk ratios are a handicap in these formations, as the invalidation level tends to be far away from the entry levels.

Flag and Pennant Pattern

The flag pattern is a technical formation that goes against the prevailing trend that tends to retrace up to fifty percent of the previous movement. To trade this formation, the investor should wait for the flag structure to complete its three peaks or valleys depending on the last move.

A buy-side position will trigger once the price breaks and closes above the descending dynamic resistance. The initial profit target will be the price range of the previous upward move. A sell-side position will show up when the price completes three peaks and breaks and closes below the lower line of the flag.

The pennant pattern looks similar to a symmetrical triangle, but the pennant takes less time than a symmetrical triangle. A bullish position will be valid if the price completes three valleys and then breaks and closes above the pennant’s upper guideline. Similarly, a bearish trade will emerge once the price breaks and closes below the lower trendline of the pennant formation.

Wedge Pattern

The wedge pattern is a technical formation that looks like a symmetrical triangle moving with the primary trend, but whose outcome is mostly against it. In consequence, an ascending wedge is a bearish formation, and a descending wedge is bullish.

In a bullish wedge formation, the investor should wait for the three peaks to be completed before deciding a short position entry. The initial profit target will be defined by the range of the broadest side of the wedge (between the upper and lower guideline).

In a bear market, the entry setup requires that the technical formation completes three valleys before a buy-side order could be established.

Conclusions

In this educational article, we presented a set of chart patterns that could provide to the chart patterns’ investor a group of strategies to entry and exit setups from the market.

Trend-follower traders should remember that in financial markets, trends show up merely about 30%. In this context, continuation patterns provide opportunities to join the trend when it is already in progress.

In the following article, we’ll present a set of guidelines to use trendlines and trend channels to create a trading strategy.

Suggested Readings

  • Fischer, R., Fischer J.; Candlesticks, Fibonacci, and Chart Patterns Trading Tools; John Wiley & Sons; 1st Edition (2003).
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Chart Patterns Forex Trading Guides

Chart Patterns: Start Here

Chart Patterns: Start Here

Something that I stress repeatedly throughout our series on chart patterns is the difference between traditional markets like the stock market and the forex market. I’m sure a good number of readers have spent time reading books on technical analysis and have recorded and have seen various statistics regarding the performance of the various chart patterns that exist. There’s a big problem that exists in the realm of technical analysis and its use in forex markets, and that is related to nearly 100% of all technical analysis trading material focused on the stock market. Why is this a problem? Several reasons.

  1. Statistical performance values for chart patterns based on the pattern’s performance in the stock market is overwhelmingly long-biased: the stock market has been in a bull market for over a decade.
  2. Forex markets do not ‘trend’ in the traditional sense of financial analysis, they range.

In a nutshell, just because a particular pattern in the stock market may not perform that well in the forex market, it does not mean that its performance isn’t positive in forex. I’ve learned that most underperforming chart patterns in the stock market perform very well in forex markets. As always, make sure you do your own due diligence and research – investigate each pattern for yourself and see how they play out in your own trading.

To begin learning about Chart Patterns, follow this series of education articles.

Chart Patterns: Pullbacks and Throwbacks

Chart Patterns: Symmetrical Triangles

Chart Patterns: Ascending Triangles

Chart Patterns: Descending Triangles

Chart Patterns: Head-And-Shoulder Patterns

Chart Patterns: Broadening Patterns

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

 

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Chart Patterns

Chart Patterns: Wedge Patterns

Wedge Patterns

I want to stress, again, that the frequency and positive expectancy of patterns in technical analysis will vary from market to market. Most of the literature is written for the stock market, which is an overwhelmingly long-biased market. So, bullish patterns perform much better than bearish patterns in the stock market. I don’t have any real statistics to reference other than my years of trading experience. It has been my experience that wedge patterns are one of the most profitable setups in the forex market.

Wedges look like (and in fact, are) extended triangles. Wedges are made of two trend lines that are drawn just like a triangle. The difference between wedge patterns and triangle patterns is simple: the trendlines in a wedge pattern point in the same direction. Ascending triangles have flat tops and a rising bottom. Descending triangles have flat bottoms with declining tops. Symmetrical triangles have a downtrend line and an uptrend line. Wedges are different. Rising wedges have a trendline both above and below price sloping up. Falling wedges have a trendline both above and below, but sloping down. Depending on the technical analysis material you read, you will see wedges that may look like channels, and that is fine – many do.

