The question, most often asked by traders, is whether chart patterns can predict the future.
From the article, you will learn about technical analysis in trading and about the most common types of chart patterns.
Chart formation, or pattern, it is a certain arrangement of price bars, when the price is expected to move according to a certain pattern. What are the patterns for? They help to identify trading signals, the signs of future price movements. It was noted quite a long time ago that the market prices are moving not randomly, but according to certain patterns. By the way, the charts of air and water temperature and some other ones are also changing according to certain rules. If you can “read” and understand the chart patterns, you can predict the future price movements.
Every trader, even the most devoted fans of fundamental analysis, has come across graphic patterns, an essential element of technical analysis. These patterns are graphic formations that can rather accurately predict the price to move in the suggested direction. These patterns give traders important clues, which should applied to technical analysis before they take their trading decisions.
A common pattern has a potential to change the price chart to a certain trend. Traders identify the patterns to have a look into future. Why charts predict the future? History repeats itself, and so certain price patterns consistently reappear and tend to produce the same outcomes. Therefore, you can forecast not just the weather tomorrow.
Types of patterns
All chart patterns can be roughly divided into three big groups, based on the way the price is moving. There are three major types of patterns
Continuation chart patterns
A trend extension pattern appears when the price is already trending in a certain direction. If you have discovered such pattern, it means that the price is likely to move in the same trend. The most common trend continuation patterns are: wedges, rectangles, and pennants.
Reversal chart patterns
They usually appear when the trend is exhausting. If you have identified a reversal pattern, and the price is trending, the price is likely to reverse after a clear paradigm emerges. A reversal pattern suggests that the current trend is going to end. They include: double and triple bottom, double and triple top, head and shoulders, inverse wedges, rising and falling triangle.
Bilateral chart patterns
They suggest a new momentum, but its direction is likely to be the same. Such models can emerge during trading flat or trading in the trend. How can you use bilateral patterns? This signs are quite important, as you can enter a new trade at the breakout at the right time.
A head and shoulders pattern is marked with arrows in the EURUSD daily chart. The blue arrow points to the left shoulder, the yellow one – to the right shoulder, the red arrow points to the head. The orange arrow marks the drop as long as the neck. Red lines mark the wedge pattern, followed by the price decline.
Chart patterns (hereafter CP) and losses
When using chart patterns, traders, especially beginners, are rather annoyed when the price is moving in the direction, suggested by the pattern. It must be admitted that the patterns suggest relevant information in about 2/3 of cases. In some market situations, CP can be of hardly any use. At some points, they can even be more harmful than useful.
Chart patterns and fundamental analysis
Almost every trader applies two kinds of analysis: technical and fundamental. It is not sensible to ignore the news. However, it is also extremely difficult to make money on the news alone. As soon as a news bit is published it is useless. If graphic analysis sends a signal, and fundamental analysis proves it, it is a perfect moment to enter a trade. If the two kinds of analysis suggest controversial information, you’d better just avoid opening a position.
Total disregard for CP
One should often tell the truth, even if it is not pleasant. And the truth is that there are speculators who don’t look at the charts at all. These traders usually assisted by secretaries. They enter trades after a talk with the secretary. “How much is the dollar now? How much is oil? Is this the price low?”, that is how an “anti-chart” traders speaks to his/her assistant.
There is a morning star pattern in the PepsiCo stock chart. It suggests the price should go up. It has completely worked out on the long-term scope.
Reading CP without any experience
The beginners are said to be lucky. There is some truth. A person, who doesn’t fear, can push a button and get the outcome. Of course, such trading won’t be successful for long. The factor of luck and false CP identifying can completely confuse the trader.
CP and timeframes
The most popular timeframe among advanced traders is one day. But you should also analyze the market situation in the weekly and monthly timeframes. But short time-periods, like five-minute charts, are not important for a position trader. Scalpers and day traders pay attention to the CP in both a few-minute and an hourly timeframes.
Common errors in CP identification
There is a theory, suggesting that there is only one real chart pattern, head and shoulders, the rest of them are its variation. I can’t say it is completely wrong. The classical head and shoulders pattern is rather informative, and works out in about 70% of cases. Inverse head and shoulders pattern is also quite useful. But you shouldn’t see the patterns where they aren’t. You should also distinguish between different markets: forex, commodities and stocks. What is good for trading commodities can be dangerous for trading stocks.
