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CHART PATTERNS

Forex traders use chart patterns to indicate a trend defined entry and stop levels in a trade. They provide entries, stops and profit targets in a pattern that is easily seen during trading. Chart patterns is a graphical presentation of price movement using a series of trend lines or curves. 

Chart Patterns work by representing the markets supply and demand. However chart pattern movement  is not guaranteed and should be used with other techniques of market analysis.

 

Technical Charting Patterns

Price action moves through phases and no movement in the market is ever random. The following patterns are the most frequently spotted on the charts, we will be going through how to interpret them and combine their specified rules alongside other aspect of technical analysis.

The Head and Shoulders Pattern:

This standard head and shoulder pattern that is displayed on the previous page is a price action signal indication that a currency pair is set to fall upon pattern completion and is usually formed at the peak of an upward trend. There is also a second version which is known as the head and shoulders bottom or inverse head and shoulders. The inverse head and shoulders pattern is simply the opposite and signals that a currency pair is set to rise and usually forms at the base of a down trend. In either case, the head and shoulders indicates an upcoming reversal, ultimately meaning the currency pair is likely to move against the prevailing trend.

The Neckline:

Both of the head and shoulder patterns have a similar construction in that there are four main aspects which construct the head and shoulder pattern: two shoulders, a head and a neckline. The pattern is a confirmed trade setup upon the break of the neckline/trend-line (a level of support/ resistance), after the formation of the second shoulder. For example; An upward trend is seen as a period of successive rising peaks and dips (retracements) whilst the downward trend is seen as a period of successive falling peaks and pullbacks. The head and shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and re- tracements.

Head and shoulders top:

  • This pattern has four main sequential steps for it to complete itself and signal the reversal.

  • The formation of the left shoulder is formed when the currency pair reaches a new high and then retraces slightly to a new low.

  • The formation of the head occurs when the currency pair reaches a higher high then falls back near the low that was formed as part of the left shoulder.

  • The formation of the right shoulder is formed with a high that is slightly lower than the high formed in the head but is again followed by a fall back to the lows of the left shoulder.

  • The price then breaks the neckline/ trend-line. In other words, price falls below support going on to break the level of the three lows created by the previous head and left shoulder.

Head and shoulders bottom (Inverse head and shoulders}:

The inverse head-and-shoulders pattern is the exact opposite of the head- and-shoulders top, because it indicates that the currency paid is set to make a move upwards.

  • The format ion of the left shoulder occurs when the price initially falls to a new low and then subsequently rallies to a new high.

  • The formation of the head occurs when the price moves to a low that is below the left shoulders low, followed a return to the previous high. This move back to the previous high creates the neckline for this chart pattern.

  • The formation of the right shoulder is typically a sell off that is less severe than the one from the previous head. This is followed by a return upwards to the neckline.

  • The currency pair then breaks above the neckline/ trend-line. The pattern is then completed when the price moves above the neckline created by the previous head and shoulder.

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After the fourth step (when the neckline is broken), the currency pair should be heading in a new direction. It is at this point when most traders fol- lowing the pattern would enter into a position.

The head and shoulders chart pattern is formulated by three characteristics and can be spotted on the majority of timeframes, however the setup and execution performs best on the Daily and H4.

How to spot a Head and Shoulders formation:

Left shoulder:The prevailing trend must be that of a bullish one, with the price anticipating its next move around a key level of resistance. Price action may often form a bearish candlestick formation, acting as a catalyst for a deep pullback.

Head: The following wave will continue to rise forming a new high before forming another bearish reversal, leading the new price slightly lower once again. This peak is the highest point in the pattern.

Right shoulder: Finally the price will rise again, but this time it will not exceed the previous high, thus forming a lower high from the head.

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Once Head and Shoulders Plays Out:

Once we have correctly established the head and shoulders pattern a 'neckline' is drawn by the connection of the lowest points of the two troughs. It is now possible to anticipate a break to the downside.

Take a look at the example on the following page:

The right shoulder is also known as a lower high, once this is formed and breaks the neckline the price declines. This break and the area of close vicinity below are great selling execution points. If you decide to execute a sell position and take a short trade, an ideal position to place your stop loss would be above the right shoulder.

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We can calculate a target level by measuring the distance between the highest point of the head and the neckline. This distance is duplicated onto the breakout point, thus giving you your target level as displayed on the above chart.

Inverse Head and Shoulders:

The previous pattern may also be applied in bearish market conditions in a reverse aspect. The exact rules apply however it is simply the other way around. Once the neckline is broken, you will be expecting the market to provide you with a long set up, otherwise known as bullish.

Once you have chosen to execute a long trade you should place your stop loss around the right shoulder. Just as the target level was calculated on the head and shoulders pattern, you would now measure the distance between the valley of the head to the neckline and duplicate it into the breakout point.

Here is a clear example of an inverse head and shoulders formation.

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The Double Top and Bottom:

One of the most common chart patterns in trading is the double top/bottom. This pattern appears so frequently on the charts that it alone could easily serve as evidence that price action is not as wildly random as many claim. As mentioned previously, one way to look at price charts is that they are simply an expression of the overall sum of traders sentiment/bias. The double top/bottom in particular represent a re-testing of temporary lows and highs also known as support and resistance.

The double top:

Double tops are usually found during an uptrend in prices where a new high is formed, followed by a pullback and a retest of that high. The retest of the initial high fails to surpass the price level established by the first peak, therefore price bounces/rejects the resistance level, often appearing on the charts in the shape of an 'M'. The second peak does not have to stop exactly at the price reached from the first peak but should be relatively close. This pattern is usually indicative of a trend that is weakening where buying interest is decreasing as shown below.

