Table Of Contents
What Are Forex Chart Patterns?
9
Type of Chart Patterns
9
Continuation Chart Patterns
9
Reversal Chart Patterns
9
Neutral Chart Patterns
10
Continuation Chart Patterns
10
Pennant Chart Pattern
10
Rectangle Chart Pattern
11
Corrective Wedge Pattern
12
Reversal Chart Patterns
13
Reversal Wedge Pattern
13
Double Top and Double Bottom Patterns / Triple Top and Triple
Bottom Patterns
14
Head and Shoulders Pattern
15
Ascending Triangle Pattern / Descending Triangle Pattern
16
Neutral Chart Pattern – Symmetrical Triangle
17
Trading Chart Patterns
18
What is the Forex Flag Pattern?
21
Structure of the Forex Flag Pattern
21
The Flag Pole
21
The Flag
21
Flag Pattern Potential
22
Target 1: Size of the Flag
22
Target 2: Size of the Pole
23
Price Action Trade Management
24
Types of Flag Patterns
24
Bear Flag Pattern
24
Bull Flag Pattern
25
Trading the Flag Formation
26
Flag Pattern Trade Entry
27
Flag Pattern Stop Loss
27
Flag Pattern Take Profit
27
Technical Analysis Using Flag Patterns
28
Difference between Flags and Pennants
29
Conclusion
30
What Is The Pennant Chart Pattern?
31
Recognizing The Pennant Technical Formation
33
Bullish Pennant Pattern
34
Bearish Pennant Pattern
35
Pennant Patterns vs. Flag Patterns
36
Technical Analysis Using Pennant Chart Pattern
38
Pennant Trading Strategy Example 1
39
Pennant Trading Strategy Example 2
41
Summary
42
What is a Triangle Chart Pattern
43
Ascending/Descending Triangle
43
Ascending Triangle Pattern
43
Descending Triangle Pattern
44
Rising/Falling Wedge
45
Rising Wedge
45
Falling Wedge
46
Symmetrical Triangle Pattern
47
Pennants
48
Bullish Pennant
48
Bearish Pennant
50
Expanding Triangle
51
Symmetrical Lines
51
Increasing Lines
52
Decreasing Lines
52
One Side Stronger than the Other
52
Trading Triangles in Forex
52
Conclusion
53
Wedge Chart Pattern
54
Rising Wedge Pattern
55
Falling Wedge Pattern
56
Broadening Wedges
58
Trading Wedge Patterns
60
Rising Wedge Pattern Trade Example
61
Falling Wedge Pattern Trade Example
63
Summary
64
Double Tops and Double Bottoms
64
Double Top Chart Formation
65
Double Bottom Chart Formation
66
Confirmation of Double Tops and Bottoms
67
Drawing the Neck Line
67
Neck Line Breakout
68
Potential of the Double Top and Bottom Reversal Patterns
68
Size of the Double Top and Double Bottom Reversal Patterns
69
Projecting the Move
69
The 11 Step Process for Trading Double Tops and Bottoms
70
Step 1: Trend Identification
70
Step 2: Creation of a Top
71
Step 3: Trend Interruption
71
Step 4: Creation of a Bottom
71
Step 5: Creation of the Second Top
71
Step 6: Drawing the Neck Line
71
Step 7: Neckline Breakout
72
Step 8: Trade Entry
72
Step 9: Stop Loss
72
Step 10: Size of the Pattern
72
Step 11: Exit the Trade
72
Double Top and Bottom Trading Example
72
Conclusion
75
Head and Shoulders Pattern in Forex
76
Psychology of the H&S Technical Pattern
77
Head and Shoulders Pattern Rules
77
Drawing the Head and Shoulders Chart Pattern
78
Head and Shoulders Neckline
79
Head and Shoulders Breakout
80
Head and Shoulders Stop Loss
80
Head and Shoulders Price Target
81
Measuring the Size of the Head and Shoulders Pattern
81
Applying the Size of the Head and Shoulders Pattern
81
Inverted Head and Shoulders Pattern
82
Technical Analysis Using Head and Shoulders
83
Inverted Head and Shoulders Trading Example
86
Conclusion
86
Rectangle Pattern In Technical Analysis
87
Rectangle Trading Pattern Dynamics
89
Rectangle Breakout and Continuation
90
Rectangle Trading Strategy
91
Bullish Rectangle Trade Setup
93
Bearish Rectangle Trade Setup
95
Summary
96
Rounding Top Chart Pattern
96
Rounding Top Chart Example
97
What Does the Rounding Top Tell Us About the Market?
98
Trading the Rounding Top Pattern
98
How To Manage The Trade
99
Where Best to Trade the Pattern?
99
Benefits of The Rounding Top Chart Pattern?
100
The Rounding Bottom Chart Pattern
100
Rounding Bottom Chart Example
100
What Does the Rounding Bottom Tell Us About the Market?
101
Trading the Rounding Bottom Pattern
102
How to Manage the Trade
103
Where to Trade the Rounding Bottom Pattern?
103
Benefits of The Rounding Bottom Pattern?
103
Points to Consider When Trading Rounding Tops and Bottoms
104
The Benefits of Trading Rounding Tops and Rounding Bottoms
105
Diamond Chart Pattern
105
Bearish Diamond Pattern
108
Bullish Diamond Pattern
109
Diamond Pattern Trading Strategy
110
Diamond Trade Setup In EURCAD
112
Diamond Pattern Signal In USDJPY
113
Summary
115
Cup and Handle Pattern
115
Structure of the Cup and Handle Technical Pattern
116
Cup and Handle Formations in Forex
117
Bullish Cup and Handle Pattern
117
Bearish Cup and Handle Pattern
118
Drawing the Cup and Handle
119
Cup with Handle Signal
119
Cup and Handle Trading System
120
Opening a Trade
120
Stop Loss
120
Take Profit
121
Trading the Cup and Handle Chart Pattern
121
Bullish Cup and Handle Trading Example
121
Bearish Cup and Handle Trading Example
122
What are Chart Pattern Failures?
123
Failure Patterns and Trapped Traders
124
Types of Failure Patterns in Forex
125
Non-Confirmed Patterns that Fail
126
Already Confirmed Patterns that Fail
126
How to Trade Failed Chart Setups
126
Entering a Failed Pattern Trade
126
Stop Loss on a Failed Pattern
126
Take Profit when Trading Failed Patterns
127
Failed Chart Pattern Trading Example
127
Useful Indicator for Trading Forex Failure Patterns
129
Trading Failed Chart Formations with the Volume Indicator
130
If you have been around the Forex market for any length of time, then you
de nitely have heard about chart patterns and their importance in technical
analysis. If you want to learn more about chart patterns and their
corresponding signals in trading, then this article will provide you a starting
point from which to increase your knowledge of classical chart pattern
trading. Today we will go through the most important chart gures in Forex
and we will discuss their potential.
What Are Forex Chart Patterns?
Forex chart patterns are on-chart price action patterns that have a higher
than average probability of follow-through in a particular direction. These
trading patterns offer signi cant clues to price action traders that use
technical chart analysis in their Forex trading decision process. Each chart
pattern has the potential to push the price toward a new move. Thus, Forex
traders tend to identify chart patterns in order to take advantage of
upcoming price swings
Type of Chart Patterns
Forex trading patterns are divided in groups based on the potential price
direction of the pattern. There are three main types of chart patterns
classi ed in Forex technical charting.
Continuation Chart Patterns
The trend continuation chart pattern appears when the price is trending. If
you spot a continuation chart pattern during a trend, this means the price is
correcting. In this manner, continuation patterns indicate that a new move
in the same direction is likely to occur. Some of the most popular
continuation chart formations are: pennants, rectangles and corrective
wedges.
Reversal Chart Patterns
The trend reversal chart patterns appear at the end of a trend. If you see a
reversal chart formation when the price is trending, in most of the cases the
price move will reverse with the con rmation of the formation.
In other words, reversal chart patterns indicate that the current trend is
about to end and a new contrary move is on its way! The most popular
reversal chart patterns are: double (or triple) top/bottom, head and
shoulders, reversal wedges, ascending/ descending triangle.
Neutral Chart Patterns
These are the chart formations which are likely to push the price toward a
new move, but the direction is unknown. Neutral chart patterns may appear
during trends or non-trending periods. You may wonder what value there
may be in neutral chart formations, since we are unable to know the likely
direction.
But actually, spotting a neutral chart pattern is still quite valuable as you can
still trade an upcoming move. When the price con rms a neutral chart
pattern, you can open a position in the direction of the breakout!
Continuation Chart Patterns
Pennant Chart Pattern
The pennant is a corrective/consolidating price move, which appears during
trends. It resembles a symmetrical triangle by shape, as both are bound by
trendline support and resistance lines. The difference is that pennants
typically occur during a trend phase, while triangles can be formed during
both trends and general consolidation periods.
Pennants could be bearish or bullish depending on the trend direction.
When a pennant occurs during a trend, it has the potential to push the price
in the direction of the overall trend. The expected move is usually a
measured move, meaning the target from the breakout point equals the
size of the pennant itself. Below is an illustration of Pennants:
The green lines indicate the size of the pennant and measures the expected
price move, which equals the size of the pennant.
When you trade a pennant you should open your position whenever the
price closes a candle beyond the pennant, indicating con rmation of the
formation. At the same time, your stop loss should be placed right beyond
the opposite level of the pennant.
Rectangle Chart Pattern
The rectangle chart pattern is a trend continuation formation, which
resembles price consolidation within horizontal support and resistance
levels. During a trend, when the price starts moving sideways forming a
rectangle, another trending move is likely to occur once price eventually
breaks out of the rectangle formation. This move is likely to be at least as big
as the size of the rectangle. Rectangles could be bearish or bullish
depending on the trend direction. Take a look at the illustrations below for
the Rectangle formations:
When you trade rectangles, you should put a stop loss beyond the opposite
extreme of the formation. Notice that this trading pattern is similar to the
pennant, the difference is the swings of the rectangle formation occur
within the same price zone.
Corrective Wedge Pattern
We have a rising wedge when the price closes with higher tops and even
higher bottoms. We have a falling wedge when the price closes with lower
bottoms and even lower tops. Wedges are very interesting chart patterns.
The reason is that wedges could be a trend continuation or trend reversal
formation.
Thus, I decided to distinguish the two types of wedges in order to provide a
more detailed classi
cation – So wedges are of two types: corrective wedges
and reversal wedges. There is no difference in overall apperance between
these two types of wedges. They look absolutely the same – for example, a
regular rising wedge and a regular falling wedge. The corrective/reversal
character is determined by the previous price movement.
The corrective wedges form as a retracement opposite to the trend
direction. In this manner, if you have an uptrend and a falling wedge, you
have a corrective falling wedge, which has trend continuation character. If
you have a downtrend and a rising wedge, you have a corrective rising
wedge, which has trend continuation character. If a corrective wedge occurs
during a trend, it has the potential to push the price toward another
trending move equal to the size of the wedge itself. This is how corrective
wedges appear:
When you trade corrective wedges your stop loss should be placed right
beyond the side, which is opposite to the breakout.
Reversal Chart Patterns
Reversal Wedge Pattern
I will start with the reversal wedges because the previous chart patterns we
discussed were the corrective wedges. This way you will see the difference
between these two.
Reversal rising/falling wedges look absolutely the same way as corrective
rising/falling wedges. The difference, though, is the relation between the
wedge and the trend direction.
Every rising wedge has bearish character. This means a rising wedge
reverses bullish trends and continues bearish trends. At the same time,
every falling wedge has bullish character. So, falling wedges reverse bearish
trends and continue bullish trends. Still not getting it? Have a look at the
image below:
You see? The reversal wedges are absolutely the same as the corrective
wedges in appearance. The difference is where they appear in relation to the
trend. When a reversal wedge occurs at the end of a trend, it has the
potential to push the price to an opposite movement equal to the wedge
itself. When you trade reversal wedges you should place your stop loss order
right beyond the level, which is opposite to the wedge breakout.
Double Top and Double Bottom Patterns / Triple Top
and Triple Bottom Patterns
These are another example of reversal chart patterns. We have a double top
pattern when after an uptrend the price creates two tops approximately on
the same level. And on the contrary, we have a double bottom pattern when
after a downtrend the price creates two bottoms approximately on the
same level. It is absolutely the same with the triple top and triple bottom
formations. The difference, though, is that the tops and bottoms here are
three and not two. This is how these formations look:
The green lines here indicate the size of the formation and its respective
potential. We determine the size when we take the highest top and the
lowest bottom of the formation. When we con rm the authenticity of these
trading patterns, we expect a price move equal to the size of the formation.
This is typically referred to as a 1 to 1 measured move.
But how do we con rm the formation? When we trade double and triple
tops and bottoms we need to settle on the signal line for the formation. The
signal line of the double top is the horizontal line which goes through the
bottom between the two tops. The signal line of the double bottom is the
horizontal line, which goes through the top located between the two
bottoms.
With the triple tops and bottoms it’s almost the same. This time, the signal
line goes through the lowest bottom for a triple top formation and through
the highest top in case of a triple bottom formation. When the price closes a
candle beyond the signal line, we have a pattern con rmation. Then you can
open a position and place a stop loss around half the size of the formation or
at the pattern extreme.
Head and Shoulders Pattern
This is one of the most reliable chart patterns in the technical analyst’s
arsenal. Head and shoulders are a reversal formation and indicate a topping
reversal after a bullish trend.
At the same time, this chart pattern has its opposite equivalent – inverted
(or inverse) head and shoulders. The inverted head and shoulders typically
appears after a bearish trend and calls for a bottom in price. Below you will
nd illustrations of this pattern:
As you see, the head and shoulders formation really looks like a head with
two shoulders. After an uptrend, the price creates a top, then it corrects. It
creates a second, higher top afterwards and then it drops creating a third,
lower top – head and shoulder.
It is the same with the inverted head and shoulders but instead of an
uptrend we have a downtrend and instead of tops the price creates
bottoms, as shown on the image above.
The bottoms forming the head are two points which create the signal line of
the formation. This signal line is called a Neck Line. When the price closes a
candle beyond the neck line, the head and shoulder formation is con rmed
and we can enter the market with the respective position. This position
should be short in case of head and shoulders and long in case of inverted
head and shoulders. Your stop loss should be placed right above the last
shoulder of the formation.
Ascending Triangle Pattern / Descending Triangle
Pattern
The ascending triangle has tops, which lay on the same horizontal line and
has higher swing bottoms. The descending triangle has bottoms, which lay
on the same horizontal line and lower swing tops.
Although many people consider these chart patterns as neutral, their
chance to reverse the trend is a bit higher. Thus, I put them with the trend
reversal chart patterns. This is how the ascending and the descending
triangles look:
As you see, ascending and descending triangles are very similar to the rising
and falling wedges. The difference is that rising wedges have higher tops
and falling wedges have lower bottoms, while ascending triangles have
horizontal tops and descending triangles have horizontal bottoms.
When an ascending/descending triangle is con rmed, we expect a reversal
price movement equal to the size of the formation.
This is shown with the green lines on the image above. The stop loss should
be placed right beyond the horizontal level of the triangle.
Neutral Chart Pattern – Symmetrical Triangle
Symmetrical triangles have two sides, which are approximately the same
size. Since the two sides of the triangle are usually the same, this creates a
technical force equivalency, which creates the neutral character of the
formation. The image below shows how a symmetrical triangle appears:
When a symmetrical triangle occurs on the chart, we expect the price to
move in an amount equal to the size of the formation. However, the
direction of the breakout is typically unknown due to the equivalency of the
two sides of the triangle. Thus, price action traders tend to wait for the
breakout in order to con rm the potential trade direction of the formation. If
you trade a symmetrical triangle, you should place a stop loss right beyond
the opposite end of the breakout side.