Chart patterns in commodity market
Graphic analysis is the same for all trading instruments. You can learn this from trading courses or even from the books on trading. In fact, the situation is a bit more complex. In the commodity market, for example, in the weekly and monthly charts, you are likely to see a long ascending or descending candlestick. Such trends are rather rare in both stock market and forex. And, when you are identifying chart patterns in the commodity market, you need to understand that this market is different. For example, a strong monthly bullish trend can instantly turn into a monthly bearish trend. It can well be that in the weekly chart, there is strong price rise, then, consolidation, followed by the trend continuation. Isn’t it the same with currency and equity prices? It isn’t. In the commodity markets, there can be very strong and quick trends. So, when you are looking for head and shoulders, triangles, and other patterns, you must always remember about the features of the market, you are analyzing.
There is a wedge pattern in the silver weekly chart. The possible price movement up, after it exits the wedge, is marked with the blue arrow. The red one marks its possible drawdown.
Chart patterns in stock market
The stock market is more direct than forex. You can be confused with the chart patterns there. For example, if a head and shoulders pattern emerges in the strong bullish market, it is hardly of any importance. It is dangerous to go short in this situation. However, such pattern is a kind of warning; don’t bet on the price rise! Why? Because, the market may start moving according to the invented scenario. Actually, it may be driven by traders, who strongly believe in chart patterns.
Chart patterns in Forex
The foreign exchange market has its advantages. It is highly liquid, and brokers provide high leverage. But it is rather difficult to suggest the trend direction. The concept of bullish and bearish market is quite clear for commodities and stock market; and it is not that valid in forex. You trade commodities and stocks for currencies. But, in Forex, you trade currencies for currencies. Therefore, a long, strong currency trend can be here much more seldom than for other assets. Nevertheless, chart patterns are quite informative for forex as well.
Chart patterns and trading discipline
If you entered a trade on the spur of the moment and gained, it doesn’t mean that you should go on in the same way. Chart patterns give you clues and you should be able to use them. You must have a trading plan. You must always follow it. You can give up a trading strategy only if it is clearly losing. You shouldn’t change your trading system every day, because you will certainly lose, doing so.
If you don’t like some patterns, you may not use them. For example, you like triangle pattern when trading stocks in the bullish market. All the other patterns don’t seem interesting to you. So, look for triangles in the stock market and go ahead.
Chart patterns and competitive advantage
Correct identification of a chart pattern can provide you a certain advantage over the market. You also need to have your own trading style. You should decide what instruments you are going to trade. If you just start at random, you will quickly lose everything. The market is always dangerous and unpredictable. To succeed, it is not enough to correctly identify a chart pattern; you also need your own trading system and get a clear advantage. If don’t know what your trading system is based on, you just don’t have any. If so, you will be always losing. Even a very simple trading system is better than no system at all.
Own chart patterns
Some speculators can make up new chart patterns and give names. For example, some traders can use their own patterns, like giraffe, hippo, ladle, icicle and so on. As a rule, such patterns are identified after years of trading. They can be derived from other chart patterns. Some of them may be useful. But it doesn’t mean that you be inventing new patterns all the time.
Who can understand chart patterns?
As a rule, chart patterns are applied by chartists, traders who use charts for technical analysis. In some way, any speculator can learn the basics of graphic analysis. In extremely rare cases, if a trader can’t efficiently work with charts, he/she may try to trade without identifying chart patterns, without even looking at charts. They can try to make money by means of fundamental analysis.
Why haven’t most traders got rich by means of chart patterns?
If a trader has studied theory well, it is not yet a guarantee of success. Correct reading the charts is just a half of business. It is important to select the right trade volume. A speculator can be excellent at theory, identify all the chart patterns but trader a very big lot. Do I need to say that such trader will suffer great losses?
Stop losses, take profits and chart patterns
Chart patterns help to identify the place to put stop losses. If traders work without any stops, they are 100% likely to fail. Chart patterns also mark the place to put take profit. A pattern can quite accurately mark where to put a pending order.
Chart patterns and indicators
If you apply indicators, you can notice that their data do not always correspond to chart patterns and a trading system. You’d better not enter a trade in this case.
Chart patterns and martingale
If you trade the martingale way, the right place to enter a trade will multiply you success chances. Chart patterns will help you open position at the right place. If the market is too volatile, you should avoid the martingale strategy, no matter how profitable the chart patterns may seem.
There is a falling pennant marked on the left, and a triangle – on the right.
Chart pattern and the wish win your money back
Traders may act on their impulses and lose their money. Then, they see some nice chart pattern. At this point, there is a strong temptation to bet a lot and gain back all the money lost. And that will be the beginning of the end, if not the end itself. This approach may do in some cases, but it doesn’t mean that it is right.
