UNIT B| Analytical Tools

4. Finding the Bonus Edge

Through this brief section we shall introduce you to some more particularities of the pattern identification process on which you can base your personal trading approach. Finding a true edge in trading is often - as in life - a question of seeing the reality differently than the majority. This section is by no means a deep research work, but it will provide you with ideas that you can further develop on your own.

Fractal Patterns and Intra-pattern Trades

One of the interesting aspects in detecting chart patterns is that the form and proportions are the most important aspects despite the size and time frame of occurrence. This is probably what enables a pattern to emerge inside another bigger pattern on a higher degree, the same way as fractals emerge.

Here’s an example on the USD/JPY for a fractal observation. See how the head and shoulders pattern that emerges in the right shoulder of the bigger pattern is anticipating the same breakout.

This phenomenon is a good evidence of the market emotional state and illustrates how a sentiment is gaining ground across all time frames becoming the true dominant feeling. Sometimes, like in the above example, the patterns become even smaller but sometimes the opposite can occur: the pattern may expand in size.

This occurrence can be considered as an additional bonus edge as each micro pattern is confirming the higher macro pattern providing great trading opportunities.

Pierre Charlebois, an expert in finding such occurrences, writes in his blog:

Another example is illustrated by the below AUD/USD wedge pattern:

Triangles Inside Channels

If a triangle is wide and long enough and its ascending (or descending) border line is clearly made of at least two contact reversals, a new parallel line to the horizontal can be traced on the chart to build an imaginary channel. The trade set-up consists in a triangle breakout at the top (or bottom) of an imaginary channel. To get the channel from its beginning, the points you need are contact point 1 and 2 at first. Then you draw a parallel line into point 3, and the channel emerges! This is a very common event across all time frames.

Price and Time

Like for waves, price patterns can be found in any time interval as you already know. The time frame that a pattern is found in should also be the time frame you use to open and manage the position.

Another notable edge when trading chart pattern breakouts is the time of day. Many studies on chart patterns include the volume variable in their trading tactics. This is because most of these studies are focused on the stock market since chart patterns can used in every market.

These studies consider a breakout significant if it occurs on high volume, and less significant if it occurs on low volume. But in the Forex, especially in the spot market, traders don't have such volume figures on a global scale.
In order to solve this handicap, let's recall one of the main characteristics of the spot market as described in Chapter A01: it says that market activity is not equally liquid at all times of the day, and therefore we can anticipate that certain times generate more volume than others. This can used as an edge to the trader's advantage.

Ed Ponsi’s presentation quoted below helps to gain a better understanding of the market and of its optimal trading times:

Beyond the intraday tactics, like the session of the day which produces the best trades, the trader may also find interest in seasonality. Seasonality can be considered a behavior pattern that occurs at given times within a calendar year. Finding out if a particular pair shows more action in certain days of the week or certain months of the year can serve as an edge for the mid/long-term trader.

Patterns Failures

A failure when trading a chart formation should not be considered as a deficiency of the analysis, but as an eventual edge over the other market participants.

First of all we need to be sure that a certain pattern we want to trade is really a recognizable pattern. Only then we can speak of the possibility of failure in terms of unexpected unfoldings, like false breakouts or the price not reaching the target zone.

For every pattern there are guidelines as to its formation and conclusion, so that you can have at least a standardized guide to help you avoid making wrong decisions derived from false chart formations. The following aspects should help you discard when a pattern is not a pattern:

• To start with, the trader has to examine the definition of a trend and be sure of the market direction. This might sound too simplistic, but sometimes we see reversal patterns when there is in fact no trend to be reversed. The technical definition of a trend is basically: an uptrend occurs when several subsequent highs have printed higher prices while several subsequent lows have also printed higher prices. The inverse scenario is a downtrend: when several subsequent highs have printed lower prices while several subsequent lows have also printed lower prices.
• In the second place of a pattern “checklist” would come the confirmation process. Some patterns have a confirmation level to help the trader in the analysis and the trading set-up. For instance, head and shoulders have a neckline, double tops have the confirmation line, etc.
• Make also sure that other requirements are met such as the angles of the sloping lines in triangles, and more importantly, their direction.
• Another aspect that you want to train your eye at is to check if the chart pattern shows weak price action within its boundaries. Usually, any chart formation must show well-defined peaks and valleys and clear reversals at their support and resistance lines.