Trading Chart Patterns
Now that I introduced you to the most important patterns for chart reading
it is now time to show you an example of the chart patterns in action. Have a
look at the image below:
This is the daily chart of EUR/USD for Oct 29, 2012 – Apr 12, 2013. Our chart
analysis shows seven successful chart patterns. The green lines show where
we could open our positions. The red lines show where stop losses should be
placed.
First, we start with a double bottom formation. The green line is the signal
line of the gure and the moment where we would go long. The red line is
the stop loss, which is approximately in the middle of the formation. The
EUR/USD price increases to 187 pips in 5 days.
The price increase turns into a rising wedge afterwards. Since the wedge
comes after a price increase, it has a reversal character. The lower level of the
wedge gets broken in bearish direction and would be a potential short on
the EUR/USD. The could be closed after two days when the price reached
the size of the formation. The pro t gain would have been 190 pips.
Then the price starts a new increase which leads us to a symmetrical
triangle. Look how the sides are approximately the same size and under the
same angle. Since the symmetrical triangle has neutral character, we wait for
a breakout. And here it is in bearish direction. We could have shorted the
EUR/USD and placed the stop loss right above the gure. In the same day
the price completes the size of the formation – 137 pips that same day.
The decrease after the symmetrical triangle leads us to the rst bottom of a
double bottom formation. When we spot the second bottom, we would put
the signal line right above the top between the two bottoms. The price
breaks the signal line and a long trade is con rmed. We would place the stop
loss around the middle of the gure. In this particular case, one could have
stayed in the market for twice the size of the formation!
Soon afterwards, price starts consolidating. Notice how the consolidation
resembles a rectangle? Indeed! This is a bullish rectangle! The price breaks
the upper level of the rectangle and a buy setup occurs in this EUR/USD
Forex pair. We could manage to stay with this long position more than the
potential of the rectangle, because we get no bearish behavior after the
bullish potential is ful lled. The price starts hesitating afterwards and we see
some bearish attitude on a lower time frame chart (H4). Furthermore, on our
daily chart the price closes a Doji candle which has a potential reversal
character.
Suddenly, the price nally starts to drop. Do you see something? See the
black lines on the image above. The last double bottom followed by the
bullish rectangle creates a shoulder and a head. The following decrease
creates a second shoulder afterwards. This is a nice head and shoulders
formation. In order to con rm the setup, we need price to break and close
beyond the neck line of the formation. So, we connect the two bottoms
which create the head and we get our neck line. A shorting opportunity in
the EUR/USD occurs right after the price breaks the neck line. We could sell
the EUR/USD and put a stop loss right above the last shoulder of the gure
as shown on the image. We would want to stay with the short position until
the price completes the size of the gure.
Then a corrective rising wedge appears. It is up to you if you are going to
close the head and shoulders position and then open another short position
to trade the rising wedge. The other option is to stay with the head and
shoulders short position until the wedge is completed. In both cases you
would have generated solid pro t from the head and shoulders pattern.
Conclusion
Forex chart patterns are technical on-chart patterns which clue us in on
eventual price moves.
Chart patterns are classi ed within three types:
Continuation Chart Patterns
Reversal Chart Patterns
Neutral Chart Patterns
Some of the most important trend continuation chart patterns are:
Pennants
Rectangles
Corrective Wedges
Some of the most important trend reversal chart patterns are:
Double/Triple Top/Bottom
Head and Shoulders
Reversal Wedges
Ascending/Descending Triangles
One of the most popular neutral chart pattern is the Symmetrical Triangle
All these chart patterns have a tendency for a price move equal to the size of
the formation itself. This is referred to as a measured move price potential.
What is the Forex Flag Pattern?
Chart patterns are a crucial component of technical analysis. Each classical
chart pattern provides the trader with a unique outlook on potential price
movement.
In general, chart patterns can be classi ed into two classes based on their
potential price move – continuation and reversal. Today we will discuss one
high probability continuation chart formation known as the Flag pattern.
The following material will teach you how to recognize and trade the bearish
and the bullish Flag pattern like a Pro.
The Forex Flag pattern is one of the best-known continuation formations in
trading. It is an on-chart gure, which typically appears as a minor
consolidation between impulsive legs of a trend. When this pattern forms on
the chart, there is a high likelihood that the price action will breakout in the
direction of the prevailing trend. We will discuss this in more detail but for
now, let’s get familiar with the technical structure of the Flag pattern.
Structure of the Forex Flag Pattern
The Flag pattern consists of two parts – a ag pole and a ag. Let’s take a
closer look at each of these two components:
The Flag Pole
The rst component of the Flag chart pattern is the Flag Pole. It represents a
trend impulse on the chart. Every trending move could transition into a Flag,
which brings us to the statement that every trend impulse could appear to
be a ag pole.
As a Flag pattern is emerging you will note the large impulse move, which is
referred to as the Flag Pole. A brief consolidation will follow and this
consolidation takes on the appearance of a Flag.
The Flag
After creating the pole, a valid Flag pattern will then begin to trade within a
tight range, taking on the shape of a Flag. The Flag consists of price action
with evenly distributed tops and bottoms. At the same time, this price
action has a corrective character on the graph. In this manner, it is angled
contrary to the trend impulse creating the pole.
Take a look at this image below, which will make the picture clearer for you:
This is a sketch of the Flag chart pattern. The red line is the pole of the ag
and the blue channel is the ag. This is how the Flag pattern is created, and
as the name implies it really does look like a ag, doesn’t it? This chart
pattern is relatively easy to recognize once you know what to look for.
Flag Pattern Potential
As we said, the Flag Pattern has a continuation potential on the chart. And
so, a valid ag pattern is likely to push the price action further in the
direction of the Flag Pole – the trend impulse. In addition to this, when you
spot a Flag formation on your price chart, you will be equipped to measure
the approximate price target of the formation. There are two targets related
to the Flag chart gure:
Target 1: Size of the Flag
The rst target of a con rmed Flag pattern can be derived using the
measured move technique. The measured move target is a distance equal
to the size of the ag. To measure the size of the ag, you would just take the
vertical distance between the upper and the lower channel within the ag.
Then you would apply this distance starting from the breakout point. Your
rst target is located at the end of this distance.
Target 2: Size of the Pole
The next target of the Flag formation equals the size of the Flag Pole. So, to
get this target 2, you need to measure the vertical distance between the
high and the low of the Pole. Once you get that distance, you will need to
apply it to the pattern. Again, as we did with Target 1, you would apply it
starting from the breakout point.
The sketch above shows the two targets of the pattern. The rst target is
marked with the magenta arrows and the magenta line. It measures the
vertical size of the ag contained within the channel marked in blue. The
second target is marked with the purple arrows and the purple line on the
chart. It measures the vertical size of the Flag Pole.
Notice that both lengths are applied starting from the breakout level of the
pattern.
Price Action Trade Management
Most times, after the Flag completes the two targets, you would want to
close out the entire position and bank your pro ts. But in some instances,
you may decide to keep a small position open to ride out a larger trend
move. So, if you continue to see signs of a strong trend even after Target 2
has been reached, then by all means, keep a portion of the position open.
Make sure to manage your trade using price action based clues to
determine a nal exit point.
For example, the trend line indicator can be very helpful in managing a
possible runner. You can decide to stay with the trade as long as the trend
line is intact.
Support and Resistance rules are of a great importance too. If you see the
price hitting a level, and then bouncing contrary to the trend, then the trend
might be getting exhausted. On the other hand, if you see the price
breaking a level with increasing momentum, then this might mean that the
trend is gaining strength.
Another important consideration would be candlestick signals and the chart
patterns. A reversal pattern might provide enough reason to close out the
trade and book pro ts.
Types of Flag Patterns
There are two types of Flag chart patterns based on their structure and
potential – a bearish Flag and a bullish Flag. Each of these is the absolute
opposite of the other. Let’s dive a little deeper into the details of each now.
Bear Flag Pattern
The bear Flag pattern forms during bearish trends. The gure starts with a
bearish trend impulse and turns into a correction, which is directed upwards.
During the correction phase, the tops and the bottoms are evenly
distributed, creating a parallel channel.
The con rmation of the Bear Flag setup comes when the price action breaks
the ag channel boundary downwards. When the breakout occurs, we have
the opportunity to short the currency pair.
This is how the bear ag pattern appears:
Notice that the Flag Pole is in a bearish direction. The Flag is a bullish
correction. Upon breakout of the lower channel line, we expect to see a
continuation of the prevailing bearish trend.
Bull Flag Pattern
The Bull Flag pattern is the absolute opposite of the Bear Flag pattern in
appearance. First, it forms during bullish trends. The pattern begins with a
bullish trending move, which then pauses and turns into a minor bearish
correction. The tops and the bottom of this correction are parallel as well.
The con rmation of the Bullish Flag pattern happens with the upside
breakout, and we would prepare for a long position. Then we apply the same
target rules as discussed earlier.
Now let’s look at a sketch of the Bull Flag Pattern:
Notice the bullish Flag pattern starts with a bullish Flag Pole, which turns
into a bearish correction. Upon breakout of the upper channel line, we
expect to see a continuation of the prevailing bullish trend.
Trading the Flag Formation
Now that we have discussed some of the characteristics of the Bull and Bear
Flag, I now want to shift the attention to creating a concrete trading strategy
around this setup. Next, we will develop some rules and guidelines for
effectively trading with the Flag pattern.
Flag Pattern Trade Entry
To enter a Flag pattern trade, should rst attain a con rmation signal. The
con rmation of the Flag comes with the breakout.
If you have a bullish ag, you will buy the Forex pair when the price action
closes a candle above the upper side. If you have a bearish ag, then you
would sell the pair when you see a candle closing below the lower level of
the pattern.
Flag Pattern Stop Loss
After you open your Flag trade, you should position your stop loss order. This
is needed to protect your trade from unexpected price moves.
One basic rule should be considered when determining the proper stop loss
placement for this type of trade. If the price breaches the opposite side of
the breakout, then you should immediately exit the trade, because the
pattern is most likely false. The most logical location to place the stop loss
would be beyond the most extreme swing within the Flag structure. So, if
you were trading a bullish ag, then your stop should be placed below the
lowest bottom in the Flag. Conversely, if you were trading a bearish Flag,
then your stop should be placed above the highest top in the Flag.
Flag Pattern Take Profit
The take pro t for the Flag pattern should be addressed using the two
targets we discussed earlier. It is up to you which target you are going to
pursue. However, I would suggest taking pro ts at each target level to
reduce risk and book pro ts.
Of course, each trader will have their own trade management style that best
suits them. Below is one example of how you might choose to manage a
Bullish Flag trade.
When you open your Flag trade, you put a stop loss below the extreme point
of the Flag. When the price increases and completes the size of the Flag, you
can close out 1/3 of your position size and book the pro ts.
Also, you would adjust your stop loss order by raising it just below the initial
target level. Then if the price continues to increase and reaches your second
target level, you can close another 1/3 of the position to lock in your pro ts
further. Now on your remaining trade, you adjust your stop again so that it
will be located just below the second target. If the price continues to trend
upwards, then you could carefully monitor price action and hold the last 1/3
of the trade position for as long as it seems prudent.
Technical Analysis Using Flag Patterns
By now you should be getting more familiar with trading the Flag chart
formation. But there is nothing like actual charts to clarify the ideas
presented so far. So now we will shift our attention to some practical chart
examples using Flag Patterns.
This is the hourly chart of the GBP/USD Forex pair. The image illustrates how
you would perform your analysis to arrive at a potential trading opportunity.
You will see the red Flag Pole and the blue Flag channel on the chart.
In the green circle, you see the moment when the price action broke
through the upper level of the Flag. This con rmed the pattern, which
creates a long opportunity on the chart. The green circle is the appropriate
time in which to buy the GBP/USD Forex pair.
Once the trade is executed, you should put your initial stop loss right below
the lowest point of the ag as shown on the image (S/L 1). Then with each
target the Stop Loss order should be moved upwards, locking in pro ts as
price advances. The two-other trailing stop loss orders are shown with S/L 2
and S/L 3.
The magenta and the purple arrows measure the size of the Flag and the
size of the Pole. As you can see, these two sizes are applied on the chart
starting from the breakout point. Each of these two targets are reached. And
as each target is hit, the stop loss order should be adjusted accordingly as
shown on the image above.
The end of the trade would come when the GBP/USD price breaks the third
Stop Loss order (S/L 3). As you see, the price reverses afterward, which would
have created unpleasant conditions for the long trade.
Difference between Flags and Pennants
The Pennant formation is another continuation pattern which strongly
resembles the Flag. The main difference between the two patterns is the
shape of the correction which comes after the Pole. The Flag pattern creates
a channel correction, while the Pennant creates a triangle correction. In both
cases, though, the potential of the patterns is the same.
As with Flags, there are two types of Pennants – bullish Pennant and bearish
Pennant. They are traded the same way as the Flag and the target rules are
absolutely identical. If the Flag is bullish, you go long when the price breaks
the upper level of the Flag. If the Pennant is bullish, you go long when the
price action breaks the upper level of the triangle correction.
Let me illustrate a Pennant setup on the chart below:
We are now looking at the H4 chart of the GBP/USD, which shows a bullish
Pennant chart pattern. The pattern consists of the blue triangle and the
thicker red bullish line, which is the Pole of the Pennant.
The buy signal on this chart comes when the price action creates a bullish
breakout through the upper level of the pennant. This is shown with the
green circle on the chart. In this case you should put a stop loss order below
the lowest point of the pennant as shown on the image.
Then you need to apply the targets of the pattern. This is shown with the
purple and the magenta arrows on the chart. The rst target equals the
vertical size of the blue triangle measured from the highest point. The
second target equals to the vertical size of the Pole.
Notice that the price completes both targets, which means the stop loss
order could be adjusted twice. This is shown with the red horizontal lines on
the image (S/L 2; S/L 3;).
The trade could be held until the price action crosses the last stop loss order
downwards.
As you can see, The Pennant formation is very similar to the Flag pattern, and
the same rules apply for trading both. Remember, the only difference
between Flags and Pennants is in the nature of the correction.
Conclusion
The Flag pattern is one of the most popular continuation patterns.
It consists of two basic elements:
Flag Pole – the current trend
Flag – a trend correction with a channel structure
There are two main targets related with the Flag pattern:
Target 1 – equals the vertical size of the Flag and should be applied
starting from the moment of the breakout
Target 2 – equals the vertical size of the Flag Pole and should also
be applied starting from the moment of the breakout
There are two types of Flags based on their potential:
Bearish Flag
It starts with a bearish move, followed by a channel correction
in bullish
It has bearish potential.
Bullish Flag
It starts with a bullish move, followed by a channel correction
in bearish
It has bullish potential.
Some rules for trading Flags in Forex:
Enter a trade when the price action breaks the Flag in the
direction of the trend.
Put a stop loss beyond the opposite extreme of the Flag.
Take pro ts at each of the targets. You can adjust your stop
loss just beyond the completed target.
The difference between Flags and Pennants is in the correction,
which comes after the Pole.
The Flag has a channel correction.
The Pennant has a Triangle correction, which is angled
contrary to the trend.
What Is The Pennant Chart Pattern?
There are many different forms of technical analysis methods used by
traders. One of the more common approaches is to trade using classical
chart patterns. In this lesson, we’re going to take a deep dive into one of
those classical chart patterns, the pennant pattern. You’ll learn how to
identify a pennant pattern, compare and contrast it to other similar patterns,
and build an effective strategy for trading it in any market.
