UNIT B| Analytical Tools

3. Dejá Vù With Patterns

Price patterns are like stories on a chart the same way as the Elliot waves display a narrative on what price action is doing. They tell you where the price is coming from, how long it has been in that condition, and through the price magnitude and the speed, they also evidence the predominant emotional state of the market. They are visual representations of crowd psychology as waves are because in a way they are also made of waves.
But besides their retrospective usefulness, patterns’ most interesting attribute for the trader is that they indicate what are the most possible outcomes, or “endings” of the story they are telling.

When you see a price pattern starting to form on a chart, you know which boundaries the pair can move. In most of the cases a pattern is a sign of a slowdown, or consolidation, at least in that time frame. By recognizing it, the trader can take a step back and evaluate what may happen to the pair under observation. What you don’t know as a trader is whether the currency pair is going to break out of the congestion and continue moving in the same direction, or if the pair is going to turn around and change direction. But this should not be an inconvenient, because specific patterns show likelihood to unfold in a certain way, offering the trader a positive win probability.
Moreover, being the pattern a measurable chart formation, it can also offer the potential size of a move, indicating what the risk/reward ratio of the trade is. We shall cover the issues on probabilities and risk/reward ratios more in detail in Unit C. For now, let's concentrate on the main elements of all price patterns:

• The prevailing trend: this is the “old” trend that the currency pair has been showing prior to entering the consolidation and forming the price pattern.
• The consolidation range: this is the proper pattern as defined by the support and resistance levels constraining the price pattern.
• The breakout point: naturally enough, this is the point at which the currency pair breaks out and leaves the consolidation range.
• The new trend: this is the trend that the currency pair establishes once it is out of the consolidation zone. It can be in the same direction than the prevailing trend or in the opposite direction.

The last element listed above brings us to the two major categories of price patterns: “continuation patterns” and “reversal patterns”.
Continuation patterns, also called “trend following”, tell you that the price is keeping the same direction than the prevailing trend and reversal patterns tell you the opposite: that the price is going to reverse directions and move against the prevailing trend.

Continuation Patterns

• Ascending and Descending Triangles

When traders try to exploit breakouts as a frequent feature of price behavior, they often face the negative effects these events may lead to. The so-called “false” breakouts may happen too often when the trader is not able to envisage the crucial price levels. Triangles are one of the chart patterns which guides traders to identify which support and resistance levels are determinant. Ed Ponsi invites the reader to have a closer look at intraday breakouts:

Let's take a closer look at the case of an ascending triangle. This pattern is usually constrained by a horizontal resistance line toping the relatively equal highs, and an up-sloping support line connecting the lows moving higher with each dip. The ascending trendline predicts a rise in prices as fewer sellers are found at lower levels. Both lines converge forming a triangular pattern, hence the name. The top horizontal line should have at least two contact points with price. Similarly, the up-sloping trendline should be traced using at least two minor swing highs.

Triangles happen to be one of the most common price patterns in Forex and there are traders making bundle of money only trading this formation. Finding an ascending or descending triangle on a chart is quite simple. This also means that if you see such a formation on a chart, other market participants are probably seeing it as well. This is not bad at all, it will even confer more probability to the unfolding of the pattern. Being an easy pattern to identify, it's also easy to confer your findings with other analysts. Make sure you follow our bloggers at FXstreet.com as most of them display chart patterns on a regular basis. If other traders or analysts are not seeing the same pattern as you, it’s probable that the pattern will not unfold as you expect.

The ascending triangle is a bullish pattern in an uptrend for a continuation to move higher but can be considered as a reversal in a downtrend.

Note the dynamic is the same in both types of triangles, ascending and descending, but in the inverted direction.

In a descending triangle, the swing highs are like a ball bouncing on the floor making successive lower highs, and the horizontal level is made of equal lows acting as support. In an article about patterns written by Teresa Appleton and published in the Trader's Journal we can read:

• Symmetrical Triangles

This pattern appears when the exchange rate starts to print lower highs and higher lows representing a price consolidation with progressively diminishing volatility. The two trendlines bounding the formation converge into a triangular shape. The trendlines don’t always have the same length and therefore the symmetrical triangle can sometimes be tricky to identify. In any case, those trendlines should manifest their status as support and resistance lines showing at least two reversal points each one. In other words, the price has to touch the lines at least on two occasions.

Make sure that the reversal points are accentuated - if you have any doubts about what a true reversal is, please revisit the Chapter A04. If the price is hooked to one of the lines or is reverting at one of the lines slowly in a kind of rounded bottom or top, be careful because this may not be the best set-up for a triangle.

The below daily chart of USD/JPY in 2008, is a pretty good example of a symmetrical triangle.

