Trading Chart Patterns

Chart Pattern Trading

A lot can be said about chart patterns, some good, some bad. My father once told me that “every ship on the bottom of the ocean had a chart on it!”. What my dad failed to realize was that ships rarely sink. Most of the time they make their destination. However, he was correct in the fact that the ones that have gone down were quite often not reading the chart properly. The point being is that if you want to use chart pattern trading successfully, you better be sure to separate the chaff from the wheat (commodity pun intended).
Chart pattern recognition can be a very valuable tool in a technical analyst inventory. But it is subjective, not science, rather art. I find it very easy to see something there that isn’t, because it supports my market beliefs. To be employ chart pattern trading successfully, it is imperative that one be meticulous in their analysis. There are components other than price that must be considered.

chart pattern trading of a head and sholder pattern

Simple Head and Sholders

Price chart trading are inherently tied to the overall emotion of the market. This is something that is almost universally overlooked. The key basic input that most traders ignore in chart pattern trading is volume and (when available) open interest. I have said many times before that market emotion is conveyed in volume as it represents the urgency in which market players feel the need to react. Consider when someone asks “why the market went down?” the flippant response is almost always “there were more buyers than sellers”. While this may seem true, it is a condition that is actually impossible. That’s because for every buyer there has to be a seller. The response to the question should be “the sellers were more motivated than the buyers”. Market volume quantifies the overall market mood.

chart pattern trading

The Rising Wedge

Think about a simple consolidation pattern, like the flag or pennant. The market has pushed up (or down) very quickly. At a certain moment in time the trade becomes exhausted. Players need a break. What this means is that price simply needs time to overcome the overbought or sold condition. Consequently, if this in fact the case, volume should drop as price catches its breath. If volume does not drop, but expands, it is a very serious sign that it is not a continuation pattern.
To successfully use chart pattern trading, it is imperative to be non-judgmental. Look at the data, especially volume and open interest, and correlate it with market emotion.
I have successfully spent many years charting the markets. However, it is a holistic approach. Make sure you know how the market feels before you make judgments.


Flag and Pennant Formations

Chart Pattern Trading

Continuation formations are patterns that regularly occur in the middle of price moves. Probably the most common chart pattern trading examples are the flag and the pennant. Both are accompanied by falling volume and simply reflect traders taking a break from the recent trend. They are useful in that their setups and breakouts offer good short-term, low risk trading opportunities. They also act as excellent measuring tools as they can accurately project price objectives. “The flag flies at half mast” was one of the first adages I recall learning from an old time chartist. What that means is that a flag or pennant will form at the mid-point of a price move. The chart below shows a small pennant formation in July 2013 Natural Gas.

chart pattern flang and pennant formation

Daily July 2013 Natural Gas

Note to Self – “Rain Makes Grain”

One of my first trades was during my summer break from college of my freshman year. The corn market had been in a serious downtrend into July as crop conditions continued to improve through out the summer. Some heavy rains over the weekend had done some minor damage in Iowa and Southern Illinois, which put a bid in the corn pit Monday morning. Being young and naive I sensed a bottom in the corn market and went long, expecting the damage to significantly affect the crop. The market traded in a narrowing range for the rest of the week and I was successful at buying the breaks to price support, and building my position. Over the weekend I bragged to my friends how well I had traded and the riches I was sure to accrue the following week. Well, Monday morning the market gapped lower and broke hard. I held on to my position not willing to admit I was wrong and take the big loss. The market trended lower most of the week and I continued to hope that the corn market would come back, but to no avail.
Thursday night after finishing up with back office work I walked to my car in an absolute downpour. I knew with the rain that corn would again be sharply lower the next morning. As I crossed La Salle Street a panhandler approached and asked me for a buck. I turned to him and said “Buddy, are you kidding me, I’m long corn!” The look on his face was priceless and I still wonder today what he thought I meant.
Needless to say I blew out of my long corn position the next morning with a hefty loss. It was at that point I realized I needed to get a better handle on how the markets worked. Not long after I bought a book on technical analysis and began charting the markets. One of the first patterns the book talked about was the flag and pennant formation. It only took me an instant to realize that the narrowing range during which I built my long corn position was probably the most perfect flag formation you could ever imagine. It was at that point that my life long fascination with technical analysis began.

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