A pennant is a continuation chart pattern that often precedes a price move
in the direction of the prior trend leg. It has the characteristics of a quiet time
within the market or a short consolidation phase. In terms of the appearance
of the pennant formation, it resembles a small symmetrical triangle with
converging trendlines that contain the price action. Pennants can be
described as bullish or bearish in nature depending on its potential future
price direction following the breakout from the structure.
Along with ag formations, pennant patterns are among the most reliable
chart based trading patterns. And in most cases pennants offer a solid risk
reward pro le when traded correctly. We will be comparing and contrasting
the ag versus pennant chart pattern in a later section, but for now, it’s
important to understand that one of the main differentiating factors
between a ag and pennant pattern is in the appearance of the support and
resistance lines within the formations. Speci cally, a ag pattern has two
parallel channel lines which make up the formation, whereas in the pennant
pattern, the support and resistance lines converge towards an apex.
In markets where the volume gures are readily available, such as the stock
market and futures markets, it is useful to analyze the breakout from a
pennant technical formation alongside volume. However, in the forex
market where the volume gures are not really available, we can use
momentum indicators to gauge the strength of the breakout. For traders,
who prefer to ride the underlying trend of the market, pennant patterns
offer an excellent opportunity to trade with the trend. Although pennant
formations are fairly easy to recognize on the price chart, we must take care
in entering trades at the most opportune times in order to avoid fakeouts
that can and do occur from time to time.
It’s important to understand that pennant patterns are fractal in nature,
meaning that they can occur at all degrees of trend from the shortest to the
longest. Additionally they can form in any freely traded liquid market.
Below you will nd an example of a pennant formation shown on the price
chart.
Recognizing The Pennant Technical Formation
Now that you have a basic understanding of what the pennant formation
looks like on the price chart, let’s continue along the same lines as we
dissect this formation further. So what are some of the primary
characteristics that we should look for to con rm the pennant chart pattern?
Below are listed a few key elements to look for when trying to label a chart
pattern as a pennant.
Prior Impulsive Move – there should exist a sharp price move prior to the
consolidation phase within the pennant formation. This impulsive move is
often seen as the agpole. The price behavior in the case of a bullish
movement higher should be accompanied on high-volume and strong
momentum, with a large percentage of up bars. And the price behavior in
the case of a bearish movement lower should be accompanied on highvolume and increasing momentum as well, but with a large percentage of
down bars.
Triangle-like Formation – The pennant pattern appears as a shortened
triangle within the price action. The duration of a pennant pattern is often
much less than that of a traditional triangle formation. As such it should be a
relatively brief pause in the price action rather than a sustained sideways
price movement. In addition, the volatility within the pennant formations
often decreases as the pattern progresses. As such, we should be able to
draw two converging lines as support and resistance trendlines around the
price action within the pennant.
Strong Breakout – Pennant structures will eventually break out to the side
from which the original trend move originated. The candle that breaks out
from the pennant formation should do so on high-volume and with
increasing momentum. Typically, you will nd a bullish marubozu candle that
breaks the resistance line of a bullish pennant pattern, and along the same
lines, you will often nd a bearish marubozu candle that breaks the support
line of a bearish pennant pattern.
Bullish Pennant Pattern
A bullish pennant formation provides clues for a price continuation to the
upside following the breakout. The con rmation of the breakout occurs
upon a candle close above the resistance line of pennant pattern. When this
occurs, we expect price to move higher, often with a target that is
equivalent to the length of the prior impulsive move, also referred to as the
agpole.
Let’s take a closer look at an illustration of a bullish pennant formation.
Notice on the image above, the bullish pennant pattern occurs after a sharp
price move to the upside. We call this the impulsive leg or the agpole. Also
notice how the bullish pennant pattern appears as a short symmetrical
triangle. Can you see how the upper resistance trendline is sloping
downward, while the lower support trendline is sloping upward? This creates
a convergence of the two trendlines that will lead to a breakout near the
apex point.
Furthermore, you would wait until you recognize a strong bullish candle that
breaks above the resistance line of the pennant formation and closes above
it. Most technical chart traders prefer to enter a long position at the
beginning of the following candle following this breakout candle. As for the
target price following the breakout, we can use a measured move
technique. This means that we would measure the length of the agpole
and project that same length forward from the breakout point as the
potential target.
The psychology within the bullish pennant pattern can be explained as a
period wherein the bulls who got in on the trend early are now looking to
lock in some of those pro ts. This is what causes the brief consolidation,
which will ultimately lead to another push higher.
Bearish Pennant Pattern
A bearish pennant structure indicates selling pressure on the price following
the breakout. The con rmation of a bearish pennant pattern comes after a
breakout and close below the support line of the formation. When this
happens, we would anticipate prices to move lower, with the target price
that is the same as the distance traveled in the prior agpole.
You will nd an illustration of the bearish pennant pattern below.
The bearish pennant pattern can be seen following a strong price
movement to the downside, which is often seen as an impulsive leg. We
refer to this impulsive leg as the agpole. As with the bullish variation of this
pattern, the bearish pennant appears as a short pause within the price
action and resembles a shortened version of a contracting or symmetrical
triangle. The price action will be contained within this contracting structure,
and we can expect a breakout to the downside as the price progresses
towards the apex point.
We want to see a break and close below the support line to con rm a valid
bearish pennant. This is often seen with a bearish marubozu candle. The
target price measurement works similar to the method we discussed earlier.
That is to say that we will measure the length of the agpole and project
that lower from the breakout point to come up with a level that the price
should fall to within the subsequent leg.
Essentially in a bearish pennant pattern, many sellers who have realized a
healthy pro t from the previous impulsive move down, are taking some of
those pro ts off the table. Soon after this period of relative quiet ends, we
can expect another push lower as the selling pressure intensi es once again.
Pennant Patterns vs. Flag Patterns
Both Pennants and Flags are considered continuation patterns and display
congestive behavior. It’s as if the market is taking a breather following a
sharp price move. There are however a few key differences that we should
be aware of when labeling a chart pattern as a pennant versus a ag.
Even though the price following a breakout from either the ag or pennant
pattern will result in a price move in the same direction from which it came,
we still need to try to correctly label it so as to ensure the correct
construction of the trendlines that contain the price action within the
patterns.
As we’ve mentioned earlier a pennant pattern is similar to a symmetrical
triangle formation. However, the duration of a pennant pattern is typically
much less than the duration of a traditional triangle structure. The trendlines
that comprise the pennant formation are contracting in nature.
The ag formation on the other hand resembles a lightning bolt or zigzag
formation. The trendlines that compose the ag pattern are parallel in
nature, and appear as traditional price channels. But unlike traditional price
channels, ag patterns are also relatively short in duration. Sometimes the
ag pattern appears as a rectangle formation rather than as a zigzag
formation. Regardless, the implications are the same.
You can see a side-by-side comparison of a pennant formation versus a at
formation on the illustration below:
Technical Analysis Using Pennant Chart Pattern
By now you should have a good understanding of pennant formations, and
some best practices for correctly labeling such a pattern. We will now
expand on that knowledge and begin to create a trading strategy around
the pennant chart pattern. As with any viable trading strategy, we need to
create rules for each component within the strategy, so that there is little if
any ambivalence when the right pennant trade setup appears in front of us.
Our trading strategy should start with trend identi cation. When we are
trading a pennant pattern, trend identi cation becomes a bit easier since
one of the characteristics of a valid pennant pattern requires a strong price
move prior to its formation. As a result, we will need to evaluate the price
move within the agpole to ensure that it displays impulsive characteristics.
As a continuation pattern, we would expect that the pennant formation
should not retrace more than 50% of the previous price leg. In the event that
it does, the chances of a signi cant rebound in the direction of the prior
trend begins to diminish. As a result we will use the 50% retracement level as
our maximum limit for trading the pattern.
These are the two primary conditions that must be met for this pennant
trading strategy.
Let’s now outline the rules for entering a long position:
The agpole of the pennant pattern must display strong bullish
characteristics in the price action.
The extreme swing low within the pennant pattern must not exceed
the 50% retracement of the prior move, the agpole.
Enter a buy order, when the price breaks out and closes above the
resistance trend line of the pennant pattern. This will serve as the
pennant pattern signal.
Stop loss to be placed at a recent swing low below the breakout point.
Targets will be calculated using the measured move technique. Target 1
will be set at 50% of the length of the agpole and Target 2 will be set at
100% of the length of the agpole, measured from the breakout point.
The rules for the short position will be the same but in reverse:
The agpole of the pennant pattern must display strong bearish
characteristics in the price action.
The extreme swing high within the pennant pattern must not exceed
the 50% retracement of the prior move, the agpole.
Enter a sell order, when the price breaks out and closes below the
support trend line of the pennant pattern
Stop loss to be placed at a recent swing high above the breakout point.
Target 1 will be set at 50% of the length of the agpole and Target 2 will
be set at 100% of the length of the agpole, measured from the
breakout point.
Pennant Trading Strategy Example 1
Let’s now apply the rules for the pennant trading strategy that we created
earlier to an actual price chart. Below you will nd the price chart for the
Australian Dollar to US Dollar currency pair.
Once we recognize a consolidation pattern that could be a potential forex
pennant pattern, you want to take the necessary steps to ensure that our
criteria for such a pattern has been met. The very rst thing that we want to
do is to look back in the price action and see if we can recognize a strong
impulsive price move leading up to the pennant pattern. This is what’s
referred to as the agpole component. Now with that said, we can see the
strong bearish price move that occurred just before the consolidation phase
of our potential pennant continuation pattern. Notice how there are a large
percentage of red candles that make up the sharp move lower.
So now that we have con rmed that characteristic, we can move along to
analyze the second component of our trade strategy. So what is that second
component that we will need to analyze?
Well, if you recall we want to ensure that the extreme swing high within the
pattern does not exceed the 50% retracement of the prior move the
agpole. Now, although it’s not marked, it’s fairly obvious from the chart that
the retracement against the agpole did not exceed the 50% mark. And so
the second condition for the Bearish pennant has been satis ed.
Now that our two primary trading lters have passed the test, we want to
prepare ourselves for a downside break to enter a short position. The sell
order to go short occurs when the price breaks below and closes below the
support line of the pennant pattern. We can see that event triggered on the
price chart as shown within the orange circled area and noted as entry.
Immediately following our short entry, we need to place a stoploss order to
protect ourselves in case our analysis turns out to be incorrect. The stop loss
placement per our rules would be entered just beyond the recent swing
high prior to the entry signal. The red line above our entry signal shows
where that stoploss placement should be.
What about our take pro t exit? Where will we get out on this trade? Our
strategy calls for a tiered exit plan. The rst target will be at the 50%
projection of the agpole as measured from the breakout point. This is noted
on the chart as target 1 and circled in green.
Our second and nal target will be at the 100% projection of the agpole as
measured from the breakout point. You can see that level marked as the
lower red line on the chart. You will also see the bar that triggered our
second target circled in green as well.
Pennant Trading Strategy Example 2
Let’s look at another example of trading pennants in the context of the
strategy that we’ve described. This example will also be of a bearish variety of
the pennant pattern in forex. The chart below shows the price action of the
Euro Yen currency pair based on the 480 minute timeframe.
Starting from the left side of the chart, we can see a sharp move lower that
forms the agpole. Notice how there is a large percentage of red bearish
candles compared to green bullish candles. This is an indication of a strong
bearish impulsive price move. You can see that the pennant formation has
been outlined with the two converging trendlines.
Furthermore, I have plotted the 50% Fibonacci retracement of the agpole.
Recall that for the purposes of our pennant trading method, we do not want
prices to retrace more than 50% of the agpole. If you look closely, you will
see that as the pennant was forming, that it’s extreme swing high moved
just below the 50% retracement level before resuming back to the
downside. A second test of the 50% retracement level occurred sometime
afterwards, but again was rejected from that level. As such our Fibonacci
based lter has been satis ed for this set up.
Our entry trigger will be a breakout and close below the support line of the
pennant pattern. Notice here that entry occurred quite a bit below the
support level just one bar prior. In any case, this would have served as the
entry trigger for the trade.
Sometimes when the entry trigger is quite a distance away from the
breakout point, it might make sense to wait for a possible pullback to get a
more favorable execution price. However, the risk in doing so is that there is
no guarantee that the price will actually retrace to give us that opportunity.
In this case, based on our simpli ed rules, we would have gone short on the
bar following the breakout close as shown by the orange circled area.
Our two-tier target is also shown on the price chart. The rst target was
reached a short time after the entry, and represents the price that measures
50% the length of the agpole measured from the breakout point. And the
second target would be set at the price which equates to the 100% length of
the agpole measured from the breakout point. Notice how the price
reaches our second target, and soon afterwards begins to nd demand in
the market from buyers that act to push the price higher once again.
Summary
The pennant pattern is a popular chart pattern used by many technical
analysts. It can be applied to any number of nancial markets, and can be
found at all degrees of trend from the very minor to the very long term. It’s a
simple pattern to recognize on the price chart, however, there are some
nuances in correctly labeling it.
We outlined some of the best practices in identifying the pennant pattern,
some of the differences between it and other classical patterns, and shown a
method for trading the pennant within a trend. It’s a simple chart pattern
that you should consider adding to your trading arsenal because it provides
for a high probability of success when applied correctly.
What is a Triangle Chart Pattern
I am sure you have heard about chart patterns in Forex trading and their
relation to technical analysis. You probably know about Double and Triple
Tops, Head and Shoulders, or Rectangles. In order to have a complete
understanding of chart pattern trading, we should also gain a good
understanding of one of the most common on-chart formations. What I
referring to are the triangle trading patterns. So in this lesson, we will discuss
the basic triangle formations and some ways to properly identify and trade
these patterns.
The triangle pattern is a speci c gure formed on the price chart, typically
identi ed when the tops and the bottoms of the price action are moving
toward each other like the sides of a triangle. When the upper and the lower
level of a triangle interact, traders expect an eventual breakout from the
triangle. As such, many breakout traders use triangle formations for
identifying breakout entry points.
There are different kinds of triangles that can be seen on a Forex chart.
Before you jump into triangle trading you should understand the difference
between the formations. We will now take a closer look at the various
triangle chart patterns and the corresponding trade setups. Once you are
equipped with this knowledge, you should be able to add a triangle trading
strategy to your trade setup arsenal.
Ascending/Descending Triangle
These types of triangles have one at horizontal side, and one sloping side,
which is moving toward the at horizontal side. The Ascending and
Descending Triangle patterns are a mirror image of each other. They are
identi ed as Ascending or Descending depending on which side is the at
horizontal side, and which side the slope is on.
Ascending Triangle Pattern
This triangle pattern has its upper side at, and the lower one ascending. In
this manner, the tops of this triangle are on the same level and the bottoms
are increasing. This type of triangle typically has a bullish character. When
you spot this triangle on the chart, you should be prepared to catch a bullish
price move equal to at least the size of the triangle. In this manner breakouts
through the upper level (the at side) are used for setting entry points for
long positions. This is a sketch of the ascending triangle chart pattern:
The black lines above indicate the price action within the triangle formation.
The blue lines refer to the sides of the triangle, which contains the price
action. The red lines correspond to the size of the triangle and its potential
target, which is typically a 1:1 measured move. When an ascending triangle is
formed during a bullish trend, we expect a continuation of the trend.
Descending Triangle Pattern
As noted earlier, the ascending and descending triangles are a mirror image
of each other. As such, the descending triangle pattern has the opposite
characteristic. The at side of the descending triangle is below the price
action. The upper side of the triangle is inclined downwards. In a bearish
market, the descending triangle has a bearish potential equal to at least the
size of the pattern. For this reason, the descending triangle is used to open
short positions after the price has broken its lower ( at) side. Let’s see the
sketch of the descending triangle:
When the descending triangle is created during a bearish price tendency,
we expect the trend to continue.
