Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
Structures have a memory
Pattern recognition plays an important role in trading. Traders look for unique patterns on charts in order to find good opportunities.
Often the biggest problem is, that you can draw an endless number of patterns on a chart. You will get an information overload. Maybe this would be nice as a piece of art, but it’s NOT really useful as trading tool.
First determine what kind of patterns you’d like to trade. The majority of chart patterns fall into two categories:
Reversal patterns indicate a change of trend and can be broken down into top and bottom patterns;
Continuation patterns indicate a pause in trend and indicate that the previous direction will resume after a period of time.
Chart patterns are a big part of our strategy, as they help to identify the end of a pullback (continuation) or the end of a trend (reversal). A lot of traders look at these patterns, recognize them, and trade based off of them. The self-fulfilling quality of patterns on charts is why they work.
Although price pattens are very reliable, price can do whatever it wants. It doesn’t need to obey what the pattern says. Patterns can develop in to larger structures that can still play out, but have taken you out in the mean time. It is all a 'game' of probability. But when combining many factors into a single strategy, basically building a "case of evidence" for our trade, chart patterns play a big role.
In this lesson I will break down the most common reversal and continuation patterns and what they indicate.
The Double Top is a bearish reversal pattern. As its name implies, the pattern is made up of two consecutive tops that are roughly the same in size, with a small trough in between.
As is shown in the image above, the double top formation is confirmed when price breaks below the neckline after the second top. This neckline was previous support, and is now reversed to become possible resistance. After the neckline is broken we now have a confirmation that the trend has changed. Before price made the double top, price stagnated to create two equal highs. From there we printed a lower low (neckline break) and a lower high. You see we went from: 'higher-high and higher low' to 'lower-high and 'lower-low'.
Confirmation of the double top comes from price breaking the neckline. Wait for a a convincing break below the neckline, preferably confirmed by a rise in momentum (impulse). If we were to trade this pattern we would not trade the break-out, but wait for support to turn into resistance. In this example, price breaks the neckline (support) to the downside, preferably with momentum and pulls back with less momentum to retest the neckline (which now acts as resistance) before falling again.
In a bull market this would look something like this:
Price breaks support to the upside and comes back to retest broken support. With the retest we have a saver entry opportunity. As with all aspects of trading, price doesn’t always tests support or resistance after breaking. It could just continue to go up or down without a decent pull back. If this is the case, we do not enter the trade.
Our plan is very strict. Either price does what our plan dictates, and we enter a trade, or price does not do what our plan dictates and we stay out the market. Watching a trade doing exactly what we anticipated, but never met our entry criteria is hard in the beginning, but you mustn't let it affect your emotional state. You will have this job for the next 20-30-40-50-60 years. There will be countless other opportunities that do meet our entry criteria.
Next to the Double Top, there are also Triple Top (and Triple Bottom) patterns. These are basically the same, but as its name implies, it has 3 tops instead of 2:
Triple tops are a reliable pattern to trade from, if the right amount of evidence is present at the time price comes up to test the recent highs for the third time. But be ware, since price failed to make a lower high and lower low after the double top, it signals that the bears were unable to reverse the direction of the market. This indicates weakness. Possibly price could fall once more from the triple top, get many traders to open sell positions, only for it to reverse to the upside and trap all these 'short traders' anticipating price to fall. This is called a 'short squeeze'. Basically squeezing out the traders that are short until they cannot take their losses anymore and close out their positions, only for price to reverse.
Once these short traders are forced to liquidate (and buy back) their positions, price will shoot up as not only buy orders are coming in from all the short traders who were wrong, but also buy orders from traders that are looking to go long now that this major resistance level has been broken to the upside. Are you beginning to see how this mental game or bears and bulls is shaping up? And how it is to be read within price action itself?
The Double Bottom is a bullish reversal pattern. As its name implies, the pattern is made up of two consecutive bottoms that are roughly the same in size, with a small peak in between.
As is shown in the image above, the double bottom formation is confirmed when price breaks out above the neckline after the second bottom. This neckline was previous resistance, and is now reversed to provide possible support. So before going long or closing your short position, you should wait for confirmation of the double bottom. Wait for a a strong break above the neckline, preferably confirmed by a rise in volume (large candle). As with the double top, a change in trend is confirmed once price breaks above the neckline with momentum (impulses) and comes back to retest it.
Head and Shoulders
A Head and Shoulders pattern forms after an uptrend, and it indicates trend reversal. The pattern is easily recognizable by its three successive tops, the middle top or the head being the highest and the two outside tops or shoulders, being lower and roughly the same in size. The lows can be connected to form a neckline that acts as support. This support doesn’t have to be horizontal, but can be diagonal, like a trendline. The neckline has the same function as in the Double Top pattern.