If you want to be safe in identifying patterns, the formation should satisfy the previous requirements. Following these simple rules will protect you from accepting anything as a viable pattern. This brings us to the next point: not all recognized patterns are good trade set-ups. But unfortunately, text book guidelines alone are often not the real crux of the matter. The trader has to know the big picture.

Many market movements can resemble a double top or double bottom formation. Pay close attention to these formations by checking the pattern development and confirmations thoroughly. Just because the exchange rate tests the same high or low on two separate occasions does not automatically constitute a viable trading set-up.

For instance, a double top can develop itself into a triple top formation which is also a potential reversal pattern. A triple top may test the resistance line two times and then cross down the confirmation line and rally back to the resistance to test this area one more time.
The confirmation line breakout is obviously a fake signal and many traders jump short into the position too early just to be stopped out with the subsequent rally. In order to avoid such situation, the trader has to assess the strength of the reversal level, in this case the resistance zone. Only if this area turns out to be a strong level of supply, then the pattern can be taken as a trade opportunity.

Although chart patterns are excellent starting points to develop a personal trading method and useful visual tools, we prefer to insist in what happens behind the scenes. Only that way, we believe, you will gain the endurance of a true discretionary trader. The following quote from Bill Young is an eye-opening description of price action.

The USD Index

The USD index (USDX) can be considered an important analytical tool for traders in just about any market. This USDX is actually a futures contract tradable like any currency futures contracts. It can be also traded using ETFs that track the USDX itself. However, rather than trading the index itself, retail traders can use it as a way to analyze the relative strength or weakness of the US Dollar in general.

The USDX is a geometric mean weighted index which tracks the USD versus a basket of other world currencies on a weighted average basis. The currencies included are: the Euro, the Japanese Yen, the Canadian Dollar, the Pound Sterling, the Swedish Krona and the Swiss Franc. Each of these currencies is given a weight within the index. Because not every country has the same size, it’s only fair that each country is given appropriate weights when calculating the USDX. These are the current weights:

The base of the index was set to 100 at its start in 1973, and its price movements are relative to this base. This means that a value of 80, as you can see in the chart below, would suggest that the USD experienced a 20% decrease in value over the time period comprising its existence.

The USDX can be part of that big picture telling you what is happening to the currencies of the world based on its price action. Its charts provide you with the clues as to where crucial supply and demand levels are, that is, where buyers and sellers are waiting to act in the future based on their actions in the past. This is fundamental information which helps you understand what is going on in the FX arena.

If you want an additional edge, always include the USDX in your analysis and watch for clues as to the sentiment of the currency traders the same way you do with any other currency chart.

Here's something interesting: since the half weight of the USDX is given to the Euro, when the Euro falls in value, the USDX moves up. The USDX will often look like an inverse of the EUR/USD spot Forex pair, or a USD/EUR futures contract.

These are the steps Pierre Charlebois follows when assessing the USDX:

Round numbers

If humans would have two shoulders on the left side and only one on the right side, you can bet the classical pattern would be the double-shoulder and not the head and shoulders as we know it.
Can we say the same of round numbers? Is it because humans are born with ten fingers and ten toes that we are so obsessed by round numbers?

Yet the truth is that market participants show a tendency to place buy and sell orders on numbers ending in zero. Because of this inclination, certain price levels may, at times, evidently produce considerable resistance or support without any reference to a previous significant price action at the same level.

Prices ending in “0”, “00”, or “50” became effective support and resistance levels, especially if that level represents an historical high or low and no past levels can be used as reference. But it is also frequent to witness the round number reaction if a certain round number has not been visited for a relatively long time.

The price action that takes place at round numbers reflects the vast quantity of orders congregated at that level. Why a trader expecting the EUR/USD to reach 1,5500 will buy the pair when it crosses 1,5450 and not 1,5445? This proves that support and resistance levels contain a psychological element as well. They are not arbitrary levels on the chart - they exist first in the traders’ minds, and second in the real market through the congregation of orders around these levels.

When tracking the waves and the exchange rate oscillation, make sure you take a closer look at price reacting to the round numbers.

While we can not give you the experience needed to make money in the Forex using chart patterns, we can give you the tools and say: “observe and practice, observe and practice.” This is the foundation when developing a personal trading style to operate with in any market.
Chartist price patterns will improve your ability to identify crucial support and resistance levels, and these will, in turn, allow you to maximize your risk to reward ratio. You will look to a chart and have that feeling of already having been there, a kind of Déjà Vu feeling...