Wedge patterns should tell you one thing: the end is coming. Because wedges have two trendlines that point in the same direction, the slope of the move is often extreme and is indicative of a climax move. These are incredibly profitable and favorable patterns when you spot them – and they are horrible to trade against if you are trading inside of them. If you read Bulkowski’s work, you’ll know that he recommends at the trendlines in a wedge should be touched at least five times in order for the wedge pattern to authentic. This is true in the stock market as well as in the forex market.

 

Rising Wedge

Rising Wedge
Rising Wedge

You might think that a rising wedge pattern shows up at the top of a trend, and it often does. But you will also find the rising wedge appear at the bottom of a trend. When you see the rising wedge appear after a prolonged downtrend, be careful! The rising wedge that forms after a long bear move is often a continuation pattern. An easy way to think of the rising wedge is that it is an overwhelmingly bearish pattern. It doesn’t matter where it shows up in any trend – it is an extremely bearish pattern.

When I am trading the rising wedge, I generally take the initial breakout that moves below the second to last test of the bottom trendline. The example above shows that there is no immediate retest of the breakout lower. Retests do happen, but they are less frequent than what we see in the ascending, descending and symmetrical triangles.

 

Falling Wedge

Falling Wedge
Falling Wedge

The inverse of the rising wedge pattern is the falling wedge pattern. It can show up at either the end of an uptrend or a downtrend. If you see a falling wedge that occurs at the top of an uptrend, then you could we witnessing a false breakdown lower and see a resumption of the prior bull move. If you see the falling wedge at the end of a downtrend, then you can expect a swift reversal or deep throwback. Just like the rising wedge, the falling wedge is heavily biased towards one direction: overwhelmingly bullish.

On the image above, I’ve added an Impulse Wave to show how you can use Elliot Waves to help determine whether or not a wedge pattern is valid. Remember: Bulkowski said that that a wedge pattern is only confirmed when the trendlines have been tested at least five times. Another condition on the chart above that we didn’t see on the falling wedge is the attempted retest of the break. Again, retests are common in all patterns, but they are definitely less frequent with wedge patterns – that has been my experience with them in forex markets.

When trading the falling wedge, I like to enter when price moves above the second to last swing high. On the chart above, the entry would be above wave four.

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: Broadening Patterns

Chart Patterns – Broadening Pattern & The Diamond Pattern

Broadening Top
Broadening Top

This pattern is also called a funnel or a megaphone pattern. It’s an inverse symmetrical triangle. This pattern is definitely not that common, and it’s a tricky pattern to trade. The behavior of price in a broadening pattern is to increase swing ranges where new higher highs and new lower lows are made. In my opinion, it is best to ignore this pattern. The breakout and retest of the upper or lower trendlines are the prevailing trade strategies utilized for this pattern. Of all the patterns, to trade, this is one of the least profitable. However, I’ve learned that the breakouts are often false, due to the nature of the final swing in the pattern being mostly overbought or oversold. It is not uncommon to see megaphone patterns turn into a triangle pattern – which results in a rare but profitable pattern known as a Diamond.

 

Chart Patterns – Diamond Pattern

Diamond Top
Diamond Top

The diamond pattern is rare. It is also difficult to even notice if it exists. In fact, Thomas Bulkowsi writes on his site, ‘Let me clear about this. I don’t like diamonds. They are as tough to spot as nightcrawlers in the grass on a summer night.’ I believe that is a pretty accurate description. But, while diamond patterns are challenging to spot, they are a very powerful pattern that often results in fast and violent moves in the opposite direction – higher for diamond bottoms and lower for diamond tops. It is ok for the patterns to have one side that seems more slanted than the other and, in fact, they often do not appear as symmetrical as the example above. We trade a diamond pattern the same way we would any other triangle pattern.