It is very important to mention that the ascending and the descending
triangles sometimes break through the inclined level, causing false signals
and trapping some traders along the way. The same holds true for the
horizontal price zone. You should always try to wait for the close of the candle
to con rm the breakout. This will help reduce many of the false signals.
Rising/Falling Wedge
The rising and falling wedges are similar to the ascending and the
descending triangle patterns. However, the rising and the falling wedges
have no at side. Both sides of the wedges are sloping in the same direction.
Let’s describe the two kinds of wedges you will nd on the price chart.
Rising Wedge
This is a triangle chart pattern, where both sides are inclined upwards. The
price creates higher tops and even higher bottoms. This causes the two
ascending lines to interact, creating a type of triangle pattern on the chart.
The rising wedge has a strong bearish character. In this manner, the trigger
side of the wedge pattern is the lower line. When you spot a breakout
through the lower level of a rising wedge, you should expect a sharp price
drop equal to at least the size of the pattern. Therefore, breakouts through
the lower level of a wedge are used for opening short positions. This is what
the rising wedge formation looks like:
Falling Wedge
With the falling wedge pattern, both sides are inclined downwards. The price
creates lower bottoms and even lower tops. In this manner, the two sides of
the triangle are descending and contract to a tight point. Opposite to the
rising wedge, the falling wedge has a strong bullish character. Therefore, the
trigger side of the falling wedge formation is the upper line. When the price
breaks the upper level of a falling wedge, you should aim at for a bullish
move at least as large as your wedge formation. As such, traders use the
falling wedge to set long entry points on the chart. Below you will see a
sketch of a falling wedge:
Now that you know what the rising and the falling wedges look like, we
should share one more detail regarding these formations. Wedges could
have trend continuation, or trend reversal character. When the wedge
appears after an extended price move, we expect a reversal of the trend,
when the wedge appears earlier in the trend, we expect it to be a temporary
retracement that will continue the main trend in place. Typically the more
powerful wedge formation is the potential trend reversal formation which
occurs after a prolonged trend move.
Symmetrical Triangle Pattern
The symmetrical triangle is a situation on the chart where the tops of the
price action are lower and the bottoms are higher. Also, the two sides of the
triangle are inclined with the same angle. This creates the symmetrical
character of the triangle.
Typically with a symmetrical triangle pattern, the expected directional
breakout is unknown. The reason for this is that the bullish and the bearish
move have equal strength as seen thru the price action.
When a breakout eventually occurs, it is likely to provoke a price move equal
to the size of the pattern. Therefore, you should carefully identify a potential
breakout in the upper and the lower level of the symmetrical triangle in
order to take the right position in the market. The sketch below illustrates
the symmetrical triangle formation and possible breakout scenarios:
As you see from the example above, the potential target is based on the size
of the triangle formation. With this type of measured move analysis, you will
know what to expect from the symmetrical triangle breakout, whether it
breaks upwards, or downwards.
Pennants
Pennants on the chart have a similar shape to that of symmetrical triangles.
They typically appear during trends and have a trend continuation character.
Bullish Pennant
The bullish pennant is similar to a symmetrical triangle in appearance, but
the Bullish pennant formation comes after a price increase. Since pennants
have trend continuation character, the bullish pennant is likely to continue
the bullish trend on the chart. When the upper side of the pennant gets
broken upwards, we are likely to see an increase equal to at least the size of
the pennant, and typically larger.
And so when trading pennants, a second target should also be used to catch
a larger move. When calculating the second target, you would analyze the
price leg immediately following the pennant. You could set the target to 1:1
of the previous leg or .618 of that leg. When the trend seems strong and has
a steep slope a 1:1 measured move would be an appropriate second target,
and in all other cases the .618 of the leg could be used. Let’s take a look at
the bullish pennant below:
See that here we have two targets. The red target is the rst one, which is as
big as the size of the pennant. The green target corresponds to the size of
the previous up move, which should be applied starting from the upper side
of the pennant.
Bearish Pennant
As you have probably guessed, the bearish pennant is the mirror image of
the bullish pennant. Bearish pennants start with a price decrease and end
up with a symmetrical triangle appearance. Since pennants have trend
continuing character, bearish pennants are likely to continue the bearish
trend.
When the price goes through the lower level of the bearish pennant, you
should rst look to capture the rst target, which is equal to the size of the
pennant itself. When the price completes this target, you can then try to
catch the expected further decrease, which is equal to the size of the
previous leg or .618 of that leg. Refer to the image below for a Bearish
Pennant:
Expanding Triangle
You can hardly mistake an expanding triangle on the chart. The reason for
this is that it has very unique parameters. Both sides of the expanding
triangle are inclined, but in opposite directions.
The direction of the potential price move of this chart pattern is very tricky to
determine. Therefore, we will now introduce a few rules, which will help you
to identify the direction of the expected price move.
Symmetrical Lines
If the expanding triangle is a horizontal mirror image of a symmetrical
triangle, then you should trade the formation as a trend continuation
pattern. The image below shows a sketch of an expanding triangle with
symmetrical lines:
Increasing Lines
If the two sides of the expanding triangle are increasing, then the pattern is
likely to have bearish character.
Decreasing Lines
If the two sides of the expanding triangle formation are decreasing, then the
gure is likely to have bullish potential.
One Side Stronger than the Other
If the tops of the price action are increasing, but the bottoms are decreasing
with higher intensity, then the pattern has bearish character. On the
contrary, if the bottoms are decreasing, but the tops are increasing with
higher intensity, then the pattern is likely to have bullish character. In other
words, you should trade in the direction of the side, which has higher
inclination.
Trading Triangles in Forex
Now that we have discussed most of the important triangle patterns in
Forex, I will now show you how a triangle trading system could work.
The image above shows the H4 chart of the USD/CHF Forex pair for Jan –
Feb, 2016. The chart illustrates ve triangle examples and their potential
outcome.
The chart starts with a big symmetrical triangle. The price creates three
decreasing tops and three increasing bottoms on the chart. The red arrow in
the beginning of the triangle measures its size. As you see, the same red
arrow is applied when the price breaks the upper level of the triangle. The
red arrow indicates the potential target of the pattern, which gets
completed after a week.
Meanwhile, on the way up the price action creates a rising wedge chart
pattern. As we discussed, the rising wedge has bearish potential. With the
the breakout through the lower level of the wedge we notice a minor
correction. (yellow arrows)
At the end of the bullish tendency the price creates another symmetrical
triangle. Later on the price breaks through the lower level and completes
the size of the pattern (pink arrows).
While decreasing, the price action actually creates a bearish pennant. This is
the consolidation after the rst impulse of the bearish trend. The price
breaks the lower level of the pennant afterwards. On the way down we see
the price completing the rst target, which equals the size of the pennant
(red arrows). Then the decrease continues and the decrease is extended to a
size equal to the previous leg. (green arrows).
The USD/CHF then creates a double bottom reversal pattern and switches
to a bullish direction. On the way up the price action creates an expanding
triangle pattern. Notice that both the upper and the lower level of the
pattern are increasing. In this case, the expected price move is bearish and
should be equal to the size of the pattern. Notice that this time the size of
the pattern is measured from the ending side of the formation. The reason
for this is that we take the widest side when we measure the expected
move from the triangle breakout. The red arrows on the chart show us that
this pattern also completes its target.
Conclusion
Triangles are among the most important chart patterns in Forex trading.
You have a contracting triangle on the chart when the tops and the bottoms
of the price action are moving toward each other.
The basic Forex triangles are:
Ascending Triangle – at tops; higher bottoms; bullish potential;
Descending Triangle – at bottoms; lower tops; bearish potential;
Wedges – sides increase/decrease in the same direction;
Rising Wedge – higher tops; even higher bottoms; bearish
potential;
Falling Wedge – lower bottoms; even lower tops; bullish potential;
Symmetrical Triangle – lower tops; higher bottoms; sides have the
same angle of movement
Bullish Pennant – comes after price increase; ends with a small
symmetrical triangle; bullish potential
Bearish Pennant – comes after decrease; ends with a small
symmetrical triangle; bearish potential;
Expanding Triangle – sides move against each other. The potential
of the expanding triangle varies depending on the lines
inclination:
Sides are Symmetrical – the potential price move is in the
direction of the trend.
Both Sides are Increasing – bearish potential
Both Sides are Decreasing – bullish potential
One Side is Steeper than the other – the potential price move
is in the direction of the steeper side.
Wedge Chart Pattern
If you are a chart pattern trader, you have inevitably come across the wedge
pattern. It is an interesting pattern that has a few different variations.
Depending on when and where the pattern appears within the price action,
it can be classi ed as a reversal or continuation pattern. We’ll dive into the
basics of recognizing and labeling wedge patterns, with the ultimate goal of
learning how to trade it pro tably in the market.
A wedge pattern is a corrective price structure that often precedes a new
trend leg. Wedge patterns are considered consolidation phases wherein
there is a contraction within the price movement. Volume will also contract
during the formation of a wedge pattern. Most wedge patterns form as a
contracting variety, and the contracting variety can be classi ed as a rising
wedge or a falling wedge. In rare cases, a wedge pattern can form as a
broadening or expanding variation. When this occurs the wedge structure
can be further classi ed as either an ascending wedge, or a descending
wedge.
We will detail all of these different types of wedge structures as we move
through this lesson, however, for now it’s important to understand that a
wedge pattern is a prolonged consolidation pattern that can form in both up
trending and down trending markets. Often the wedge pattern resembles a
triangle formation that has been tilted either up or down. As such, these
formations are sometimes referred to as a triangle wedge.
Wedge patterns often occur at the terminal point of a trend. That is to say
that a rising wedge pattern can form near the terminal point of a bullish
trend, while a falling wedge pattern can form near the terminal point of a
bearish trend. Elliott wave traders will recognize the technical wedge
formation as an ending diagonal.
When the wedge pattern occurs in the direction of the trend and within the
late stages of the trend is considered a reversal pattern. The price action
following the break of the lower line within a rising wedge will often lead to a
sharp price reversal to the downside. And similarly the price action following
the break of the upper line within a falling wedge will often lead to a sharp
reversal to the upside.
Rising Wedge Pattern
Let’s now take a closer look at the rising wedge pattern. Below you will see
an illustration of the rising wedge pattern.
The rising wedge pattern can be seen as two contracting trendlines sloping
upward and wherein the majority of the price action is contained within
these trendlines. Notice the upper line of the rising wedge pattern which
represents the diagonal resistance level for the price action, and how the
lower line of the rising wedge pattern represents the diagonal support level
for the price action. Both lines are clearly pointing upward and are
converging towards each other.
The most important level to watch for within the rising wedge pattern is the
lower support line. We expect that the price will break this lower trendline,
which will lead to a bearish price move. As such a rising wedge structure is
considered a bearish wedge pattern in terms of its price potential.
The rising wedge is often seen at the end of a bullish price move. When the
rising wedge appears in the direction of the uptrend and after a prolonged
price move higher, the most likely implication is for a reversal of the current
trend.
The rising wedge can also occur within the context of a down trending
market. When the rising wedge formation occurs within this market
context, it is considered as a continuation pattern, meaning that, the
breakout should occur at the lower trendline and lead to continued bearish
price movement. In either case, the implications for the rising wedge
pattern are the same. And that is to say prices should move lower following
the downside break out.
Falling Wedge Pattern
Let’s now take a look at the opposite scenario with the falling wedge
pattern. The illustration below shows what the falling wedge pattern appears
like.
The falling wedge pattern will also be outlined using two contracting
trendlines. But in this case the two converging trendlines that contain the
price action will be pointing downward. The upper trendline represents
diagonal resistance, while the lower trendline represents diagonal support.
In the case of a falling wedge pattern the most important line to watch for is
the upper resistance line. When the price breaks above this upper trendline,
prices will often be propelled higher into a new trend leg. As such, a falling
wedge structure is considered a bullish wedge pattern in terms of its price
potential.
The falling wedge pattern can also be a terminal pattern or a continuation
pattern. When the falling wedge pattern appears in the direction of the
downtrend and near the end of a sustained price movement lower, the
implication is for the current downtrend to end, as demand enters the
market pushing prices to higher levels. In this scenario, the falling wedge
pattern would be classi ed as a reversal pattern.
In the case where the falling wedge pattern occurs within an overall
uptrend, and can be seen as moving against the uptrend, it would be
considered a continuation pattern. In either case the breakout should occur
to the upside and lead to higher prices. It should be noted, however, that
the intensity of the price movement higher will often be much more
pronounced when the falling wedge pattern is a reversal pattern.
The same tendency also holds true for a rising wedge pattern. That is to say
that the intensity of the price drop following the wedge breakout to the
downside will often be much more pronounced in the context of a trend
reversal.
Broadening Wedges
Broadening wedges are a less common variation of the wedge pattern
formation. There are also referred to as an expanding wedge formation.
Within broadening wedges the price action expands rather than contracts.
And so, on the price chart a broadening wedge formation will appear as two
diverging trendlines that contain the price action.
There are two variations of the broadening wedge formation. The rst is the
ascending broadening wedge which occurs in the context of an uptrend,
and the second is the descending broadening wedge which occurs in the
context of a downward.
Let’s take a look at the ascending broadening wedge rst. Below you will
nd an illustration of the ascending broadening wedge.
Notice how the upper trendline connects higher highs, and how the lower
trendline connects lower lows. As such, this wedge is expanding or
broadening as the price action progresses. The implications of the
broadening wedge are similar to that of the rising wedge.
More speci cally, when the price breaks below the lower line of the
broadening wedge formation, we can expect continued follow-through to
the downside following the breakout. We will often see the slope within
upper line within the broadening wedge to be steeper than that of the
lower line. However, this is just a tendency and not necessarily a
requirement for de ning an ascending broadening wedge.
Now let’s turn our attention to the illustration below which represents the
descending broadening wedge formation.
With the descending broadening wedge the upper and lower trendlines will
also diverge from one another. The most important line within the
descending broadening wedge formation is the upper trendline with acts a
diagonal resistance level. Once the price breaks above this upper line, we
would expect prices to move higher following the breakout. Additionally, we
will often see the slope of lower line of the descending broadening wedge to
be steeper than that of the upper line within the pattern.
Broadening wedges are trickier to trade compared to the traditional
contracting wedge formation. One of the reasons for this is that the
broadening variety creates a less attractive risk to reward pro le compared
to the contracting wedge formation.
Within the normal wedge formation, we can often place a stop loss just
beyond the extreme swing point of the structure. This can provide for a fairly
tight stop loss. Due to the expanding nature of the broadening wedge, the
stop loss placement is often a far distance away from the breakout point. As
such, we are left with either choosing between a distant stoploss level or a
less than optimal stoploss placement within the broadening wedge
structure.
Trading Wedge Patterns
Now that we have a good understanding of the different types of wedge
formations, and their implications, let’s try to build a wedge pattern trading
strategy. We will focus on the rising and falling wedge patterns that occur as
terminal structures. These offer the best tradable opportunities.
So essentially, our strategy will start with scanning for rising wedges that
appear in the context of an uptrend, and after a prolonged price rise.
Similarly we will scan for falling wedges that appear in the context of a
downtrend, and after a prolonged price decline.
Once we have located a well-de ned wedge structure, will want to add a few
additional elements to the trade strategy to isolate the best trade setups.
For one, we want to ensure that the current market conditions are pointing
to an overextended price move.
