It is often said that chart analysis is both an art and a science.
One component of technical analysis includes the study of patterns, which is simply identifying the formations that markets etch on the charts as they move up and down and back and forth.
One of the premises of technical analysis is that all known fundamental information is priced into the current value of a market at this exact moment of time. The market is comprised of millions of traders—some fundamental, some big institutions with teams of research analysts, and some individual traders just like you and me. It may be too much for one individual trader to stay on top of the myriad of constantly changing fundamental factors that impact the markets.
But, it's easy to look at a chart.
HISTORY AND PATTERNS REPEAT
Within those squiggly lines and up and down movements, technicians over time identified repeating formations and were able to assign specific forecasting values to them. According to traditional technical analysis, pattern development on a price chart can be a useful trading tool. There are many different types of patterns including various top and bottom formations and continuation patterns.
Pattern analysis is universal and wide-reaching. Patterns or formations when they appear on price charts can be utilized and analyzed on any market—from an individual stock to spot forex to commodity charts. Also, these patterns can develop and offer tradable signals across all timeframes from 1-minute charts to monthly charts.
CLEAR ENTRY AND EXIT POINTS
A great benefit to pattern analysis is that the formations offer clear “breakout” or trade entry points, specific measured move targets or objectives and also specific stop-loss or “if you are wrong” levels.
Some say technical analysis can become self-fulfilling prophecies. Maybe true. If a potential double top or double bottom is forming on a price chart in a highly liquid market, it is very likely that many professional and individual traders are eyeing the same price level for a potential breakout. The risk is that sometimes speculative players will probe and test that level looking to trigger stops and action can be volatile and lack-follow-through if such a move occurs.
Traders can instead use a two-or even three-bar close screen to confirm continued follow-through and to avoid short-term whipsaw moves. Another important concept for beginning technical traders to understand and utilize is confirmation.
Pattern analysis works well in conjunction with other technical tools, whether it is moving averages, momentum tools or volume. Most traders hone in on two or three favorite technical indicators that can be used over and over again in conjunction with various patterns that emerge on the charts. Pattern analysis, like most other technical methodologies tends to work best when confirmed by one or two other technical tools.
REVERSAL OR CONTINUATION
Overall, most patterns are either reversal or continuation patterns. Simply put, a reversal pattern signifies the end of a trend while a continuation pattern evolves during a trend and is a “pause” as the market consolidates before resuming its previous path.
DOUBLE BOTTOM: TEXTBOOK EXAMPLE ON KIWI CHART
Head and shoulders patterns and double or triple tops or bottoms are probably two of the most easily recognizable and recurring reversal patterns. Given the limited space here, I’ll focus only on double bottoms. A nearly textbook example is seen on the daily USD/NZD chart from late spring/early summer. See Figure 1.
Double bottom (and other patterns) offer clear entry points, targets and stop loss points. The double bottom on the USD/NZD chart formed with the May 23 and the June 1 daily lows, marked at Point A and B on the chart.
GO LONG ON A RALLY ABOVE "C"
The "confirmation" breakout point that triggers a trade entry on a double bottom pattern is a rally through the intervening high or this case the May 29 daily high marked at Point C.
However, the more conservative approach is to wait for a second consecutive settlement to avoid whipsaw. For the initial stop-loss which can be placed at entry, traders can put their stop just below the “breakout” point.
COMBINE METHODS OF ANALYSIS
In this case waiting for a second session of confirmation would have been wise. The bearish shooting star candle on June 7 reveals a lack of commitment by the bulls and conservative traders would likely not have entered the bullish trade.
As the stop is generally placed just under the break-out point (Point C or .7650). Traders would have been stopped out by whipsaw action on June 8 before the bullish momentum took hold and the kiwi rallied higher.
The upside target or measured move objective is simply calculated by measuring the distance between the top of the pattern and the bottom and then adding that onto the breakout point. In this case the pattern projected to roughly .7840, which the market hit just a few days later.
Generally, these targets can be thought of as minimum objectives and in this case, the trade offered even more on the upside, and is a good example of how and when trailing stops can be utilized to let your profits run.
LISTEN TO THE SONGS
As the old Chinese proverb goes: “A bird does not sing because it has an answer. It sings because it has a song.”
While the bird may just be singing, the market is just moving and creating its patterns. Wise traders listen to the songs of the market, as they may offer clues as to where it's going next.