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: The Head And Shoulders Pattern

The Head And Shoulders Pattern

Of all the patterns that exist in any market, the most well known is the Head And Shoulder Pattern. Kirkpatrick and Dahlquist’s book, Technical Analysis, detailed many studies on the performance of this pattern. The result of all the data is that the Head And Shoulder Pattern is the most profitable of all standard patterns. Interestingly, Dalquist and Kirkpatrick made no distinction between the performance of the head and shoulder pattern and the inverse head and shoulder pattern (sometimes called the bottom forming head and shoulder pattern). While this pattern is successful across many markets, it is also the pattern that causes the most losses to new traders. We’ll get into the specifics of why this pattern destroys a good number of traders. First, we need to understand what the pattern is.

Regular and Inverse Head & Shoulder Pattern
Regular and Inverse Head & Shoulder Pattern

The image above shows two head and shoulder patterns, the regular pattern and the inverse pattern. It just so happened that the daily chart of the AUDUSD conveniently had both of the patterns right next to each other – not a common occurrence. Now, you can and will read a lot of rules and theories behind the head and shoulder pattern. I could go into the behavior of this pattern, the psychology behind the three triangles that make up the broader pattern, the symmetrical nature of the left and right shoulders, etc., etc., etc., but we don’t need to complicate a pattern that can be very easily understood.

There’s a great book by Larry Pesavento titled Trade What You See. While the book Trade What You See is focused primarily on Harmonic Patterns, the title always stuck with me. If you were to stand in front of a mirror, you would more than likely notice the symmetrical nature of your left and right shoulders (unless you’ve had some significant injury or disease. There’s a good number of people who believe that both the right and left shoulders need to be as exact as possible – but this isn’t necessary.

Here’s a simple rule to follow:

If it doesn’t look like a human head and shoulder, then it probably isn’t a head and shoulder pattern.

 Are you familiar with the poker game Texas Hold’em or any other form of poker? There are several maxims that poker players follow, one of them is ‘Don’t chase the straight or the flush.’ Why? Because when you get dealt a hand that is missing just one card for your straight or one more suite to complete your flush, the odds are overwhelmingly against you getting that final card to complete the straight/flush. Head and shoulder patterns are the same way. The head and shoulder pattern is only complete when the neckline has been broken. Let me repeat that three times for you:

A head and shoulders pattern is not complete until the neckline is broken.

A head and shoulders pattern is not complete until the neckline is broken.

A head and shoulders pattern is not complete until the neckline is broken.

Failed Head & Shoulder Pattern
Failed Head & Shoulder Pattern

 

Many a trading account has been the victim of trying to anticipate the completion of a head and shoulder pattern, only to have it be broken. In addition to being the most profitable basic pattern, the head and shoulder pattern is also one of the most rejected patterns. We don’t chase straights or flushes in poker, and we don’t chase patterns in trading. In addition to the information above, here are some other factors that can help you interpret the head and shoulder pattern:

  1. If the volume in the left shoulder is greater than the right shoulder, there is an increased likelihood of the head and shoulder pattern completing.
  2. If the volume in the right shoulder is greater than the left shoulder, failure rates are higher.
  3. Horizontal necklines increase the probability of a head and shoulder pattern completing.
  4. The more dramatic the slop of the neckline, the more likely the pattern will fail to develop.
  5. Aggressive entries can be taken immediately when the price breaks the neckline.
  6. Conservative entries can be taken after the neckline has been re-tested post-breakout.
  7. If price breaks the neckline, retracements occur almost 70% of the time.

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: Flags and Pennants

Flags and Pennants

If you’ve ever traded a chart and you’ve seen what looks like a reversal in the trend, but as soon as you enter the trend seems to continue, odds are you were trading against a continuation pattern. Flags and pennants are titles given to patterns that show up as small countertrend moves that ultimately trap participants and then use their momentum to keep the price moving in the direction of the trend. Flags are represented as rectangular channels, and pennants are represented as triangles.

Before a flag or pennant can be identified, we first need a flag pole. A flag pole is any clear trending price action that, well, looks like a pole. See below:

Flags and Pennants
Flags and Pennants

 

The images above show examples of bearish flags and bearish pennants, as well as bullish flags and bullish pennants. If you are unfamiliar with how to trade triangles or rectangles, refer to the articles that discuss the various triangle patterns. But we can review the basics of entering these great continuation patterns.