In essence the head-and-shoulders pattern consists of just 3 steps:
Price making a (final) higher high (head);
Then price fails to make a higher high, closing below the previous high (right shoulder);
Next price drops below the neckline, making a lower low, confirming the end of the uptrend.
The slope of the neckline is also an important indicator.
If the neckline slopes down, this signals bearishness, as price in fact already made a lower low prior to the right shoulder;
An upsloping neckline indicates bullish potential.
The Head and Shoulders pattern can bee seen very often. As it is seen by many traders, it is also used by "smart money". They use retail traders as liquidity for the move ahead. This means the following. When the right shoulder is taking shape and price approaches the hight of the left shoulder, there are many short traders that have the Fear Of Missing Out (FOMO) and jump into the trade before price actually hits the highs of the left shoulder. In some cases this might actually work, but in most it will not. As many traders are now short, smart money pushes price to and beyond the left shoulders high - you guessed it - short squeezing these traders out of their positions.
As these traders liquidate their position (and buy their position back), price shoots even higher. At his point new long biased traders enter the market as well thinking the H&S has failed. Once the pair is flooded with buy orders, smart money pushes price down trapping all long traders. As price is now back below the left shoulders high, many traders will sell their losing buy positions and voila, this creates a flood of sell orders from new short traders as well, finally confirming the right shoulder and price will fall quickly. Long story short, the right shoulder usually is slightly higher than the left shoulder due to this phenomenon.
Although the head and shoulders pattern is a reliable pattern to trade, when entering or exiting the market one should rely on more than chart patterns alone. It is the meaningful combination of independent tools that gives you the most reliable signals.
Important lesson: often during the “left shoulder” the volume and momentum are bigger than during the “head”, even though the head makes a higher high. This divergence gives us an early signal that the head probably is the highest high, and we can expect a lower right shoulder next, confirming the head-and-shoulder pattern. For us to see this divergence we use an indicator called MACD which we will discuss in detail in the chapter called 'indicators'.
Reversed Head and Shoulders
The reversed head-and-shoulders pattern, is the opposite of the 'normal' head-and-shoulders pattern. It forms after a downtrend and signals a possible reversal to the upside. It is a very reliable bullish chart pattern, consisting of three swing lows. The pattern is confirmed by a break above the neckline and the market mechanics of it is exactly like its non-reversed brother only inverted.
A Falling Wedge pattern consists of two downsloping trendlines that form a resistance line and a support line:
As the lines slope down, price makes lower highs and lower lows, indicating bearishness. The two lines converge as buyers and sellers come closer together. The lower support line is less steep, indicating the lows are getting less low and downward momentum is decreasing.
Although a falling wedge pattern can continue its down trend after it breaks to the downside, the Falling Wedge is generally regarded as a bullish pattern. We only pay attention to a falling wedge when it approaches a key support and resistance level. For instance if price is making a double bottom and price is approaching the previous low (first bottom) in the shape of a falling wedge. It is a great sign of deceleration (which we will get back to later) and a reversal in trend.
A bullish breakout is confirmed by a close above the resistance. Conservative traders wait for the more reliable signal when price test broken resistance as support and it holds;
A bearish breakout is confirmed when price breaks below support and it subsequently holds as resistance as price tests it.
For a breakout to be reliable it should also be confirmed by increasing volume i.e. an impulse.
The Rising Wedge is the exact opposite pattern and is a generally seen as a bearish signal. As with the falling wedge, we only pay attention to this pattern if it is formed at a support and resistance level.
Continuation patterns are formed when a market is in a clear trend and needs to temporarily "cool off" after a run up or down. It creates an equilibrium between buyers and sellers, creating specific chart patterns, before resuming the overall trend.
Flag, Pennant and Wedge
All of these patterns are considered to be continuation patterns when formed after a sharp move up or down. We just learned that a rising wedge is a reversal pattern in an uptrend and a falling wedge is a reversal pattern in a downtrend. A falling wedge in an uptrend is considered to be a continuation pattern. Same goes for a rising wedge in a downtrend. To make make an easy comparison and distinguish between them we made this visual comparison:
These are all continuation patterns that show a small consolidation before the previous trend is resumed. It is important to notice that these continuation patterns are almost always preceded by a big price jump or drop and look like a pause in the middle of the run up or drop down.
Without such a sharp initial advance or decline, it is not considered to be a reliable pattern. The sharp rise and drop in front of the pattern (impulse) is often called the “flagpole”. The Flag and Wedge are usually sloping against the trend, the Pennant is usually sloping neutral. Again a breakout of the pattern signals a trend continuation.