Essentially, we want to clearly de ne an overbought market during an
uptrend, and an oversold market during a downtrend. The way that we will
do that is with the Bollinger band overlay. We will utilize the standard
Bollinger band settings of 20, 2 as the parameters.
Speci cally, during an uptrend we want to see the price within the nal leg
of the wedge penetrate above the upper Bollinger band. This would indicate
an overextended bullish market sentiment that should lead to a reversal in
the price movement. Similarly, during a downtrend we want to see the price
within the nal leg of the wedge penetrate below the lower Bollinger band.
This would clue us in to an overextended bearish market condition that
should bounce back to the upside.
Here are the rules for a long trade set up:
A well-de ned rising wedge formation can be seen on the price chart,
which is sloped upward and occurs after a prolonged price move to the
upside.
The price action within the nal leg of the rising wedge pattern
penetrates above the upper Bollinger band.
Enter a short position one PIP below the low of the bar that penetrated
the upper Bollinger band.
Stop loss to be placed above the most recent swing high preceding the
entry signal.
The target will be the touch of the opposite side of the Bollinger band,
which in this case would be the lower band.
Here are the rules for a short trade set up:
A well-de ned falling wedge formation can be seen on the price chart,
which is sloped downward and occurs after a prolonged price move to
the downside.
The price action within the nal leg of the falling wedge pattern
penetrates above the lower Bollinger band.
Enter a long position one PIP above the high of the bar that penetrated
the lower Bollinger band.
Stop loss to be placed below the most recent swing low preceding the
entry signal.
The target will be the touch of the opposite side of the Bollinger band,
which in this case would be the upper band.
Rising Wedge Pattern Trade Example
Now that we have outlined the rules for our wedge trading strategy, let’s
now see what that would look like on an actual price chart. Below you will
nd the price chart for the Australian Dollar Japanese Yen currency pair
based on the four hour timeframe.
The green bands overlaid on the price chart is the Bollinger band study. You
can also see the rising wedge formation outlined with the two orange
trendlines. As a price was moving higher, it became evident that there was a
contraction in the price movement that resembled a rising wedge
formation.
Once we are able to recognize this, we would begin to go through the
process of validating this potential set up. Firstly, we want to con rm that
the rising wedge is a reversal type pattern. The way that we would do that is
by con rming that the rising wedge occurs after a prolonged price move. As
we can see from the price chart, the price action leading up to the rising
wedge was clearly bullish.
Next, we want to wait for the nal leg within the rising wedge to penetrate
above the upper end of the Bollinger band. Notice how the bullish candle
immediately to the right of the upper trendline of the wedge pattern moves
above the upper Bollinger band. This is the penetration signal that con rms
the rising wedge pattern.
Now, we will need to take steps to prepare for a short entry. The short entry
signal would occur at the break of the low of the candle that penetrated the
upper limit of the Bollinger band. You can see that entry level marked on the
price chart with the black dashed horizontal line.
Shortly afterwards the price did break below this entry level, which served as
our entry signal. Once the short entry order was lled, we would immediately
place a stop loss to protect our position. The stop loss would be placed just
above the swing high prior to the entry signal. That stoploss level can be
seen on the chart and is noted accordingly.
At this point, we will need to be patient and monitor the price action closely
to execute our exit, assuming that prices continue to move lower in our
favor. Following the short entry signal, the price did begin to slide lower
eventually reaching the lower end of the Bollinger band, which would have
signaled the take pro t exit point.
Falling Wedge Pattern Trade Example
Let’s now shift our attention to a trade that demonstrates the falling wedge
pattern. On the chart below, you will nd another example of a wedge
pattern in forex. The chart shows the New Zealand Dollar to Japanese Yen
currency pair based on the 240 minute timeframe.
Again, notice the green bands that contain the price action. These bands are
the Bollinger band study overlaid on the price chart. The downward sloping
trendlines represent the falling wedge formation. You can see how the price
action was contracting during the late stages of this bearish trend.
Let’s now go through the process of con rming the falling wedge set up.
First and foremost, after we have identi ed the falling wedge formation, we
want to analyze the price action leading to the falling wedge formation to
con rm that a bearish price trend was underway.
As we can see, this was clearly the case. Next, we will need to wait for the
price action to cross below the lower Bollinger band. This would con rm the
set up for the falling wedge based on our trading rules described. If you look
closely, you can see the hammer candle that clearly broke below the lower
Bollinger band. The hammer candlestick formation is essentially a bullish pin
bar that often occurs at or near the termination point of a downtrend.
The entry signal would be set at one tick above the high of this pin bar
formation. We have noted this level with the black dashed line labeled, Entry.
After a few bars of consolidation following the pin bar, the price broke above
this threshold which would have executed our buy order. We would
immediately place a stop loss just below the swing low preceding the entry
signal. That would coincide with the low of the pin bar as noted on the price
chart.
Our signal to take pro t and exit the trade would occur upon the price
touching the upper band within the Bollinger band. You can see the exit
level marked accordingly. It’s important to keep in mind that this Bollinger
band exit strategy is dynamic, meaning that, it will print a new level with
each passing bar. As such, we must monitor the price action closely to
con rm that event. Alternatively, you can set up a scan within your trading
platform to alert you when that speci c event is triggered.
Summary
The wedge pattern is a popular chart formation used by many technical
traders. As we discussed, the wedge pattern can appear as a reversal pattern
or as a continuation pattern. In our discussion here, we have focused on the
reversal wedge pattern for the most part. This was done intentionally
because the reversal variation offers the best tradable opportunities as it
relates to this formation.
Chartists can trade the wedge pattern in a number of ways. We have
illustrated one such methodology here. Depending on your style of trading
you may integrate some of your own techniques and analysis into the mix.
This is completely natural and worth the effort. Just make sure to backtest
any ideas before committing your hard earned money to trading your
preferred wedge strategy in the market.
Double Tops and Double Bottoms
Chart patterns are an integral part of the technical trader’s arsenal. Their
effectiveness has been studied and validated. One reason why many traders
nd chart trading attractive is because these patterns can offer precise entry
and exit points based on the rules of each pattern.
Today we will discuss two of the most popular chart patterns used in Spot
Forex. This is the Double Top and its reversed equivalent the Double Bottom.
We will discuss the structure of these two patterns and the potential they
create on the chart. Finally, we will show you how to trade the Double Top
and Bottom reversal formations using practical examples.
Double Tops and Double Bottoms are reversal chart patterns. They consist of
two price swing located approximately on the same level.
These patterns typically appear after a trend move. After the con rmation of
the pattern, you expect the trend to be reversed. Let’s now dissect the
structure of each of the two patterns:
Double Top Chart Formation
The Double Top technical formation starts with a bullish trend. The trend
gets interrupted at some point and the price of the currency pair starts to
range. The range consists of two swing tops on the chart. After the creation
of the second top, the price action drops and starts a new bearish trend.
The diagram below will help you visualize this process:
Above you see the structure of the Double Top chart pattern. Notice that the
initial trend is bullish but later it gets reversed after the Double Top
formation.
Double Bottom Chart Formation
The structure of the Double Bottom technical formation is absolutely the
same as the Double Top pattern, but upside down. The Double Bottom chart
pattern starts with a bearish trend, which gets interrupted at some point.
The price action then enters a range, which creates two bottoms on the
chart. After the second bottom, the price breaks the range to start a new
bullish trend. Look at the sketch of the Double Bottom chart pattern below:
As mentioned, this is pretty much the same situation as the Double Top, but
this time the price action starts with a bearish trend, which gets reversed
into a fresh bullish move.
Confirmation of Double Tops and Bottoms
Although the pattern is fairly easy to recognize and can be traded using a
basic set of rules, you cannot simply jump into a trade whenever you see two
bottoms or tops on the chart. To initiate a trade based on this pattern, you
should rst con rm its validity. There are two details related to the
con rmation of the Double Top and the Double Bottom reversal patterns.
This includes the Neck Line and the breakout.
Drawing the Neck Line
The Neck Line of the Double Top pattern is the horizontal level at the
bottom between the two tops.
Opposite to this, the Neck line of the Double Bottom pattern is the
horizontal level at the top between the two bottoms. This is how the neck
line looks:
The rst thing you need to do when you spot the pattern is to manually add
the Neck Line on the chart. It plays the role of a trigger for your trade.
Therefore, this level is of a great importance for your pattern.
Neck Line Breakout
The con rmation of the pattern comes when the price action breaks the
Neck Line. Closing a candle beyond the Neck Line means that there is a valid
breakout of the range, which comes after the initial trend. Since the
breakout is opposite to the trend, we con rm the emergence of a new
trend.
If you have a Double Top pattern, you will wait for a bearish breakout. If you
have a Double Bottom pattern, you will wait for a bullish breakout for your
con rmation. Then you would trade the pattern in the direction of the
breakout.
Potential of the Double Top and Bottom Reversal
Patterns
As we already said, the Double Top and the Double Bottom have a reversal
character. In this manner, they are expected to change the direction of the
trend, creating a brand-new tendency.
In addition, when you spot the Double Top or Bottom reversal pattern, you
can use the structure to extrapolate how far the potential price move could
go.
There are two things you need to do in order to identify the minimum
potential of your Double Top/Bottom chart pattern. We will discuss this in
the next section.
Size of the Double Top and Double Bottom Reversal
Patterns
First, you need to measure the size of the pattern. To do so, connect the two
tops/bottoms with a single line. Then add a perpendicular line to the line
between the two tops/bottoms starting from the Neck Line. This distance is
the size of your Double Top or Bottom pattern.
The size of the Double Top pattern is illustrated with the magenta colored
arrow on the image above. It works the same way with the Double Bottom
pattern, but in reverse.
Projecting the Move
After you measure the size of the pattern, you need to apply this distance
starting from the opposite side of the neck line. In other words, your
minimum target equals the size of the pattern.
This time we have added a second arrow which is equivalent to the rst
arrow. So, the rst arrow measures the size of the pattern and the second
arrow applies this size as a minimum target of the pattern.
Again, the same is in force for the Double Bottom gure, but in a bullish
direction.
The 11 Step Process for Trading Double Tops and
Bottoms
To trade Double Tops and Bottoms properly, you need to implement some
basic trading rules. The following steps will help you identify and trade the
Double Top reversal:
Step 1: Trend Identification
The rst thing you need in order to identify a Double Top pattern is a bullish
trend. You cannot con rm the pattern in the absence of a trend. Although
Tops and Bottoms can and do occur when the market is not trending, a valid
Double Top/Bottom formation must exist in the context of a trend.
Step 2: Creation of a Top
Each top within a bullish trend could be the beginning of a Double Top
pattern. Therefore, you should carefully observe the price action at swing
highs on the chart.
Step 3: Trend Interruption
To continue with your analysis, you need to see the price action interrupting
its current trend. Typically, this would come in the form of a price
retracement that breaks the bullish trendline. It is important to note that
this (Step 3) may sometimes come at a later point in the sequence of events.
Step 4: Creation of a Bottom
After the top is created on the chart, the pattern needs to create a bottom.
Many times, this bottom could be located on a bullish trend line, but that is
not a requirement.
Step 5: Creation of the Second Top
After a bottom has formed, the price action needs to create a second top on
the chart. This is often referred to as the retest. The perfect Double Top
pattern will have a second top, which is slightly lower than the rst top. This
indicates that the trend is at least slowing down and likely exhausted.
In many instances the two tops are on the same level, and sometimes the
second top could even be slightly higher than the rst top. If the second top
is higher than the rst top, you will typically see a divergence pattern
forming as well.
Step 6: Drawing the Neck Line
The sixth step of our trade identi cation process is to plot the actual neck
line of the pattern. To do this you need to reference the swing bottom,
which is located between the two tops. Then you would draw a horizontal
line at this level. This would be the Double Top Neck Line.
Step 7: Neckline Breakout
The next step is to con rm the validity of the pattern. If the price action
closes a candle below the Neck Line, we con rm the validity of the
formation.
Step 8: Trade Entry
Since you have a con rmed Double Top pattern on the chart, you now have
the go ahead signal to enter a position. For the Double Top, you would open
a short (bearish) trade.
Step 9: Stop Loss
You should always secure your open trades with a stop loss order. Although
the success rate of these patterns is relatively high, there is never a
guarantee that the trade will work in your favor.
The optimal place to put your stop loss order is just above the second top of
the Double Top reversal pattern.
Step 10: Size of the Pattern
Now that you are short based on the Double Top pattern, you need to
project a possible target. You should measure the size of the pattern as
discussed earlier and then apply it downwards starting from the Neck Line.
This would be your minimum target.
Step 11: Exit the Trade
You should exit your trade when the price action reaches the minimum
target of the Double Top chart pattern per Step 10.
This 11-step process works absolutely the same way with the Double Bottom
reversal. However, the rules are applied in the opposite direction.
Double Top and Bottom Trading Example
Now that we have discussed the steps for trading the Double Top, we will
shift our attention to an actual price chart which has a Double Top formation.
Have a look at the following example:
This is the four-hour chart of the EUR/USD currency pair. The image covers
the period during August 2016 and shows each of the 11 steps designated
with different colors, which will help you connect them to the respective
events on the chart.
Step 1: We have the yellow bullish trend on the chart.
Step 2: The price creates the rst top.
Step 4: Notice that the next bottom created is on the trend line and not
through the trend line. Therefore, the trend is not broken yet and Step 4
appears right after Step 2. Step 3 comes at a later point.
Step 5: The price creates another top, which is slightly lower than the rst
top on the chart.
Step 3: The price action nally breaks the trend line, which puts Step 3 right
after Step 5.
Step 6: We plot the neck line on the bottom between the two tops of the
pattern.
Step 7: The price action breaks the blue neck line of the Double Top reversal
pattern.
Step 8: Sell the EUR/USD when you identify the breakout and candle close
beyond the neck line.
Step 9: Put a stop loss order right above the second top of the pattern.
Step 10: Then you measure and apply the size of the pattern as your
minimum target.
Step 11: You close the trade when the price action reaches the minimum
target.
Notice that after the break through the Neck line, the price action creates a
big bullish correction as a result of high volatility. A bearish candle with a very
big upper candlewick is created and it nearly hits our stop. However, our
stop loss order is well positioned and it sustains the pressure.
Now let’s take a look at a Double Bottom chart formation and apply the
same 11 step process.
You are now looking at the daily chart of the USD/JPY for Sep – Nov, 2013. The
image illustrates the 11 step process you need to follow to trade this Double
Bottom. Let’s evaluate each one:
Step 1: We have the yellow bearish trend on the chart.
Step 2: The price creates the rst bottom.
Step 3: This time the price action breaks the trend line after creating the rst
bottom.
Step 4: The price action creates a top afterwards.
Step 5: The second bottom is created after the top.
Step 6: We plot the neck line on the top between the two bottoms of the
pattern.
Step 7: The price action breaks the blue neck line of the pattern, creating a
neckline breakout.
Step 8: Buy the USD/JPY pair when you identify the breakout and closing
candle through the neck line.
Step 9: Place a stop loss order below the second bottom of the pattern.
Step 10: Then you measure and apply the size of the pattern as your
minimum target.
Step 11: You close the trade when the price action reaches the minimum
target.
Take note that in the two examples we discussed, the trend line breakout
appeared at different times in the process. In the rst case the price broke
the trend after the creation of the second top. In the second case the trend
breakout came right after the creation of the rst bottom. In both cases the
patterns were valid and led to a price move equal to the size of the pattern.
Conclusion
Double Top and Double Bottom patterns are two of the most prevalent and
popular reversal chart patterns.
These patterns consist of two price extremes located approximately on the
same level.