Bearish Pennant
Bearish Pennant
Bear Flag
Bear Flag
Bullish Pennant
Bullish Pennant
Bull Flag
Bull Flag

 

Learning how to trade flags and pennants is one of the most useful and enjoyable things that you can learn – especially as a new trader. Flags and pennants help train your brain to get used to buying dips during bull runs and shorting rallies during bear moves. If you get to a point where you can profitably trade flags and pennants, then you have transitioned into a trader who is very near outperforming the vast majority of your peers. It may seem like an easy thing to do – but it is an entirely different thing to execute. Analyzing and identifying a flag or pennant is easy; trading it is difficult.

I can not stress enough how profitable these patterns can be – and how easily you can miss them even in plain sight. The problem resides with your brain – that ‘lizard’ part that kicks in when you are are fearful of your account. When you begin to feel the fear of your account losing money, that triggers a powerful part of your brain known as the limbic system. The limbic system controls fear and pleasure. And when your fear sense is triggered, it hyper focuses the synapsis across your brain. Things that you would passively identify like flags and pennants are tertiary in their importance when the limbic system is acting in your defense. You need to find ways to ‘pause’ the process with things like alerts. On the images above, you saw horizontal lines above prior swing highs and below prior swing lows. Placing alerts at those points may be enough to interrupt your primary fear response and allow you to make money on your emotions.

Because if you are feeling it, so is everyone else.

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: Symmetrical Triangles

Symmetrical Triangles

Out of all the triangle patterns, symmetrical triangles are perhaps the most common and the most common and the most subjective. Symmetrical triangles have a standard neutral bias; however, symmetrical triangles most often form after a prior trend, because they most commonly form after a prior move. The preference of their trading direction is determined by the direction from the previous move. If the preceding move was bullish, then the symmetrical triangle is viewed as a bullish continuation pattern. Like all triangle patterns that form after a trending move, they are known as pennants.

The construction of a symmetrical triangle is like any other triangle: it requires to trendlines that intersect: one upward sloping angle and one downwards sloping angle. Price action should touch both the upper and lower trendlines at least twice – but ideally three times. A lack of open space within the triangle is ideal. Breakouts often occur in the final 1/3rd of the triangle. Volume typically falls before the breakout.

I believe that understanding the psychology of how this pattern forms is essential. The symmetrical triangle is the result of a condition that is very common in any traded market: consolidation. It’s not just common; it’s normal. Consolidation is representative of two things: equilibrium on the part of buyers and sellers and indecision by active speculators. The psychology of price action inside a symmetrical triangle is different than what occurs in an ascending or descending triangle, which both have a marked bias during the construction. Symmetrical triangles are the epitome of indecision, and traders can very quickly fall victim to whipsaws.

Symmetrical triangles, while the most common, are also the most confusing. Take the image below:

Symmetrical Triangle

The symmetrical triangle on the daily chart for the AUDJPY is a bearish pennant – a bearish continuation pattern. While any triangle that forms after an established trending move has a high probability of pushing the price in the direction of the trend, it doesn’t always happen that way. As I wrote above, symmetrical patterns are inherently neutral – so it is important to watch them. We can see that this symmetrical triangle did not cause a continuation move south – it reversed. Regardless of the direction of the breakout, some rules should be applied when entering a trade based on a breakout of a symmetrical triangle.

Symmetrical Triangle - Long Entry
Symmetrical Triangle – Long Entry

First, unlike the ascending and descending triangles, we don’t enter on the break. We want to enter when price breaks the prior high (or low). For the chart above, we would enter long above the previous swing high that touched the downtrend line.

Symmetrical Triangle - Short Entry
Symmetrical Triangle – Short Entry

The short entry from a breakout below a symmetrical triangle is the inverse of the bullish entry. On the chart above, the short entry is when price moves below the prior swing low that tagged the uptrend line – not on the initial breakout.

Pullbacks and throwbacks occur 59% of the time. Symmetrical triangles are notorious for many false breakouts, so look for frequent wicks/shadows to pierce the trendlines. Dahlquist and Kirkpatrick wrote that volume that increases on the breakout increases the performance of the pattern, but it is otherwise below average in its performance.