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After a confirmed signal to take a short trade from the double top formation, the neckline acts as a firm target.  Always be aware of the bigger pictures directional bias presented by the overall timeframes.

A double top indicates a key selling opportunity by showing us clear barriers in price, which has trouble breaking. The market will rise to a strong key level of resistance twice, with the second time forming a clear bearish candlestick formation bringing with it a chance of reversal to the downside.

After the initial rejection from the resistance key level the price will tend to fall and create a base known as the ''Neckline'. The price will then have a second attempt at testing the same level of resistance, which is the highlighted n strip in the image below. Often, the price is seen to spike above the resistance, creating a new high if the prevailing trend is bullish. Double tops frequently provide the highest chance of reversal at weekly and monthly levels of resistance on the Daily or H4.

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The Double bottom:

A double bottom is simply the opposite of a double top. This pattern most often occurs during a downtrend and is a signal of a reversal of the downtrend into an uptrend. This pattern is easily recognizable after the fact by its resemblance to the letter 'W'. The initial downward move will find a support at the first bottom and then the price action will rally off the support to a temporary new high (the middle of the 'W'). Another selloff will take place that will reach the same support level of the first bottom, and consequently cause another rally upwards. Lastly, the trend is confirmed when the price breaks through the upper resistance to complete the pattern and reversal as displayed below.

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These are the most basic pattern structures of double tops and bottoms that can be found on the charts. As you can see, the key levels of support and resistance are absolutely vital when it comes down to pattern structures and clean chart price action setups. We will now go into some more advanced price action setups surrounding double tops and bottoms.

This second rejection confirms the double bottom formation; ideal for a buying opportunity or even an exit if you have been holding a short trade over a considerable period of time.

Double top and double bottom variations:

There are a multiple variations of the double top and bottom which can be found in the market. The double top/bottom can be seen as trend reversal patterns as well as corrective moves in line with the current trend as displayed below.

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Traditional double tops/ bottoms: have a greater potential to break out to the upside/downside; have a greater potential to break out to the upside/downside.

Corrective Double tops/ bottoms: have more of a potential to continue in line with the current trend especially if they are on a 50% or 61.8% FIB retracement level (more on that later).

Overbalanced double tops/ bottoms: This is where the correction prior to the double top/ bottom is greater than the preceding correction and has more of a potential to reverse back down/ up. They could even spike above/ below the resistance/ support level to give a false breakout before the reversal takes place.

Running double tops/ bottoms: These formations will eventually reach a new high/ low if there is a reversal off the level back inline with the current trend, especially if the support/ resistance level ties in wit h a 50% or 61.8 FIB retracement level.

Double top and double bottom breakout patterns (rectangles and wedges):

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The double bottom reversal and breakout trade:

Usually if the market has reversed at a double bottom you will get an opportunity to enter long on the 1st correction and by that time the continuation/ move upwards would have some credence to be believable. The easiest thing you can do is sell double bottom breakouts as they have a huge following amongst savvy traders as they are places where many establishment investors get forced into the wall, at least temporarily.

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Pennants and Triangles:

In the world of forex, the pennant is a pattern which takes shape by the consolidation and build up of price before a breakout/ continuation of the prevailing market direction/trend. Pennants are continuation patterns that resem- ble its 'cousin', the triangle pattern and are both constructed of lower highs bound by downtrend sloping resistance trend-line and higher lows bound by a rising uptrend line as displayed in the example below.

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A pennant has to be preceded by a strong steep up move or down move that resembles a flagpole. No flagpole, then it's a triangle and not a pennant.

Pennants are continuation patterns that usually breakout in the direction of the previous trend that started.

The two trend-lines that construct the pennant converge at a point is known as the 'apex'. At first glance, that sounds like the exact description of a triangle. However, there are additional features that differentiate the forex pennant from the forex triangle. We go into more depth on the following pages.

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Pennants are a form of consolidation:

Pennants usually form after there has been a fundamental announcement and/or a large breakout. They can also form right before a fundamental announcement, as they are considered a form of consolidation. Pennants can also form when prices have reached the value that traders are willing to pay, not more, not less.

When traders spot a pennant, which is a form of consolidation, they most often anticipate a breakout:

A breakout is when prices break out of a sideways pattern or pennant/ accumulation and break through either lines of support or lines of resistance. For a high probability pennant/flag or triangle breakout, be sure to trade in the direction of the prevailing trend. If the bulls take control of the market, they will break out to the north and establish new highs. If the bears take control of the market, they will break out to the south and establish new lows.

There are different shaped pennants that appear on a range of time frames:

  • Flag pole pennants

  • Ascending triangle pennants

  • Descending triangle pennants

  • Diamond pennants

Rules for trading the pennants in the buy and sell zones:

  • Find and draw all trend-lines; inner, outer and long term as this will help you to determine if the market is in an uptrend, downtrend or if a trend-line has been broken signifying the potential end of a trend and reversal.

  • Draw your pennant trend-lines and determine what type of pennant you have.

  • Establish the buy and sell zones whilst becoming aware of the backside of the trend-line (potential resistance or support after the pennant breakout).

  • Whether it be diamond pennants, ascending pennants, descending pennants or flag pole pennants, the stop loss placement is the same for every one.

  • Diamond and flagpole pennants can breakout either side regardless of the previous trend.

  • Ascending pennants have a higher probability to breakout to the north whereas descending pennants have a higher probability to breakout to the south.

  • You will need to wait for the confirmation of a full bodied bullish/ bearish candle to form outside of the pennant. Your stop loss will need to be placed 10/ 15 PI Ps above/ below the last high.

  • If you cannot afford the stop loss, pass on the trade. Remember that the pennant pattern is nothing more than a form of consolidation. They often form before fundamental announcements.

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