The Double Top is a mirror image of the Double Bottom pattern:
The Double Top starts with a bullish trend, which turns into a
sideways movement. The range then gets broken downwards and
the price action reverses.
The Double Bottom starts with a bearish trend, which turns into a
sideways movement. The range then breaks through the upper
level and the price action reverses.
We need two things in order to con rm the pattern:
Neck Line – a manually added horizontal line on the bottom
between the two tops (for a Double Top) or on the top between
the two bottoms (for a Double Bottom)
Neck Line breakout – a candle closing beyond the Neck Line.
The trade signal occurs when the price action breaks the neck line:
Open a short trade if the pattern is Double Top.
Open a long trade if the pattern is Double Bottom.
The Double Top/Bottom pattern has a xed minimum potential. You
can project the minimum target by applying the following:
Size of the Pattern – the distance between the Neck Line and the
perpendicular line which connects the two tops/bottoms
Applying the Size as a Target – The potential of the pattern is equal
to its size applied from the Neck Line.
The 11 Steps for Trading Double Tops (reversed for Double Bottoms):
Step 1: Trend Identi cation
Step 2: Creation of the rst Top
Step 3: Trend Interruption
Step 4: Creation of a Bottom
Step 5: Creation of the Second Top
Step 6: Plotting the Neck Line
Step 7: Neckline Breakout
Step 8: Trade Entry at Neckline Breakout
Step 9: Stop Loss above second Top
Step 10: Measure Size of the Pattern for a Target
Step 11: Exit the Trade at Minimum Target Projection
Head and Shoulders Pattern in Forex
Chart pattern recognition is one of the most popular techniques to trading
the forex market. There are many different types of chart formations that a
trader can study and incorporate into their setup arsenal. Today we will go
through one of the more reliable chart patterns within the pattern universe.
What I am referring to is the classic Head and Shoulders Pattern.
The Head and Shoulders pattern is a chart gure which has a reversal
character. As you might image, the name of the formation comes from the
visual characteristic of the pattern – it appears in the form of two shoulders
and a head in between. The pattern starts with the creation of a top on the
chart. The price action then creates a second top, which is higher than the
rst top. A third top is created afterwards, but it is lower than the second top
and is approximately at the same level as the rst top.
The image above is a sketch of the Head and Shoulders chart pattern. The
tops at (1), (2), and (3) create the three important swing points of the pattern.
Top (1) corresponds to the rst shoulder of the pattern.
Top (2) is the “head” of the pattern.
Top (3) corresponds to the second shoulder of the pattern.
Notice in the sketch above, there is an initial bullish trend (green arrow).
Then the left Shoulder is created, followed by the Head, and nally the right
shoulder is completed. Often you will see a divergence pattern between the
left shoulder and the Head.
Psychology of the H&S Technical Pattern
As I have mentioned, the Head and Shoulders formation is a reversal chart
pattern. In this manner, the formation represents the loss of faith in the
prevailing trend. The right shoulder on the chart which is lower than the
head presents some important clues to the trader. The tops have been
increasing initially until the creation of the third top (right shoulder). This
decreasing top on the chart, represents the deceleration of the trend which
is likely to lead to a trend reversal.
Head and Shoulders Pattern Rules
Let’s now discuss some trading rules surrounding the Head and Shoulders
Pattern. After we go through these guidelines, you will be ready to start
scanning for this pattern on your own price charts.
Drawing the Head and Shoulders Chart Pattern
The rst important sign of an emerging Head and Shoulders reversal pattern
comes from the bottom created after the head is formed. If you have and
established trend on the chart, this bottom is likely to create a slowdown in
the trend’s intensity. In many cases this bottom also creates a breakout from
a bullish trend line.
This is the rst indication of a reversal potential and an emerging Head and
Shoulders reversal pattern on the chart. We have two tops which are
increasing and correspond to the bullish trend. However, the bottom
created after the head formation, typically breaks the trend line and ends
near the same level as the previous bottom. This indicates that the bullish
momentum is slowing.
After the head is completed, followed by a bottom outside the trend line, we
should anticipate the third top, which will be lower than the head.
Sometimes, during the formation of the right shoulder, price may test the
already broken trendline as a resistance.
The creation of a third, lower top on the chart creates the H&S formation on
the chart. However, this doesn’t mean that the pattern is con rmed. We will
discuss how to con rm a valid Head and Shoulders pattern in the next
section.
Head and Shoulders Neckline
The Head and Shoulders neckline is considered the most important
component in trading the H&S pattern. The reason for this is that the H&S
neckline acts as the trigger line for trading the pattern.
The neckline needs to be manually drawn on your chart. To draw the
neckline, you need to locate two bottoms – the bottom just prior to the
head formation, and the bottom just after the head formation. Then you
should connect these two swing points with a line.
The sketch above shows you how a Head and Shoulder neckline should be
built. It is important to note that this line could be horizontal, or it could be
inclined if the H&S chart pattern is inclined itself. Also, it is possible for the
neckline to be declined, but that is less common. Regardless, it makes no
difference whether the pattern has a straight, inclined, or declined neckline,
as long as the price action follows the Head and Shoulders pattern rules.
Head and Shoulders Breakout
The Head and Shoulders breakout is the signal we need in order to open a
short trade. To get a valid H&S breakout, we need to see the price action
breaking through the neck line of the pattern. It is when a candle closes
below the neckline, that a short signal is triggered for the Head and
Shoulders setup.
Head and Shoulders Stop Loss
The Head and Shoulders trade setup should be used in conjunction with a
stop loss order. Obviously, the H&S pattern, like any other pattern, does not
provide a 100% success rate, so we must protect our trading account in case
price moves against us.
The optimal place for your stop loss order is above the second shoulder on
the chart. This corresponds to top (3). When you short the Forex pair after a
Head and Shoulders breakout signal, you place the stop above the 3rd top of
the pattern.
Head and Shoulders Price Target
The next question we must ask ourselves is “How long should we stay in the
Head and Shoulders trade?” The answer to this question is a two-step
process:
Measuring the Size of the Head and Shoulders Pattern
The size of the Head and Shoulders structure holds a direct relationship with
the potential target for the trade. Therefore, it is paramount to understand
how to measure the size of the H&S pattern. To do so, you need to take the
distance between the tip of the head and the neck line. This will yield the
size of the head and shoulders pattern.
Applying the Size of the Head and Shoulders Pattern
Now that you have the size of your H&S pattern on the chart, you should
apply this length downwards, starting from the initial breakout through the
neck line. This is the price move you should expect when trading the Head
and Shoulders setup. In other words, the expected price move after the H&S
pattern equals to the size of the pattern. This is often referred to by chart
technicians as a measured move. Take a look at the diagram below:
Notice that in this diagram, we have applied the target of the Head and
Shoulders pattern. The size should match the distance between the head
and the neck as shown on the image. After you measure the size, you simply
add it downwards from the point of the breakout. When the price reaches
the minimum target, it is an opportune time to close out the trade in full, or
at least a sizable portion of it.
So, as an option you can keep a portion of your position open beyond the
minimum target. After all, if the price is trending in your favor, you may want
to see if you can catch a runner. If you want to extend the target on the
chart, you can do this by using simple price action rules or a trailing stop. Be
on the lookout for important support and resistance levels, as well as trend
lines, price channels, or reversal candles and chart patterns. Each of these
might help you to determine your exit point on the chart.
Inverted Head and Shoulders Pattern
The Head and Shoulders pattern has its bullish equivalent. This is the
inverted Head and Shoulders pattern. Contrary to the H&S pattern, the
inverse H&S pattern appears during a bearish trend and it implies that the
existing bearish tendency is likely to be reversed.
This pattern looks the same as the standard Head and Shoulders, but
inverted. And so, the inverted Head and Shoulders pattern formation
concerns bottoms, and not tops. This is how the inverted Head and
Shoulders gure appears:
This sketch shows you that the inverse Head and Shoulders is an exact
mirror replica of the Head and Shoulders pattern. Thus, the potential of the
formation is reversed. The Head and Shoulders pattern has a bearish
potential outlook, while the inverted Head and Shoulders has a bullish
potential outlook.
Technical Analysis Using Head and Shoulders
Now that we have discussed both the bullish and the bearish versions of the
Head and Shoulders reversal pattern, I will now show you a couple of H&S
trading examples as part of a technical analysis approach.
You are looking at the EUR/USD chart for Nov, 2012 – Apr, 2013. The image
illustrates a Head and Shoulders trading example.
The chart starts with a bullish trend which lasts from November, 2012 to
January, 2013. On the way up the price action creates a Head and Shoulders
chart pattern. We have marked the gure with the black lines on the graph.
Since we have now identi ed the pattern, we will now draw in its neck line.
This is the blue horizontal line on the chart. A short position could be opened
in the EUR/USD when a candle closes below the blue neck line. Also, a stop
loss order should be placed above the second shoulder of the pattern as
shown on the image. The minimum target of the pattern is applied with the
two green arrows. The minimum target equals the size of the pattern as we
discussed earlier.
As you can see, the EUR/USD price enters a bearish trend after the pattern
gets con rmed. Fourteen periods after the Head and Shoulders breakout,
the price action completes the minimum potential of the pattern.
At this point you could either close out your entire position or decide to
keep a portion of it open, to try to gain further momentum from the trade. If
you decide to keep a small position open, you will want to take clues from
the price action so that you can exit the remaining position in an informed
manner.
The yellow bearish line on the chart is the trend line, which marks the
bearish price action. The Head and Shoulders trade could be held as long as
the price is located under the yellow trend. When the price closes a candle
above the yellow trend line, the trade should be closed on the assumption
that the bearish trend has been interrupted.
Let’s now turn our attention to another Head and Shoulders trading
example:
This is the H1 chart of the AUD/USD major currency pair for Feb 3 – Feb 10,
2016. The image shows another trading opportunity based on a Head and
Shoulders chart pattern.
The H&S gure is illustrated with the black lines on the image. The blue line
represents the neck line of the pattern, which goes through the two
bottoms at the base of the head. The short trade should be opened when
the price action breaches the blue neck line of the pattern. A stop loss
should be placed above the second shoulder as shown on the image. Then
the size of the pattern needs to be measured in order to attain the
minimum potential price move. This is shown with the green arrows on the
chart.
The price action enters a strong bearish trend after the short Head and
Shoulders signal on the chart. I have outlined the bearish price move with a
bearish trend line on the chart (yellow).
Although the price action completes the minimum target of the pattern in
just three periods, the trade could be held further since the AUD/USD
momentum was sharply downwards. This short Head and Shoulders trade
could be held until the price action breaks the yellow bearish trend line in
the bullish direction.
Inverted Head and Shoulders Trading Example
Let’s now look at a trading example of the Inverted Head and Shoulders
setup. We will apply the same pattern rules we used for the Head and
Shoulders pattern, but reversed.
Here is the daily USD/CAD chart for Feb, 2011 – Jul, 2011. The black lines on the
chart illustrate an inverted Head and Shoulders chart pattern.
Notice that the pattern comes after a bearish trend and reverses the price
action. The blue line on the image is the neck line of the pattern. This time
the neck connects tops and not bottoms, because the pattern is upside
down. The USD/CAD pair could be bought when the price action closes a
candle above the blue neck line. A stop loss should be placed under the
second shoulder which forms the pattern.
Then you need to determine the size of the inverse Head and Shoulders
pattern and to apply it upwards starting from the breakout through the
neck line. This is illustrated by the green arrows on the chart.
The price starts increasing after the long signal on the chart. However, the
price increase is not very sharp and it shows price hesitation. The pink lines
on the image show that the price increase resembles a consolidation in the
shape of a Rising Expanding Triangle. This type of triangle has a strong
reversal potential. Therefore, the best option in this case would be to close
the trade immediately upon reaching the minimum target of the inverted
Head and Shoulders Pattern.
Conclusion
The Head and Shoulders pattern is one of the most reliable chart patterns in
Forex.
It forms during a bullish trend and has the potential to reverse the uptrend.
The name of the Head and Shoulders pattern comes from its visual structure
– two tops with a higher top in between.
The H&S pattern consists of three tops:
The rst top should be found in the context of a bullish trend.
The second top should be higher than the rst top.
The third top should be lower than the second top and should be
approximately on the same level as the rst top.
To trade the Head and Shoulders chart pattern you should apply the
following rules:
Identify a valid H&S pattern and draw each of the three tops that
form the pattern.
Apply a neck line through the two bottoms at the base of the
head.
Identify a Head and Shoulders breakout. Open a short trade when
the price action breaks the neck line downwards.
Put a stop loss above the second shoulder – the top prior the neck
line breakout.
Stay in the trade for a minimum price move equal to the size of the
pattern – the distance between the tip of the head and the neck
line.
You can stay in you trade longer and use price action clues to exit,
if you expect additional gains from your H&S trade.
The Head and Shoulders chart pattern has its opposite equivalent – the
inverse Head and Shoulders pattern.
The inverted H&S pattern could be found during a bearish trend
and it is expected to reverse the downtrend.
The Inverse H&S pattern requires analyzing bottoms to con rm
the formation.
The neck line should go through the two tops that are
immediately before and after the head formation.
The stop loss order should be placed below the bottom, which
corresponds to the second shoulder on the chart.
Determine your price target using the Measured Move rule.
Rectangle Pattern In Technical Analysis
The rectangle chart formation is considered a part of the family of classical
chart patterns within technical analysis. It is one of the more easily
recognizable chart formations, and is a fairly simple pattern to trade. We will
review some of the basics of identifying this structure, and provide some
best practices for incorporating it within your own trading arsenal.
The rectangle technical pattern is a classical chart pattern that appears as a
well-de ned trading range. It is typically considered a continuation type
pattern and serves as a temporary pause within the market. After which,
another price leg forms in the direction of the preceding trend. Rectangle
patterns are fairly easy to recognize on the price chart.
Essentially, to identify a rectangle pattern, you will need two swing highs
that occur along the same line, and two swing lows that can be seen along
the same line. When you plot a horizontal line connecting the two swing
lows and the two swing highs, it will appear as a horizontal parallel channel
that contains the price action. Below you can nd an example of a rectangle
pattern:
Let’s analyze a few of the primary characteristics of a continuation rectangle
pattern, in this case a bullish version.
First and foremost, we need to ensure that we are correctly labeling a
structure as a rectangle formation. As we’ve noted, the rectangle formation
should appear as a trading range or consolidation phase with two swing
highs, and two swing lows that occur along the same plane respectively. As
the chart shows this is clearly the case in this example.
Next, we want to make sure that there is a clear trend leading up to the
rectangle chart formation. This will provide us the best expectation for the
future breakout from the rectangle formation. In the case of an uptrend, we
would expect a bullish breakout from the rectangle formation. Conversely, in
the case of a downtrend, we would expect a bearish breakout from the
rectangle formation. In this example, we can see that the trend is up prior to
the rectangle formation. As such we would anticipate a breakout of the
resistance level, and a subsequent price increase.
In addition to this, we want to analyze the overall structure of the rectangle
pattern. More speci cally, we want to ensure that there are at least 40 bars
that make up the rectangle formation. Now, this is a general guideline to
keep in mind and not necessarily a hard and fast rule. The reason for this, is
that the best rectangle formations tend to be a prolonged consolidation
phase. As such, we want to ensure that the structure is relatively signi cant
and one that provides a viable trading opportunity.
Although we have been discussing rectangle patterns as continuation
patterns, they can also display countertrend characteristics from time to
time. This is particularly true when we are looking at rectangle top and
rectangle bottom formations. Unfortunately, it is quite dif cult to gauge
beforehand whether a rectangle pattern will materialize into a continuation
pattern, or reversal pattern. Having said that, the most dominant type of
rectangle pattern seen in the market is the continuation pattern. And so,
rectangle tops and bottoms as reversal structures should be in the back of
our mind, but the highest probability play is to the trade the structure as a
continuation pattern.