Chart patterns: gain more than lose
Whatever the chart pattern is, but you trading system must yield you more profits than losses. You mustn’t try to earn $10, risking $20 or $30. Some speculators may claim that they have discovered some chart patterns that provide profits in 80%-90% of cases. So, they are willing to risk more money, than they try to make. Are their claims really worth trust? The question is still open.
Who can’t understand chart patterns?
If a trader doesn’t understand the basic logic, he/she shouldn’t trade or read the charts. Some, really talented fundamental analysts can trade, based on the news alone. Though, there are very few of such traders.
Chart patterns and analysts’ mistakes
Even real experts don’t know the future. You can read a lot of forecasts that didn’t come true. Experts saw some chart patterns, but they didn’t work. On the whole, there are more correct predictions than wrong ones; but there is some food for thought.
Price spikes and chart patterns
It often happens that a certain CP works out, but the general picture is spoiled by a spike that emerges at worst possible time. You should be prepared for such unexpected events. If the spike triggers your stop loss it is not the reason for panic. Next time, based on probability theory, it will reach your take profit.
Chart Patterns and Expert Advisors
Nowadays, robots are replacing humans in all industries. And trading is no exception. Can expert advisors identify chart patterns? Yes, they can, though not so well as humans. It is like the situation with robot pilot – an aircraft mustn’t be left without a pilot, just like the market mustn’t be left without the trader. You’d better identify chart patterns in different timeframes by yourself, and give your orders to the robot.
Chart patterns and breaks from work
If you are trading all the time, you may burn out. Chart patterns will always emerge, they won’t disappear. It is not the reason to spend all your time trading. Whatever promising the chart patterns may be, you need to have breaks from time to time.
Efficient and inefficient chart patterns
Is there a pattern that really works? If a certain formation is thought to be so, it is not by chance. They are usually tested for a long time and only then described in books. Head and shoulders is thought to be one of the pattern ever been. It is especially productive when the right shoulder is lower than the left one. Triangles work out far less often than Head and shoulders.
Identifying chart patterns in difficult life situations
You’d better avoid trading during life crises. If still have a strong will to trade, you should do it with very little trade volume, as you are quite likely to be wrong in such situations.
Chart patterns and the market escape
In some cases, the market can just leave your behind. Something like this happened to many traders in the gold market in the 2000s, for example. It often occurs in the stock market and other markets as well. A chart pattern may not send a signal on time. In this case, you shouldn’t try to catch the leaving train. There will be more opportunities to enter.
Chart patterns and demo account
You can be trading successfully on a demo account and correctly identify chart patterns; but you may quickly lose your funds on a real account. The matter is that you fear when you are trading real money, so you identify chart patterns under psychological pressure. Large experience is the only thing to protect you from losses in future.
Red arrows point to the triple bottom pattern, and the blue one marks the trend direction
Trading on the contrary and chart patterns
Many traders are successful trading on the contrary. But it is a wrong approach to look for chart patterns and go the opposite way. Contrary-thinking traders take unusual decision but at the right time, rather than just read chart pattern in the opposite way.
Diversification and chart patterns
Speculators like to diversify, and it is sometimes quite reasonable. They find multiple chart patterns and enter a few trades. This approach may be right if you, for example, identify several interesting patterns in the strong bullish market and enter a few trades in the trend. If you open dozens of positions in different directions, you are likely to lose your money.
Identification of chart patterns and optimism
It is always good to be confident in yourself. But you should remember that trading is not a game of chess. There is nothing exact. Have you correctly identified one chart pattern, then one more, and the third one? Have you been trading at your full capacity with a huge lot all the time? Such trading system is rather dangerous.
Chart patterns and position volume
However good you may be at identifying chart patterns, you need to trade the appropriate volume. If you trade too small amounts of money, the trades won’t be of interest to you. Too big lots will result in your soon going bankrupt.
Chart patterns and intuition
Intuition helps traders a lot. But you mustn’t confuse intuitive trades and impulsive ones. Impulsive trading results on bankruptcy.
Why aren’t common chartists the best traders? Chartists are the traders, who take their decisions, based on graphic analysis. It may seem that people, who are good at technical drawing, will be excellent speculators. In fact, it is not so. Speculating is not just arithmetical calculations or geometry. You don’t need to count in trading, it is performed by computers. Speculating is psychology. Therefore, many fans of social sciences, psychology, philosophy, social study, have succeeded in trading. Reading charts is only one of the elements of success, rather than the key to success.
Chart patterns repeat. Why? It is because day is followed by night, and the cold season by the warm one. Traders treat it as a law and try to get use of it.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.