Triangles are usually considered continuation patterns, but do not always play this role. They can sometimes reverse a trend. In any case, triangles are made to be broken. Any true break of a well-formed triangle should be considered a significant technical event and presents a solid potential trading opportunity.

Symmetrical triangles can occur when the price is trending up or trending down and their length of time depends on the time frame. The triangle is called “symmetrical” because the angles of its lines to the horizontal are quite similar, however this is not a prerequisite.

You often hear analysts label this as an ‘indecision’ pattern. The lower highs and higher lows create a completely sideways market suggesting participants are not interested in entering neither long nor short.

In order to find the target zone, follow these simple steps:

• First, measure the distance from the highest reversal point to the lowest reversal point inside the formation, then add this difference to one of the points depending on the direction of the breakout. If the breakout is to the upside, then add the difference to the highest point in the formation, and vice versa in the case of a breakout to the downside. It's not rare to see the apex of the triangle acting as support or resistance after the breakout.
• Second, since the pattern is not reliable to determine in which direction it will unfold, wait for price to breakout and pullback close to the triangle line to enter the position.

• Flags and Pennants

Flags are considered a market pause prior to a continuation move. An impulse move to the upside with a slight downward/sideways pause is called a bullish flag formation. In the context of a downtrend, an impulse move to the downside with a slight upward/sideways pause is called a bearish flag formation. On a chart, both formations appear like a short rectangle (or channel) usually bounded by two parallel support and resistance lines.

Pennants are like a flag made of a triangle. The impulse movement, much like in the case of flags, forms a tight little symmetrical triangle to break and continue the primary direction of the trend. In this pattern, the two lines converge slightly upwards in a downtrend and slightly downwards in an uptrend, but exceptions can obviously be found.

Flags and pennants look similar and in many ways they unfold alike. From a trading tactic perspective, the target zone of this chart pattern is calculated projecting the length of the prevailing price movement before entering the congestion to the breakout point. To get the length of the move, pick the distance from the last valid swing low (in uptrends) or swing high (in downtrends) before the extended move and the pattern. Protective stops can be placed on the outer border of the pattern where the set-up would be no longer valid if price reaches it. If you prefer a more aggressive approach, the stop can be placed inside the formation, but in this case it will be more vulnerable to premature breakouts.

Before attempting to measure their potential price target, make sure there are no other strong support and resistance levels in between which would make the price stop and reverse. Although these formations offer an extraordinary risk to reward ratio, it is always wise to apply your discretion when making use of any charting tools. More often than not the potential price zone is not reached. As always, we suggest that any scenario with risk to reward of less than 1:3 is not worth trading.

Both types of formations are short on duration signaling a big unbalance between buyers and sellers. These formations are very powerful but because of this attribute, they are much easier to recognize retrospectively than in a real market situation.

Usually, flag and pennant trendlines slope upwards in a downtrend and downwards in an uptrend, that is, against the main trend. But as mentioned before, flags and pennants can be horizontal too. They appear most of the time after an explosive and large movement in the exchange rate, or after a steep price trend. In Elliot Wave Theory terms, a flag or pennant could perfectly be a wave 4 after the completion of wave 3. The so called “flag pole” would be wave 3 and the flag itself wave 4. This could be the explanation why they typically move against the trend as wave 4 is a corrective wave.
For identification purposes though, the most important guideline is the rapid price movement forming the flag pole.

Pierre Charlebois tells in his blog what he does to avoid impulsive trading:

• Wedges

James Chen's description should suffice to alert the reader that we are facing a triangular formation which is however not classified as such. As additional identification guidelines we can add that the support and resistance lines shall always have an inclination and not be parallel to the time axis. Remember: if one of the lines is horizontal, then you are seeing a triangle.
In case of a wedge the lines must eventually intersect but note that this pattern's main characteristic is the elongated shape - more than any of the previous mentioned patterns.

Another characteristic is the number of contact points which shall be also higher than two because of the relatively longer lifetime of the formation. Be skeptical if there are only few contact points at the support and resistance lines. Ideally, the wedge has to show a well distributed price action inside its borders. This, by the way, is something you want to check in all formations: too much “white space”, literally space where the price did not go through on the chart, is not a good sign.

Usually prices break out of the wedge at about two-thirds of the length of the formation - from the start to the eventual apex, the apex being the point were both lines meet. They are quite common, not so easy to find, and can occur at any time during the trend. But in most cases expect them to happen at the end of a long trend. James Chen mentions above that there are “other case scenarios” for wedges, and the following edge shall display one of them.

Taking the ending diagonal trading tactics into account will save you from the usual retracements. The chart below illustrates a wedge where price breaks down but finally reverts. The optimal target zone though is the origin of the diagonal pattern.

