In today’s episode, you’ll discover how you should not trade chart patterns.
So tune in right now…
Hey, hey, what’s up my friend? In today’s episode, I want to talk about when you should not trade chart patterns. Chart patterns here refer to things like head and shoulders, cup and handle, the ascending triangle, descending triangle, pennant and symmetrical triangle patterns.
1. Don’t attempt to trade every single chart pattern
Because to be honest, I find that some of them are useless. For example, a chart pattern like the diamond chart pattern. First and foremost, I don’t understand what it means in the context of price action trading.
And even if I do know what it means, it’s difficult to define my entry point and my stop loss levels. Again, avoid trading chart patterns that don’t make sense to you or are meaningless. (And I’ll talk more about this later on and which you should focus on instead.)
2. Don’t treat every chart pattern as equal
You can have two identical-looking chart patterns, but the probability of one working out could be higher than the other. Let me give you an example. Let’s say you have a bull flag pattern which forms after the price broke out of multi-year highs, with relatively small range candles on its pullback. This market has strong momentum and it’s in a long-term uptrend.
Now compare this bull flag pattern with another bull flag pattern, formed when the market is in a downtrend. Let me ask you, which bull flag pattern has a higher chance of working out?
Well, it’s a no brainer, the one in an uptrend that broke out to multi-year highs is the bull flag pattern with a much higher probability of continuing to move in its direction. This is what I mean by not every chart pattern is equal.
You got to look at the context of the market. And we’ll talk more about that later on as well.
3. Avoid trading reversal chart patterns that formed too quickly
A reversal chart pattern could be something like the head and shoulders pattern, the inverse head and shoulders pattern. Beware of trading them when the pattern is formed too quickly.
For example, if you take a head and shoulders pattern that took 20 bars to form compared with another head and shoulders pattern that took, let’s say, 100 bars to form, which one of these two patterns is more significant and which of them is likely to lead to a reversal?
In my opinion, the one that took longer to form is more significant because the neckline of the head and shoulders pattern is more significant as more traders will pay attention to the level.
If the neckline breaks, it becomes more of a self-fulfilling prophecy where the breakdown is likely to occur. Of course, other contexts also matter as well. But if all else equal, or I would rather take a reversal chart pattern that took a long time to form because it’s most significant and the next move is likely to be longer as well.
At this point, you might be wondering, “I have learned what not to do when trading chart patterns. Now, how do I trade chart patterns correctly?”
Here are a few tips to share with you.
Solution #1: Filter down the chart patterns that you trade
As mentioned earlier, you don’t want to be trading every single chart pattern, because a lot of them are pretty much useless or difficult to trade. Instead, focus on those chart patterns with horizontal boundaries.
What I mean by this is that the chat better is defined by using a horizontal line or a horizontal area on your chart. This could be something like the ascending triangle pattern, the descending triangle pattern, the head and shoulders pattern with the neckline being horizontal.
These are the type of chart patterns you want to focus on. Because these patterns are much easier to time your entry when the price breaks out of a horizontal area level. When the price breaks out of resistance, it means it’s a breakout, there’s no discretion, there’s no subjectivity over here.
And also when you manage your risk, your stops can just go below the breakout point. It’s easy to manage your risk compared to chart patterns where it involves, let’s say, diagonal lines like the symmetrical triangle. This one is a bit trickier because the way you draw those patterns is subjective.
This means that your entry point and your stop loss might be subjective as well because it depends on how you draw those chart patterns. Given a choice, I very much prefer to focus on trading chart patterns with horizontal boundaries.
I tend to avoid those with diagonal lines and stuff like that because it’s much harder to nail down the entries and exits. That’s the first thing.
Solution #2: Trade in the direction of the trend
If you trade chart patterns, especially trend continuation chart patterns, like the bull flag, you want to trade it in the direction of the trend as this increases the odds of the trade working out.
As I mentioned earlier, as much as possible, trade chart patterns in the direction of the trend. It doesn’t just have to be for trend continuation chart patterns. It can even be trading reversal chart patterns.
If you want to trade, let’s say, an inverse head and shoulders pattern that has formed in an uptrend, that’s fine as well. It’s perfectly fine. If you read the price action of the market and there’s a bullish reversal chart pattern in a long-term uptrend, that’s a good sign.
As much as possible, trade in the direction of the long-term trend.
Solution #3: Give the chart patterns time to form
If you want to trade reversal chart patterns, like the inverse head and shoulders pattern, double bottom, triple bottom, etc., give those chart patterns time to form. The market doesn’t just reverse all the time.
Yes, it does happen from time to time, but more often than not, when the market makes a reversal, it needs time to digest. The uptrend or the trending move will go into consolidation before it breaks down.
If you want to trade reversal chart patterns, my guideline is to give it at least 80 candles to form so that you can see the boundaries on the chart, which will be much more obvious for you to time your entry.
When you want to place a stop loss, it’s also much easier to define it on the chart after the reversal chart patterns have taken some time to form. And finally…
Solution #4: Identify volatility contraction pattern
If you want to trade reversal chart patterns, you also want to identify what I call a volatility contraction pattern. This is a term from Mark Minervini.
You’re looking for a decrease in volatility before you trade the breakout. For example, if you want to trade a head and shoulders pattern and the market is in an uptrend, where it forms a big head and shoulders pattern that took 100 candles to form.
You can imagine if you sell the breakdown of the neckline, the closest stop loss is going to be above the shoulder or the head and it’s going to be pretty wide. What I want to see instead is a volatility contraction pattern at the shoulder area.
I want the volatility contraction pattern to be nice and tight near the shoulder. This way, when I do sell the breakdown of the head and shoulders pattern, my stop loss can just go above the highs of the volatility contraction pattern. Thus my stop loss is tighter.
Basically, what I’m trying to say is, if you want to trade breakout chart patterns, make sure there’s a tight consolidation before the breakout. Because if there’s a tight consolidation before the breakout, you can reference that tight consolidation to set your stop loss below its lows. That’s what I’m trying to say.
Let’s do a quick recap.
- Don’t trade every chart pattern out there because some of them are just meaningless and difficult to trade
- You shouldn’t be looking to treat all chart patterns as equal because the context of the market matters as well
- Avoid trading reversal chart patterns especially the ones that formed too quickly
With that said, I wish you good luck and good trading. I will talk to you soon.