Rectangle Trading Pattern Dynamics
We should always attempt to understand the underlying dynamics within
various price structures, and the rectangle pattern is no exception. So what
is the psychology within a rectangle pattern? What is going on behind the
scenes?
Well, we know that the rectangle pattern is a consolidation pattern with
trading occurring within two well de ned price levels, and upper resistance
level, and a lower support level. If you look at this phenomenon at a deeper
level, you will come to realize that what is actually occurring during this time,
is that the market is in equilibrium, with the bulls and bears having an equal
amount of conviction. This is why the price trades up and down within a
clearly de ned range.
As the price moves higher, supply from sellers comes in to push prices lower,
and similarly, as price moves lower, demand enters the market via the
buyers pushing the prices higher. Ultimately, the price will give way and
either the bulls or bears will take control. A potential breakout to the upside
signals that the bulls are in control, while a breakout to the downside signals
that the bears are in control.
Another way to view the underlying market psychology within this
congestion phase is as a period of complacency or pro t-taking. During a
rectangle formation, some traders who have realized pro ts from the prior
leg are now taking pro ts on their positions. This often creates that
prolonged sideways price movement that is indicative of rectangle
formations.
Rectangle Breakout and Continuation
Now let’s dive a little bit deeper and talk about how we might go about
trading a rectangle pattern breakout. Obviously, we will rst need to identify
the rectangle structure. Once we have done so, we will draw our support
levels connecting the two swing lows that lie along the same plane, and the
two swing highs that lie along the same plane.
Once we have the price action contained within the newly formed sideways
parallel channel, we will want to wait for a breakout and close above the
resistance line in the case of an upside breakout, and below the support line
in case of a downside breakout.
Once this important breakout event occurs, we can either enter into the
trade immediately following the close of the breakout candle, or we can wait
for a potential pullback to the broken horizontal level, and execute a trade
near that area. The choice of which rectangle breakout method you should
utilize depends on your own trading style and preference. Keep in mind that
each type of breakout trade described will have its advantages and
disadvantages.
For example, entering a trade immediately after the breakout close has been
con rmed, will allow you to participate in every market move following the
breakout con rmation signal. The downside to this method comes in the
form of an entry price that may be less than ideal. For example, the breakout
candle could be a wide range bar that penetrates quite a bit beyond the
horizontal price level. This can have the effect of entering a position that has
stretched too far and is now more prone to a retracement, which could put
you at a higher risk of getting stopped out.
So what about waiting for a pullback following the con rmed rectangle
breakout? In that case, you will usually wait for prices to retrace back to the
horizontal price level, and execute a limit order entry near that level, as prices
are moving towards it. Alternatively, you could use some price action signal
near the horizontal line as a con rmation signal.
Either way, the major advantage to this entry execution strategy is that it will
likely provide a much better price for your trade, allowing you to realize a
much healthier reward to risk ratio on your position. Now, the drawback of
the breakout pullback method for trading the rectangle formation, is that,
such an event may never be realized. That is to say that prices could
continue to move in the direction of the breakout in an accelerated manner,
leaving no opportunity for prices to return back to the breakout level. In
such an event, we would incur the opportunity cost of not having
participated in that speci c trade. Below you can see an illustration of the
immediate breakout close entry, and the breakout pullback entry within the
rectangle structure.
Rectangle Trading Strategy
Let’s now start to build a rectangle strategy that seeks to trade breakouts. As
we’ve noted, a majority of rectangle formations tend to be continuation
patterns. As such, we will focus on trading in the direction of a breakout that
is in alignment with the larger trend. In other words, we will seek to trade an
upside breakout from a rectangle formation when we have a discernible
bullish trend leading up to the rectangle formation.
And along the same lines, we will look to trade a downside breakout from a
rectangle structure when we can recognize a bearish price trend preceding
the rectangle pattern. Along with these conditions, we will also incorporate
the momentum technical indicator, which will help us to validate the
strength of the breakout. As you should be aware, breakouts from rectangle
pattern trading ranges tend to be much more signi cant when there is
strong underlying momentum behind the move. This helps to validate the
breakout signal, and helps reduce the number of fake outs that can occur
near horizontal price levels.
So here are the rules entering into a long position:
There exists a clearly de ned rectangle formation, wherein, the price
move leading to the rectangle is of a bullish nature.
The rectangle structure should be comprised of at least 40 price bars.
The breakout from the rectangle must occur through the resistance
level.
The breakout candle must penetrate the upper resistance line, and
close above it.
The momentum indicator, with a look back of 10 periods based on the
close, should be above the zero line.
Enter a market order to buy at the start of next candle.
The stop loss will be placed at the middle point of the rectangle’s
trading range.
The target will be measured using the width of the range. More
speci cally, the target will be set at the level at which the price would
be equal to the width of the range, measured from the breakout point.
And here are the rules entering into a short position:
There exists a clearly de ned rectangle formation, wherein, the price
move leading to the rectangle is of a bearish nature.
The rectangle structure should be comprised of at least 40 price bars.
The breakout from the rectangle must occur through the support level.
The breakout candle must penetrate the lower support line, and close
below it.
The momentum indicator, with a look back of 10 periods based on the
close, should be below the zero line.
Enter a market order to sell at the start of next candle.
The stop loss will be placed at the middle point of the rectangle’s
trading range.
The target will be measured using the width of the range. More
speci cally, the target will be set at the level at which the price would
be equal to the width of the range, measured from the breakout point.
Bullish Rectangle Trade Setup
Let’s now take a look at an example of the rectangle breakout strategy that
we just described. In this example, we’re going to show the rectangle
breakout strategy in the context of an uptrend. Below you will nd the price
chart for the Euro to British pound forex pair shown on the daily timeframe.
We can see that there was a clear uptrend in the market preceding the
range bound price movement which forms the rectangle formation. Notice
the series of higher highs and higher lows that make up the up trending
market move.
Let’s now take a closer look at the actual rectangle structure. We know that
we would need to connect two signi cant swing highs to form the
resistance level of the rectangle, and two signi cant swing lows that form
the support level within the rectangle. We’ve plotted this on the price chart,
and we can see that it resembles a sideways parallel channel.
Remember, we want to make sure that the rectangle structure is not just a
minor sideways correction, but rather a prolonged sideways price
movement. The way that we do this is by counting the bars within the
rectangle structure. We want to see a minimum of 40 price bars comprising
the rectangle formation. We can clearly see that the structure shown here
has many more bars making it up than this minimum requirement.
Now that we have recognized the rectangle structure, and con rmed that it
has occurred within the context of a bullish market, we should know that
the breakout from the upper resistance line is the level that we will need to
watch closely for our entry trigger. As the price progressed within the
rectangle formation we can see that the third major test of the resistance
level led to a con rmed breakout.
Remember, a con rmed breakout is one wherein the breakout candle
penetrates beyond the horizontal line, and closes above it. If you refer to the
magni ed area on the price chart, you will recognize the bullish candle that
ultimately broke above and closed above the upper line of the rectangle
structure.
At the same time that this breakout candle occurs, we can see that the
momentum indicator, as shown on the lower pane of this chart, was
registering a reading above zero. The blue line shown on the momentum
indicator represents the zero line. Now that all of our conditions have been
met for this bullish rectangle trade set up, we want to prepare for entering
our long position. We would enter a market order to buy at the beginning of
the very next candle following the breakout candle.
The stop loss for this trade would be placed at the midpoint of the
rectangle’s trading range as is illustrated by the black dashed line below the
entry signal. Finally, our take pro t target would need to be set so that we
can exit our trade at the most opportune time.
Based on our rules, the target would be set at a price level at which it would
be equivalent to the width of the rectangle itself. And this would be
measured from the breakout point. You can see where that exact target
would have been triggered by referring to the green vertical brackets which
represents a one to one relationship of the rectangle’s range.
Bearish Rectangle Trade Setup
Let’s now move on to our second example. In this example, we will see what
the bearish variety of the rectangle pattern in forex appears like. On the
chart image below, you will nd the price action for the Australian Dollar to
Japanese Yen currency pair based on the 240 minute timeframe.
We can see here that there was a clear down trending price movement
leading to the rectangle formation. We’ve outlined the upper and lower lines
within the rectangle formation, which serves as the resistance and support
levels respectively. Additionally, we can con rm that this rectangle structure
is a relatively large pattern which exceeds a minimum of 40 price bars. This
validates the rectangle pattern based on the trading rules outlined.
As price was trading within this clearly de ned range, we can see towards
the right end of this chart, that the supply in the market forced a bearish
breakout from this rectangle formation. Keep in mind that since the
preceding trend was bearish, it is the support line within this rectangle
pattern that is of most interest to us. The breakout candle appears as a
strong bearish price move. The candle has been magni ed for easier viewing,
and we can see that it breached below the support line and was able to
close below it as well. As such, this can be considered a valid breakout below
the rectangle formation.
If we refer to the lower portion of the chart, we can see the momentum
indicator plotted. Again, the black line represents the actual momentum
indicator reading, while the blue horizontal line represents the zero line. At
the time of the breakout, we can see that the momentum indicator was
registering a reading that was below the zero threshold. As such, this
con rms the bearish rectangle set up based on our trading rules.
Immediately following this event, we would place a sell order at the market.
The stop loss would be placed at the center of the rectangle’s trading range.
The target point for this trade set up would be calculated using the width of
the rectangle’s trading range. More speci cally, we will want to exit the trade
for pro t when the price reaches a level that is equivalent to the width of the
rectangle. Essentially, this creates a two to one risk reward ratio for us. We
can see from the green vertical brackets on the price chart, which represents
this measurement, that our target was easily reached.
Summary
Trading with classical chart patterns is one of the more popular trading
methods used by technical analysts. It is a timeless trading technique that
offers many advantages. Our focus here has been on one such type of
classical pattern, the rectangle formation. We have learned that the
rectangle pattern is most often a continuation pattern, offering a solid
opportunity to trade in alignment with the larger trend.
We have outlined one speci c strategy for trading rectangle patterns, but
the pattern can be traded in many different ways. As you gain experience in
recognizing these structures on your price chart, you will begin to gain more
con dence in executing your own variation of the set up on your preferred
instruments.
Rounding Top Chart Pattern
In the world of technical trading, identifying chart patterns and price
structures has always been one of the most popular ways to analyse and
trade the market. These formations give us an insight into the underlying
order ow in the market. As traders they help us make decisions on where to
buy and sell. The beauty of trading using chart patterns is that they can be
identi ed without the use of technical indicators. Discretionary traders who
have spent the necessary time learning these formations will be able to
identify these exciting market opportunities.
Over the years, there are a few patterns in particular which have carved out a
reputation among technical traders as being the most reliable and effective
structures to use. Two of these structures are going to be covered in this
article. This includes the rounding top chart pattern and the rounding
bottom chart pattern. So, let’s jump right in and take a look at the rounding
top chart pattern
rst. We’ll introduce how you can identify the pattern on
your chart, explain what the pattern is revealing about the market direction
and walk through how to trade the pattern.
The rounding top chart pattern is a bearish reversal pattern. This means that
the presence of the pattern indicates there is a likelihood that the market
will reverse lower, offering selling opportunities for traders. In this respect,
the pattern can be thought of as similar to a head and shoulder pattern. The
pattern is identi
ed via the presence of a series of highs which follow an arc:
lower highs on the left, slightly higher peaks in the middle, and then lower
peaks again on the right.
Rounding Top Chart Example
In the image above you can see a great example of a rounding top chart
pattern. Price is rising initially before making the rst peak on the left. We
then see a small correction before price continues higher, rising into the
peaks found in the middle of the arc. Price then corrects again before
making another attempt to rise. This time however, price is unable to
surpass the peaks found in the middle of the arc, forming another lower
peak, allowing us to draw in our arc to highlight the pattern.
What Does the Rounding Top Tell Us About the Market?
So, now we know how to identify the rounding top technical formation, you
might be asking, why is it important? Well, the beauty of the rounding top
chart pattern is that it tells us some important information about the
underlying order ow in the market.
If we think about what is happening in the market to create this formation,
we know that bulls were in control initially, driving price higher before sellers
take price lower. However, price once again meets demand which takes
price higher into the centre of the arc. Then the bulls are met with strong
selling pressure taking price lower. Price then runs into one nal stage of
buying but bulls are only able to take price back up partially giving us our
lower right-hand peak, before sellers drive price down.
Ok, so now we know how to identify the rounding top reversal pattern. We
also understand what the rounding top technical formation is telling us
about the underlying order ow. The next question is, how do we trade the
pattern?
Trading the Rounding Top Pattern
Based on the information the pattern is giving us, the best way to trade this
pattern is to place a sell trade as price reverses lower.
Looking at the example from earlier you can see that we are able to draw in a
support line at the lows established after the correction from the rst peak.
This essentially gives us a trade line. Following the reversal from the nal
peak in the pattern, we can then sell as price trades below that level. We can
also place a protective stop just above the nal peak of the pattern.
How To Manage The Trade
In terms of a target, as with all trading methods and strategies, the trader’s
focus should always be on achieving an acceptable risk to reward. This
means always banking more on a winning trade than you lose on a losing
trade.
So, once you have set your stop loss and entered your trade, a good rule of
thumb is to set a target which is at least 2 x your stop loss. So, if your stop
loss is 100 pips, set a target of at least 200 pips. This will help you achieve
more sustainable pro tability with your trades in the long run.
Where Best to Trade the Pattern?
Given the nature of the pattern, it is usually best to trade the structure
following a price run up where the rally has met resistance (selling pressure).
On the other hand, the pattern can also be useful if it forms during the
correction during a bearish trend.
Benefits of The Rounding Top Chart Pattern?
The great thing about the rounding top pattern is that once you have
learned to identify it, it becomes very easy to spot. So long as you can draw in
the arc, and identify a trade line, you have the right view. Another bene t to
the pattern is that it can be found and traded in all instruments and asset
classes and on any time frame. Let’s now move onto the rounding bottom
chart pattern.
The Rounding Bottom Chart Pattern
The rounding bottom chart pattern is simply the inverse of the rounding top
chart pattern. The pattern is a bullish reversal pattern. This means that the
presence of the pattern identi es the likelihood of a reversal higher and
offers buying opportunities to traders. In this respect, the pattern can be
thought of as similar to the inverse head and shoulder pattern.
The pattern is identi ed via the presence of a series of price lows which
follow a gentle “U” shape or an inverted arc.
So, there will be initial lows, lower lows in the middle of the pattern and then
higher lows on the right-hand side completing the rounding bottom
technical formation.
Rounding Bottom Chart Example
So, in the rounding bottom chart above you can see a great example of a
rounding bottom technical formation. We have our initial low on the left.
Price then makes a small correction higher before continuing lower into the
lowest points found during the middle of the “U” shape. Price then corrects
higher again, before once more turning lower. However, this time we put in
higher lows which complete the right-hand side of the structure, giving us
our rounding bottom chart pattern.
What Does the Rounding Bottom Tell Us About the
Market?
The rounding bottom technical formation tells us that there has been a shift
in power between sellers and buyers. So, if we think about what is
happening in the underlying order ow to create the pattern: sellers are in
control initially driving price down to the rst lows on the left-hand side.
However, buyers then step in at this point to drive price higher. However,
this move higher runs into selling pressure once again and price is driven
down rmer to new lows. However, at this point, in the middle of the round
bottom, buyers step in to drive price higher once again. This upside move
meets selling pressure again, but the pressure is weaker and price is unable
to form a new low. At this point we have our higher lows on the right-hand
side of the pattern. At this point, the pattern is complete.