• Trend Reversals

Though the Forex market is prone to trending, it’s also known for sharp reversals. By now, you should already be very skeptical towards the concept of “trend” and eventually more inclined to adopt a contrarian approach.

Seeing the market as an unfolding of waves has taught you that what comes down will probably go up, and often in a dramatic fashion. This is the case of double bottoms.

• Double Bottom and Double Top

A double bottom is a sharp fall in the exchange rate followed by a rally and another sharp fall to the previous levels, finally concluding with another rally. It looks like a “W” on the chart. The same flip upside down is a double bottom, looking like the letter “M” upon completion. These patterns are easy to identify but quite difficult to trade because of the low risk to reward ratio they sometimes offer.

The following chart clearly illustrates a double top formation. After a prolonged uptrend to all-time highs, the EUR/USD pair formed the first top at around 1.6000. A rapid retracement was quickly followed by a retest of the previous resistance, creating the second top, hence the name. After that, the pair precipitated downward changing the direction of the trend.

Finally, the pattern and change of trend were confirmed after the pair breached the confirmation line level around 1.5300.

The two well-defined peaks (or bottoms) have to be relatively close in terms of price and time, so that the pattern can be classified as such. The double top occurs after an uptrend and indicates a possible reversal or that the uptrend is at least leveling off.
The double bottom occurs after a downtrend, indicating a possible reversal as well.

The target zone for a double bottom, for instance, is the distance from the support level to the confirmation level projected to the upside from the confirmation level. Traditionally, the confirmation level is defined by an intermediate swing high reached between the two bottoms. Until price surpasses the confirmation level, the pattern remains unconfirmed, hence the name “confirmation level”. A close above the confirmation level signals a breakout.

These patterns typically occur after a prolonged trend that takes the market to price extremes, otherwise it can not be considered an optimal condition for a reversal pattern. Make sure this condition is met to avoid surprises with false unfoldings.
A retest of a low level may lack the buying enthusiasm to revert the trend, and instead of continuing upward, the exchange rate can throwback to the support level, break it and resume the prevailing trend.
If prices drift below the support zone (in a double bottom) or above the resistance zone (in a double top), then the pattern is no longer valid. Note we are using here the term “zone” rather than “line”. Please refer to Chapter A04 if you have any doubts distinguishing S&R zones from S&R lines.

• Head and Shoulders

Along with the double tops and bottoms, the head and shoulders are perhaps the most popular chart formations. This is due to their reliability and to the fact they are easy to recognize. The characteristic three-rounded tops with the higher bump in the middle (the “head”) make the formation easy to spot.
The confirmation line has a fancier name: it's called the “neckline”. The neckline can be horizontal or slightly sloping up- or downwards. As for the angle of the neckline we have no statistical evidence that the slope and direction of the line can be a predictor of the severity of the price decline or not. In any case, the angle of this support line has to be small.

The head and shoulders pattern is a great example of resistance levels turning into support and vice versa. The same with its sister pattern, the so-called “inverted” head and shoulders.
The pattern develops with the exchange rate trending up and forming the left shoulder on a reversal - perhaps a rounded top formation. Then the market trends higher to form the head and falls back to the same support of the first shoulder to form the right shoulder. The neckline is thus the line connecting the troughs between the peaks. If it is broken, expect a downside move to occur.

There are variations of the pattern, with identification guidelines different from the classical formation. This reversal pattern can appear in a variety of shapes such as a central head with four shoulders, which instead of being labeled with some monster name is simply called a “complex” head and shoulders.

The target is measured taking the distance from the high of the head to the neckline, and projecting it down from the neckline break. The neckline is often used as a trigger point to sell (or buy, in case of an inverted head and shoulders).
In an inverted head and shoulders bottom, on the other hand, the middle trough (the head) is lower than the other two troughs (the shoulders). The line connecting the peaks in a head and shoulders bottom, is also called the neckline. Breaks of this neckline are considered long trading signals. Targets for the inverted pattern are measured similarly: using the length from the bottom of the head to the neckline, projected up from the neckline break.

Here too, expect to see pullbacks unfolding after the breakout. You can consider them as the confirmation that the support neckline has turned into resistance, or the opposite in the case of the inverted figure.

We do not pretend to hide the fact that trading patterns is sometimes very tricky. The bellow example of a head and shoulder pattern is clearly conflicting with a descending triangle, which is a continuation pattern. Notice how the head and shoulders pattern was invalidated by the small breakout and price reversal inside the formation.

Most people who are interested in trading or the financial markets in general have already heard about the famous chart patterns here introduced. Although this is very basic stuff, it shows how chart patterns can be completely relevant in the Forex markets today.