 

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: Descending Triangle

Descending Triangle
Descending Triangle

The descending triangle is another version of the many triangle patterns in technical analysis. It is the opposite of the ascending triangle. This pattern is overwhelmingly bearish and is one of the more common bearish continuation patterns. If you’ve read Dahlquist and Kirkpatrick’s Technical Analysis, you will find that this pattern is treated with some considerable positivity. It was one of the best-performing patterns. But there is a caveat to why this is.

Descending Triangle
Descending Triangle

The two trendlines required for the formation of a descending triangle are a flat, horizontal trendline that acts as support with a downward sloping trendline that acts as resistance. Ideally, price should touch both the upper and lower trendlines twice. Volume typically decreases as price gets closer to the apex. Breakouts occur within the final 1/3rd of the pattern. Dahlquist and Kirkpatrick report that increasing volume is actually more favorable for this pattern. The most common breakout is lower at 64% of the time.

I’ve written in prior articles about the dangers of putting to much stock into technical analysis books where the initial testing of patterns and results have been in traditional equity markets (stock markets). I believe that one of the reasons that Dahlquist and Kirkpatrick have reported such powerful and swift moves with a downward breakout is due to the nature of bear moves in equity markets. Because markets like the stock market are exceedingly long-biased, any dramatic drop below crucial support will have an exceedingly more dramatic move when compared to the forex markets – which are primarily range bound. Another factor that may attribute to the overperformance of this pattern in stock markets vs. forex markets is the ease of shorting in forex vs. the stock market.

Sources:

Kirkpatrick, C. D., & Dahlquist, J. R. (2016). Technical analysis: the complete resource for financial market technicians. Upper Saddle River: Financial Times/Prentice Hall.

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.

Categories
Chart Patterns

Chart Patterns: Pullback and Throwbacks

The most common term people associate with retracements in price that retest prior areas of support or resistance is a pullback. There is another term that goes with pullback, and that is a throwback. Let’s review the differences between these two definitions.

Pullback

Pullback
Pullback

Pullbacks occur after the price has moved lower. Think of any pattern or support line that has price breaking out to the downside. When price pulls back up to the price level of the initial break, that is known as a pullback. Pullbacks occur during breakouts lower.

 

Throwback

Throwback
Throwback

Throwbacks occur after the price has moved higher. Think of any pattern or level of resistance that has price breaking out to the upside. When the price is thrown back down to the first level of the break, that is known as a throwback. Throwbacks occur during breakouts higher.

While there are different definitions for retests of breakout zones, know that people will often call throwbacks, pullbacks. In practice, the description itself does not matter as much as you see the behavior that price exhibits after breaking out of support or resistance. The table below identifies the average occurrence rate for a pullback or throwback from the following patterns.

Pattern

Pullback Rate (%)

Throwback Rate (%)

Ascending Triangle

56

60

Descending Triangle

55

50

Double bottom

—-

56

Inverse Head-And-Shoulder

—-

57

Head-And-Shoulder

59

—-

Symmetrical Triangle

58

58

Triple Bottom

—-

58

Triple Top

63

 

The table above comes from Thomas Bulkowski’s book, ‘Visual Guide to Chart Patterns.’ His book is part of the Bloomberg Financial Series. Bulkowski is, by far, the authority on the frequency of patterns experiencing pullback and throwbacks. His work focuses extensively on chart patterns. However, there is one problem, and it has nothing to do with his phenomenal work. This is a problem for anyone who focuses primarily on the Forex markets. Why? Because Bulkowski’s work and the broader technical analysis writer/education community focuses primarily on equity markets. This is a big deal because equity markets spend the vast majority of their time in one direction: up. This is especially true over the past decade. Again, this is not a dig towards the truly phenomenal authors and analysts who spend years creating their written work – it’s just a reality of the world we are in. It’s important to understand that the Forex markets, as we know them, are still a relatively new market – especially when compared to the stock market.

If you read Bulkowski’s work or any other work studying the frequency of throwbacks and pullbacks from patterns and support/resistance – I would recommend attributing the same rate of throwbacks to pullbacks in the forex market.

 

Sources:

Bulkowski, T. N. (2013). Visual guide to chart patterns. New York, NY: Bloomberg Press.

Bulkowski, T. N. (2008). Encyclopedia of candlestick charts. Hoboken, NJ: J. Wiley & Sons.

Bulkowski, T. N. (2002). Trading classic chart patterns. New York: Wiley.