Symmetrical triangles can be both a reversal and a continuation pattern. When it forms in a clear uptrend of downtrend it is most likely a continuation pattern. When it forms without a clear prior trend it can be a reversal pattern as well.
The pattern must at least consist of at least:
two lower highs
two higher lows
An important characteristic of chart patterns, which also applies to symmetrical triangles, is that the direction of the next major move can only be determined after a valid breakout.
As the triangle extends, price consolidates, and the triangle gets narrower, you should see volume start to decrease and candles getting smaller and smaller (the quiet before the storm). But what is a valid breakout?
A valid breakout is confirmed by an impulse out of the pattern.
The direction can’t be determined before the breakout, don’t try to do this anyway, as it is very dangerous and unpredictable. There are also “false breakouts”, where price spikes out of a pattern only to fall back into it later.
To make sure that the pattern we drew was correct, we look for an explosive move out of out the pattern as conformation. When price impulses out of the pattern, it has to sustain these new levels for some time before pulling back, indicating that the break-out was valid and not false. False breakouts tend to fallback into the pattern with momentum directly after the impulse out, where as a valid breakout will impulse out, sustain this level for some time before slightly pulling back. This is where we get interested in joining the trend. More on this in our chapter on strategies.
A rectangle is a trading range that acts as a pause in the trend. It is often called a continuation pattern, as most of the time the trend continues after the break of it.
The pattern is easily identifiable by two equal highs and two equal lows that are connected to form the parallel resistance and support lines, respectively the top and bottom lines of the rectangle.
Near support buyers push the price back up;
Near resistance sellers push the price back down.
These are called trading ranges, and are areas where price consolidates. As with most patterns, the end is characterized by a break out of the pattern. Volume doesn’t always decrease during the development of a rectangle though, as we have seen with other patterns. Sometimes it just fluctuates. But we always look for breakout confirmed by an impulse out of the pattern.
The ascending triangle is a bullish pattern that forms as a continuation pattern in an uptrend.
The pattern shows us that momentum is building up, pushing against the resistance, as support is making higher lows. Resistance keeps sloping horizontally, as it makes equal highs. The upsloping support line consists of a minimum of 2 lows, the horizontal resistance consists of a minimum of 2 highs.
Similar to the symmetrical triangle, the ascending triangle also shows volume decreasing as the triangle develops. Often the horizontal resistance is caused by some big sell orders at that level, but as the pattern indicates, buying pressure is building up. Once it “eats” through the sell wall, the only way is up. A breakout should also be confirmed by an impulse out of the pattern in order to have a high probability.
The descending triangle is the opposite of the ascending triangle pattern. Two equal lows make a horizontal support line, and two highs make up the downsloping resistance. It is a bearish continuation pattern, as price is making lower highs. This is what it looks like:
Volume also decreases while the triangle develops, and should increase when price breaks out of the triangle.
A price channel looks similar to the rectangle we discussed earlier. The difference is that a price channel slopes up or down and is a true continuation pattern. It consists of an upper trendline that acts as resistance and a lower trendline acting as support.
Downsloping price channels are considered bearish
Upsloping price channels are considered bullish
In a downtrend the resistance is the main trendline, the parallel support line is also called the channel line;
In an uptrend, the support is the main trendline and the parallel resistance is called the channel line.
Ideally the main trendline and the channel line are each based on 2 highs or 2 lows. In an uptrend, traders often want to buy near the support line, or sell near the resistance line.
Although a price channel is a continuation pattern, a price channel that is approaching key support or resistance can be an early sign of reversal. After price reaches key SR in this manner, it often creates a H&S pattern or a double top/bottom formation after which price reverses.
Try to include as much wicks as possible when drawing your chart patterns:
Most experienced traders use logarithmic (“log”) charts. New traders often stick to the default “linear” charts.
The difference between a linear and logarithmic chart:
A linear chart has a scale with units that have equidistance spacing between them.
On a logarithmic scale the distance between the units is increasingly smaller. But 2 equal % changes have the same distance on the scale. For example:
If price grows 100% from $10 to $20 (a $10 growth), then the space between these units is the same, as when price grows 100% from $50 to $100 (a $50 growth).
So instead of measuring the absolute change, it measures the % change.
Here in a more schematic form:
It is skeptical when traders solely use one piece of information, like chart patterns, in their trading method. We always look for meaningful confirmation by independent perspectives. We are not particularly impressed by the usefulness of all these kind of chart patterns, unless they are used complementary to other independent analytical tools and provide a "case of evidence" or "entry criteria" we seek to have present in order to take a trade.