Technical Analysis Series — Article #3: Introduction to Pattern Trading
Background
You may have thought that the chart of an asset you were analyzing was starting to look just like another asset. Could this mean the outcomes would be the same?
Well, they definitely can be. The market is full of patterns and similar structures that traders often use for forecasting future price action. Many of these common patterns, ranging from triangles and rectangles, to wedges and head and shoulders can often determine if a market will continue to rise upon breakout, or drop once the price breaks down.
How Do I Trade These Patterns?
If you come across a pattern that looks similar to one on the infographic, draw some support / resistance trendlines.
The main idea behind trading patterns is just like support and resistances. If you’re trading with the trendlines, you’d buy at support and sell at resistance. If you’re trading against, you’d buy when price action breaks through the resistance, and sell when it breaks through the support. Remember that hindsight makes these look easier than they actually are, and is why I stress the point that multiple tools should be used to confirm your analysis.
Let’s look at a few examples of these patterns:
In BTCUSD on the daily, we see a descending triangle pattern form. Descending triangles are usually a bearish pattern, however you should never sell before price action confirms that it would go down, such as when the support level breaks. In order for you to have traded this, you would have sold when the support line broke.
In BTCUSD on the daily, we see a symmetrical triangle form. Triangles are usually a continuation pattern, so if the previous trend was to the upside, the triangle would break to the upside, however this did not happen here. This is why I emphasize on selling when there’s confirmation, such as when a support or resistance level is breaking. By doing so, you would have sold when the support trendline broke.
In BTCUSD on the 4 hourly, we see a falling wedge form. Wedges are usually a reversal pattern, so this falling wedge would be considered bullish. In order to trade this, you would wait for price action to break above the resistance trendline, and if it does, you buy.
In BTCUSD on the 4 hourly, we see a flag pattern form. Flag’s are usually a continuation pattern, so if there was a bullrun / uptrend before the pattern, it would be bullish. In order to trade this, you would wait for price action to break above the resistance trendline, and if it does, you buy.
Going deeper within the same chart, we see a descending triangle form.
Descending triangles are usually a bearish pattern. In order for you to have traded this, you would have sold when the support line broke.
In the S&P 500 on the monthly, you could look at this pattern in four ways. A flag, a rectangle, a double top, and a double bottom.
Flags are usually a continuation pattern, so if there was a bullrun / uptrend before the pattern, it would be bullish. In order to trade this, you would wait for price action to break above the resistance trendline (you can extend the resistance trendline to see the breakout), and if it does, you buy. Rectangles are similar to flags, however they are less slanted. You would trade this the same way as a flag.
Double tops and double bottoms however are usually reversal patterns. In order to trade the double top, you would tie in another strategy and look for a confirmation on whether or not the price would reverse in the resistance area, and in order to trade the double bottom, you would do the same thing but for a confirmation on whether or not the price would reverse in the support area.
Here, we could use an indicator called the Relative Strength Index (RSI) to know when an asset is oversold and overbought. Near the resistance area, the RSI went into the overbought acting as a sell signal, while near the support area, the RSI went into the oversold area acting as a buy signal.
Tip: Stay away from using just one signal / confirmation, by using more than one you can reduce the chances of being caught in a fakeout.
In BTCUSD on the 4 hourly, you could view this pattern as a triangle, or a pennant. Generally speaking, pennants and triangles act in the same way and can be traded like so. With both being continuation patterns, the pennant would imply that it would be bullish, while the triangle we drew would imply that it’s bearish. In order to not get caught up in this ambiguity, this is why I emphasize on selling when there’s confirmation, such as when a support or resistance level is breaking. By doing so, you would have sold when the support trendline broke, regardless of if the triangle implied it would break downwards, or the pennant implied it would break upwards.
Sounds Easy?
Don’t be fooled. Trading is not as easy as this, and is a discipline that requires extensive learning. The truth is that 90% of traders lose money. However, with proper training and money management, you are able to be in the 10% that do not. Always have a trading plan, use stop-losses to cut your losses and move on, and never trade greedily.
This is the author’s perspective and is meant to be used for educational purposes. This is not financial advice.
Written by Fahim Ahmed, Writer for the Junior Economist
