I love chart patterns. I know that sounds a little cliché, or funny, but I love chart patterns since they help us forge a trading plan in the markets. Knowing what different patterns are in the market not only help us with a plan for when to enter the market, but also assist us in knowing where a possible exit should be. Knowing your risk in a trade upon entry is always crucial (and in my opinion stop is #1 in trading) but also knowing where you may be looking to take profits is equally important.
I thought I would take this opportunity to identify some basic chart patterns for you and this way you have a guide to know what to look for, and what to expect (generally speaking) when you come across one. But also, keep in mind the markets are always changing, from the macro backdrop, to correlations, to cross rate effects which can all alter the outcome of any pattern. These are guidelines, not absolutes. As there are no absolutes in the market.
In the coming weeks we will also be releasing an education segment on the Forex Analytix website which will be a great guide for traders. There will be educational information on chart patterns, candlesticks, macro, Harmonic and Elliot Waves patterns.
In the meantime, here is a simple breakdown of some of the most basic chart patterns I follow. Let’s talk about each one:
Flag patterns are the most basic continuation pattern. Typically, you want to make sure you have a consolidation after a strong move, and that consolidation be less than 50% of the current trend (strong move). One of the characteristics I look for is to make sure the flag does not exceed more than 50% distance of the pole. If it does, you are probably looking more at a channel.
Similar to a flag pattern, the pennant is a continuation pattern that tends to trade back in the direction of the strong and current trend. Usually we have a consolidation that takes the form of a symmetrical triangle. If it is consolidating after a strong run higher/lower, you probably are dealing with a pennant pattern.
A bullish or bearish wedge is usually defined by “consistent highs and higher lows” which would be bullish or “consistent lows with lower highs” which would be bearish. Just because they are bullish or bearish doesn’t mean that they will break in those directions. There just is a higher probability of it.
Also known as a rising or falling wedge, these patterns happen to be my most favorite patterns. They are reversal patterns that usually have a pretty explosive move once the trend line is broken. I usually will target at least a 38.2% retracement of the previous trend following the reversal.
A channel is defined by at least 4 points of contact. Topside and downside. Channels can be rising, falling or just horizontal. Traders like channels because you can have precise entries with tight stops. But keep in mind, channels usually over time evolve to triangles as traders attempt to undercut each other inside the channel while range trading.
A double top or bottom is defined by at least 3 points of contact then a move past the “neckline.” A target can be made as an extension of the distance between the upper and lower points of contact.
Similar to a double top, except you are looking for 5+ points of contact. Targets remains the same, just a range extension. It’s important that you look for a neckline break, because it may just end up being a channel.
Heads and Shoulder’s Patterns:
Probably my least favorite chart pattern, and also the most common and misinterpreted (in my view). First and foremost, a head and shoulder’s pattern is a reversal pattern, not a continuation pattern. In other words, when trending higher, you are looking for a head and shoulder’s pattern. When in a downtrend, you should be looking for an inverted head and shoulders pattern. Traders get that confused a lot, and it is a huge pet peeve of mine. One of my other issues are the risk/reward associated with a Head and Shoulders pattern. The entry is typically below the neckline, and stops are above the right shoulder. Targets are the top of the head to the neckline. If you are lucky, your risk (above the shoulder) and reward (distance from head to neckline) is close to 1:1.5.
Cup and Handle Pattern:
A Cup and Handle pattern is a continuation pattern. Basically it is a drop from resistance which finds a long consolation below and slowly grinds back to resistance. The small reversal (handle) takes on the look of a possible channel, but the reversal past resistance usually is powerful as it trips stops of traders who were short against the resistance level. Targets are usually the bottom of the consolidation to the resistance. Then you take that distance from the bottom of the handle and that will give you the proper target.
Keep in mind that all these chart patterns can be bullish or bearish. Inverse or standard. These are some of the most basic chart patterns that you will see myself (and other Forex Analytix analysts) post about in future posts. Keep in mind they are a guide and a plan. But the markets are tricky, and the landscape can change at anytime. It’s always important to keep your stops in place and risk reasonable for your risk tolerance.