Chart patterns can and will drive you crazy.
Sometimes they form the most beautiful picture that makes you feel like Nostradamus. When you look at a chart pattern you believe with all your heart you know what’s going to happen next.
Then price does exactly the opposite of what you were taught. In the blink of an eye you are ready to give up on technical analysis.
Two days later the same pattern unfolds, you hesitate and like clock-work price moves perfectly in sync with the picture in our trading book.
So how do you win?
What are Chart Patterns?
To give you the best visual image from the start, chart patterns are pictures of price action that show us supply and demand.
The cleanest visual of a chart pattern I can offer you is a candlestick.
One lonely candlestick is a chart pattern that shows a high, low, open and close for a specific period.
Chart patterns are supposed to show you who is winning the battle so you can anticipate the next move in price action. In the first paragraph we alluded to the fact that this doesn’t always unfold cleanly.
You may feel this way as well which means you need to recalibrate how you think about trading in general. You should download the free audio program on peak performance to give yourself a new perspective.
To give you a preview, you should never think in absolutes. Charts or any type of edge represent a probability. When you’re frustrated with the charts or your trading, keep in mind, you are trading an edge, not a guarantee.
Chart Patterns and Technical Analysis
We should be clear from the start, chart patterns are a sub-set of technical analysis. Chart patterns work within the larger framework of indicators and such. It’s important to note that chart patterns should also be viewed in the context of the larger picture. The longer term order flow.
For example this pattern is called a “descending wedge.” The price action is telling us that sellers are pushing price lower and a stalemate has met at the lower horizontal level.
Chart Patterns and Entry Signals
The entry signal, in this case, would be for us to expect price to push through the stalemate with the mounting selling pressure. The entry signal would be to “sell a long” (stock you own) or to “sell short” to enter a new position believing price are going lower.
The problem with taking the pattern at face value is you are removing it from a larger context of order flow (longer term buying or selling pressure). It’s like making a perfect parallel park in front of the wrong building. It’s nice but wrong.
When you learn the various chart patterns and combine them with trends, your odds of intended follow-through increase. This is good trading. Stacking the odds is what experienced traders know that new traders don’t.
Chart Patterns and Risk Management
You may not think of risk in the concept of chart patterns but I can virtually guarantee you are applying it in your trading today. The most common risk management application for patterns would be a stop-loss that triggers at the low of the previous day. A general rule for patterns as well would be the longer the time to create the pattern the longer the significance.
In other words a wedge as shown above that takes 3 weeks to develop, would require a slightly wider stop loss. Yesterday’s low as a stop loss would be a tighter, absolute number.
Again we need to remember to keep the context in our assessment of the chart and the trade.
Our next articles will start to delve into more individual chart patterns and how to interpret them.
Have a great day.