It is said that the chart pattern is the psychological representation of the market. Many traders successfully use chart patterns to their advantage. Some only play a particular chart pattern and make a good living out of it. But many experience traders can’t see them till after they have formed. I’m not going to talk about all of these chart patterns. If you want to learn about the different chart patterns, go here, The Pattern Site. This guy, Thomas N. Bulkowski, even wrote a book, Encyclopedia of Chart Patterns (Wiley Trading), well a few other books. His website has great info even though it looks a little rough.
The problem with chart patterns is that people don’t look for them. They don’t understand how they form and even why. And therefore they don’t see them until its already too late. Or many don’t bother to look. Which is sad really. Considering the value of chart patterns isn’t just in the perceived outcome, but as they form, they serve as a guide for the perceived market momentum and direction. Ergo…confirmation of what you are reading is true or false. That is valuable.
The Trap
There are probabilities of success fail on all these chart patterns. I’ve already discussed with you why there is failure on the basic chart patterns. If you dwell on these numbers and it is all you’re basing your understanding of chart patterns on these probabilities then, it is of no use to you. Oh look a double top! Oh but the probabilities of it working out in this environment is bad, it wont work out. Its not the pattern. Its the underlying.
The How and WhyThey Form
By now you should already understand the main theme of my message. It is all a matter of accumulation and distribution. The basic chart patterns are the bullish/bearish wedges. The more complex are the double bottom, double top, head and shoulders and inverse head and shoulders. And there are others, which are variations of the basics patterns I’ve already mentioned.
The problem is that people don’t understand how they form and therefore cannot utilize chart patterns to the full extent. Complex chart patterns are a result of accumulation distribution initiated by lower timeframes, against a heavily one sided higher timeframe. The highly bullish higher timeframe, while the distribution is already working in the lower timeframe, this will causes complex distribution patterns to form (double tops, head and shoulders, ect.). The distribution must be sustained or substantial to offset the bullishness of the higher timeframe.
While the highly bearish higher timeframes causes complex accumulation patterns to form (double bottoms, inverse head and shoulders, ect.), as the lower timeframe starts its accumulation. The lower timeframe accumulation must be sustained or forceful to offset the bearishness of the higher timeframe.
On both instances, what do you use to see if the efforts of the lower timeframe is working? Look for you higher timeframe MACD to converge. Review all of my previous charts and you’ll see what I mean.
What is it about lower timeframes vs. higher timeframes? Buckets. The higher the timeframe, the bigger the bucket. The higher the timeframe, the larger the volume it represents. The larger the volume, the truer the trend it represents. Timeframes is sampling. Gives you near term, intermediate term and longer term views of the market. In order to bring the price down/up significantly, you must see the accumulation/distribution from the lower timeframes affect the higher timeframes. So if the higher timeframes are bullish, you should understand why the head and shoulders form, the peaks are being formed because the bullishness of the higher timeframe impose their strength.
Text Book Chart Patterns
Sometimes, in fact most of the time, the chart pattern before you wont be text book. There are variations of these chart patterns. It isn’t the exact shape that is really important. It is the underlying. The process of accumulation and distribution. Remember also, that each timeframe has an agenda. Lower timeframes work to hit their levels of significant. Accumulation moves toward lost support and previous highs. Distribution moves toward previous support and previous lows. This happens in all timeframes and so a higher timeframe usually has a higher price level in mind while the lower timeframe is incremental to that goal (higher timeframe goal). Deformations are normal and the uglier the chart pattern the better. Those who have no imagination or are anal about exacting chart patterns fund your winnings. This is why those who can visualize well, make better traders.
If you haven’t understood yet, don’t have tunnel vision. Tunnel vision can be deadly. You may have a head and shoulders in lower timeframes and only have a 2 bar reversal in a higher timeframe. Your huge 5min head and shoulders may only be a inverse cup and handle in a 120min chart. If you see a chart pattern, figure out how the higher timeframes will help or fail that chart pattern. It will help you on managing your risk. It will help you anticipate the formation of the chart pattern before it is even recognizable.
Setting Stops On Complex Chart Patterns
Ideally, you should your stop based on a higher timeframe. Primarily because, it has a higher level of significance will be easier to assess from there than if you are gauging from a lower timeframe event. This will prevent you from losing your stop money. You may be playing a lower peak only to have it retest the previous high off another peak. My general rule, set your stop based on the higher peak for distribution, lower bottom based on accumulation.
No Shortcuts
If you’re too lazy to put in the work to figure out how to play these charts patterns and understand how they form and why they form, then you’re not going to be able to use a very significant tool in your arsenal. To use it you must practice. It can be argued that they are not necessary. Semantics. A tool is a tool. Why labor for something when a tool can make your life easier. The only shortcut you have is for you to visit Bulkowski’s site and get familiar with the chart patterns. Invest time on each chart pattern so you can recognize them and know the in’s and out’s of each. Another good site to visit AskBucky. This is the guy who taught me about chart patterns and trendlines. Comb through each of his charts. It only took 4 of his charts for all the stuff I’ve ever read about chart patterns and trendlines to click in. Visit him here too.
Thank you friend.