Trading the Rounding Bottom Pattern
Ok, so now we know how to identify the pattern and we understand what
the pattern is telling us about the underlying order ow in the market the
next question is: how do we trade the rounding bottom pattern?
So, remember how the rounding top is a bearish pattern and we look to sell
a breakdown as price reverses lower? Well, this time around because the
rounding bottom technical formation is a bullish pattern, we will look to buy
a rounding bottom breakout higher.
So, if we refer back to the example of a rounding bottom pattern we used
earlier, let’s walk through how to trade a rounding bottom reversal. As with
the rounding top, we need to establish a trade line. So, if we look at the high
that was established following the move up from the rst low at the start of
the pattern, this gives us our trade line.
So, we want to place a buy trade as price breaks out above the trade line
because this con rms the bullish reversal suggested by the pattern. We can
then place out protective stop just beneath the last low in the pattern on
the right-hand side.
How to Manage the Trade
So, once you have entered your buy trade and placed your protective stop, it
is time to think about targets. As we discussed earlier, the best option is to
always use a target which is at least 2 or 3 x your stop loss to ensure that you
achieve a solid risk to reward ratio.
If we think about the shift in sentiment which is happening as the pattern
forms, we can almost think of the market as a coiled spring. So, when the
pattern has formed and price eventually breaks above the trade line, we are
looking to capture a burst of momentum as the rounding bottom breakout
occurs.
So, when managing the trade, you really have two options. The rst is to
proceed with a set target in place. Or, if you are a longer-term trader who is
comfortable with the ebb and ow of holding a longer position, you can look
to move your stop to break even as the rst target is hit and then keep your
position open longer. This will allow you to capture a bigger pro t if the move
develops into a proper trend reversal.
Where to Trade the Rounding Bottom Pattern?
Due to the nature of the pattern as a bullish reversal pattern, the rounding
bottom chart pattern is best traded at the end of a bearish trend. When the
trend runs out of steam or runs into support and we can identify a rounding
bottom pattern, this alerts us to a shift in market sentiment and the
potential for a reversal to occur. Similarly, if we can identify the pattern
during the correction in a bullish trend, this can be a great way to get in as
the longer-term trend resumes.
Benefits of The Rounding Bottom Pattern?
As with the rounding top chart pattern, the rounding bottom reversal
structure can be identi ed and traded on all instruments and asset classes
and on all time frames. So long as you can draw in the “U” shape and identify
the trade line, you know you have the correct view and the pattern is there
to be traded.
Points to Consider When Trading Rounding Tops and
Bottoms
As brie y touched upon at the start of article, the beauty of trading rounding
tops and bottoms is that the patterns can only be identi ed by the naked
eye. There are no indicators which plot the pattern for you. As a technical
trader you will need to develop the skill in identifying the pattern and
picking the trade. The best advise here is simply to practice. If you need to
you can print off the examples used above and keep them as a handy guide
to measure any potential chart formation you nd against it.
With that in mind, here are key tips to keep in mind when identifying the
patterns:
Shallow is better
You will notice that in both the examples used here for rounding tops and
bottoms, the price structure is fairly shallow. Even the “U” shape describing
the rounding bottom is more of a gentle smile shape than a “U”.
The reason for this is because if we think again about what is taking place in
the underlying order ow to create these patterns, it is essentially a war
being fought out around a certain price point where power is shifting. With
the rounding top, power is shifting from the buyers to the sellers and with
the rounding bottom power is shifting from the sellers to the buyers.
Now, due to the way this shift in sentiment takes place, this is why the
patterns are comprised of many peaks and lows. A gentle pattern suggests
that the market has undergone the proper shift in power between supply
and demand and therefore, has a higher likelihood of working. If the pattern
is not shallow, and the moves up and down are much bigger (more volatile),
this suggests that the price action is too erratic and is not favorable for
placing a trade.
Combing rounding top and rounding bottom patterns with other technical
elements
Another key aspect to point out about the patterns is that they can be used
in conjunction with other forms of technical analysis in order to bolster the
chances of success. Whilst it is perfectly valid to place a trade upon
identifying the pattern, traders can incorporate other technical elements
such as trend lines, support and resistance and technical indicators.
Combing technical elements can be a great way to gain stronger conviction
in your trading idea.
Focus on location of the pattern
Finally, it is worth noting that as with all technical formations and strategies,
the set-up is not guaranteed to be successful. It is the job of a good technical
analyst and trader to study the markets and identify the best conditions for
placing a trade.
As we discussed earlier in the article, there are certain locations which are
better for taking a trade than others. As you spend time practicing
identifying the patterns and trading them you will learn to identify the best
locations and trading conditions for the speci c markets you prefer.
Finally, it is worth considering the bene ts of trading rounding tops and
bottoms over other price structures and patterns.
The Benefits of Trading Rounding Tops and Rounding
Bottoms
The main bene ts of the rounding top reversal and rounding bottom
reversal lie in its ability to catch other traders off guard. To traders who have
not learned to identify the structure, it can simply look like a period of
consolidation before trend continuation. However, as we have learned, the
underlying order ow shift taking place is signi cant and when the reversal
occurs, it can be powerful, offering great opportunities for traders.
As we have seen in the examples, because the changeover in order ow
causes demand or supply to become pent up like a coiled spring, as the
rounding top breakout or rounding bottom breakout occurs, the moves can
nd a lot of momentum. Remember, to set your stops and targets and
always focus on achieving a good risk to reward pro le.
Diamond Chart Pattern
The diamond pattern is an advanced chart formation that occurs in the
nancial markets. It is one that is less well known to technical traders and
investors alike. As such, many traders are not very familiar with its structure
or trading application. In this lesson, we will dive into the speci cs of
recognizing and trading the diamond pattern.
The diamond formation is part of the family of classical chart patterns. But
unlike the commonly seen ag, pennant, head and shoulders, and rectangle
patterns, the diamond chart pattern occurs less frequently on the price
chart.
As such there are not as many opportunities to trade the diamond chart
pattern as some of the others mentioned. Nevertheless, technical traders
should become familiar with this pattern as it provides a solid trading
opportunity when it is recognized early enough.
The diamond chart pattern is often confused with the head and shoulders
chart pattern. Though there are similarities between both of these
formations, there are some distinct differences between the two formations.
We’ll be diving into the speci cs of the diamond pattern structure
momentarily, but for now it’s important to understand that the diamond
pattern is a more advanced chart pattern that has reversal characteristics.
The diamond pattern occurs most often after a prolonged trend phase.
When it occurs within the context of a bullish market, the pattern is referred
to as a diamond top, or a bearish diamond pattern due to its bearish
implication. Conversely, when it occurs within the context of a bearish
market, the pattern is referred to as a diamond bottom, or a bullish diamond
pattern due to its bullish implication.
Let’s take a closer look at the illustration below which details the structure of
the diamond chart pattern.
On the illustration above we can see what the diamond top formation
appears as. Notice the strong uptrend preceding the diamond structure.
The market rallies to a high point, and then retraces lower. Then the market
makes a higher high. After which the prices drop below the previous swing
low and creates a new swing low point.
Prices then move higher once again creating the peak within the structure.
Following that, the price action moves lower, but does not take out the
previous swing low point. Prices resume higher once again, and settle below
the peak point reached earlier. The price again falls, and it stays above the
prior swing low point.
Once this price action completes, we can draw four fairly equal sized
trendlines that connect the swing highs at the top of the structure, and the
swing lows at the bottom of the structure. This creates a diamond shaped
appearance which is where the pattern gets its name from.
Sometimes, we may not see each and every up and down price leg noted
earlier within the pure de nition of the diamond structure. This will not
necessarily invalidate the labeling of the structure as a diamond pattern.
What is most important is that we can plot four trendlines around the
structure that are of relatively similar length.
Bearish Diamond Pattern
The bearish diamond pattern variety, also known as, a diamond top was
described in the earlier section. Again the pattern can be seen as a series of
up-and-down price swings that resemble the structure of the head and
shoulders formation.
More speci cally, the left shoulder and head will connect to form a trendline,
the head and the right shoulder will connect to form a second trendline. This
completes the trendlines for the upper section of the bearish diamond
formation. Then, for the lower portion, we would connect the swing lows
within the troughs which will form a V shape.
Referring to the illustration above, we can see the bearish diamond pattern
once again. Additionally on this diagram we have shown the breakout entry
signal for trading the structure, along with the target level for the pattern. As
for the short entry signal, that would be triggered at the break and close
below the lower right-hand line sloping upward.
Some traders prefer to wait for just the breakout below this line without the
requirement for a close below it. This is a viable entry point as well, however,
keep in mind that it will lead to more false signals as compared to waiting for
the breakout and close condition.
The price target for the structure is calculated using a measured move
technique. More speci cally, we want to measure the peak to valley distance
within the structure, and then project that distance downward from the
breakout point. This will provide a level at which we can expect the followthrough on the breakout to begin to subside or potentially reverse. As such,
it represents an excellent take pro t level and trade exit.
Bullish Diamond Pattern
Let’s now look at the inverse of the bearish diamond pattern, which is the
bullish diamond pattern. A bullish diamond pattern variety, also referred to
as a diamond bottom, occurs in the context of a downtrend. Typically we will
see a strong price move lower, and then a consolidation phase that carves
out the up and down swing points of the diamond bottom.
In this case, the appearance will be similar to the inverted head and
shoulders formation. We will connect the peaks and troughs within the
structure in a similar manner as described earlier. Once we have drawn the
four trendlines around the structure, and can con rm that the four lines are
fairly equivalent in size, we will be able to validate the structure as bullish
diamond pattern.
Looking at the illustration above of the diamond bottom, we can see that
the formation is preceded by a downward price move. We can then see the
up down sequence within the diamond structure which is outlined by the
two upper trendlines pointing downward, and the two lower trendlines
pointing upward.
The long entry signal is triggered at the break and close above the upper
right-hand line sloping downward. Again, the preferred method would be to
wait for an actual breakout and close rather than just a breakout above this
trendline in order to prevent the occurrence of false signals and potential
whipsawing price action around this area.
We would calculate the upper price target by measuring the high to low
within the enclosed structure. Once we have that distance calculated and
plotted on the chart, we would extend that same distance from the
breakout point projected upward to arrive at the preferred target level. Once
price reaches this level we should consider exiting the entire position or at
least a large portion of it, and possibly leave a smaller portion open if desired.
Diamond Pattern Trading Strategy
Let’s now shift our focus to creating a trading strategy that incorporates the
diamond pattern. We have seen that the diamond technical formation
occurs both in the context of an uptrend and a downtrend. When a bullish
price move precedes the diamond pattern it is called a diamond top and
which has a bearish implication. When a bearish price move precedes the
diamond pattern is called a diamond bottom which has a bullish implication.
In this particular diamond trading strategy, we will attempt to keep it as
simple as possible by utilizing a pure price action-based approach. We know
that the diamond pattern is one that does not occur very often in the
market. As such we do not want to put too many variables into the strategy
which would lter out an otherwise good set up.
Here are the rules for trading the diamond top chart pattern.
A clear uptrend must be in place prior to the diamond top formation.
The diamond top formation should be clearly de ned with four trendlines
that connect to each other, and which are relatively close in length to one
another.
Enter a sell order at the market upon a break and close below the upward
sloping trendline near the completion of the pattern.
The stoploss should be placed at the most recent swing high preceding the
breakout point.
The target level will be calculated based on a measured move calculation.
We will measure the distance between highest high and lowest low within
the structure, and project that downward from the breakout point. This
projected level will act as the pro t exit point.
There will be an additional time stop component on the trade. Speci cally, if
after the passing of 50 candles, the price has not triggered either our
stoploss or target level, we will immediately exit the trade at the market.
Here are the rules for trading the diamond bottom chart pattern.
A clear downtrend must be in place prior to the diamond bottom formation.
The diamond bottom formation should be clearly de ned with four
trendlines that connect to each other, and which are relatively close in
length to one another.
Enter a buy order at the market upon a break and close above the
downward sloping trendline near the completion of the pattern.
The stoploss should be placed at the most recent swing low preceding the
breakout point.
The target level will be calculated based on a measured move calculation.
We will measure the distance between highest high and lowest low within
the structure, and a project that upward from the breakout point. This
projected level will act as the pro t exit point.
There will be an additional time stop component on the trade. Speci cally, if
after the passing of 50 candles, the price is not triggered either or stoploss or
target level, we will immediately exit the trade at the market.
Diamond Trade Setup In EURCAD
We’ll now look at an example of the diamond pattern in the Forex market.
This example of the diamond top trade set up is based on our previously
outlined strategy and will be shown on EURCAD cross currency pair. Below
you’ll nd the price chart for the EURAD pair based on the eight hour trading
timeframe.
As we’re well aware, our diamond strategy is based on a pure price action
analysis. As such we will need to monitor the price closely for potential signs
of an emerging diamond chart formation. If we look at the EURCAD price
chart again, we can see the diamond top pattern outlined. Notice how the
diamond formation starts with prices making a swing low, and then making
a higher high, followed by another swing low, followed by another swing
high, and nally the last swing low before the breakout.
Notice how the two lines connecting the swing highs, and the two lines
connecting the swing lows are of relatively similar lengths. This provides us
with con rmation that this is indeed a symmetrical diamond top pattern,
worthy of further consideration.
Now that we have labeled the structure as a diamond formation, we must
ensure that there is a clear uptrend preceding this diamond top formation.
As we can see from the price action leading up to the diamond top, there
was a strong and consistent uptrend present in the market. This con rms
our trend requirement per our outlined strategy. And with that we can make
preparations for a potential short trade.
If you look closely at the price chart you can see where that breakout and
close occurs to the downside. This is also shown by the red arrow noted as
Sell. Once this sell entry order was executed, we would turn our attention to
the stoploss and take pro t level. The stoploss would be placed at the recent
swing high prior to the breakout point. You can see that noted on the price
chart above the sell trigger.
The target level is calculated using a measured move technique. That is to
say that the price move following the breakout from this structure should be
at least the length of the entire structured measure from peak to valley. That
distance is represented by the orange vertical bracket shown to the left of
the diamond top chart formation. The second bracket represents an equal
length to the rst bracket measured from the breakout point. You can see
where the target level rests based on this measured move target technique.
You will note that after the breakout there was some follow-through to the
downside, however, the bearish momentum zzled out, and the price began
to trade in a sideways manner forming a long horizontal consolidation
structure.
But based on our strategy rules, we would not have had to endure this
extended consolidation phase. This is because our diamond trading strategy
incorporates a 50 candle time stop. You can see where that time stop would
have triggered taking us out of the position entirely. Though the price did
not reach our intended target, we would’ve still booked a pro t on the trade.
Diamond Pattern Signal In USDJPY
We will now illustrate an example of the bullish diamond bottom pattern. For
example, we will be looking at the daily chart of the US Dollar to the
Japanese Yen forex pair.
If we look at the lower part of this price chart, we can see the forex diamond
pattern outlined by four trendlines. Notice how the center of the diamond
bottom formation has the longest length within the formation. We can see
the two swing high points that connect each of the two upper sections of
the diamond bottom formation. Similarly we can see the two swing low
points that connect each of the two bottom sections of the diamond
bottom formation. This overall structure resembles a diamond appearance,
and each of the four trendlines containing the price action within the
pattern are of relatively similar length.
Now that we have properly classi ed this as a diamond formation, let’s now
dissect the other aspects of this potential trading opportunity. We know that
based on our strategy rules, the diamond bottom pattern should be
preceded by a clear downtrend. Referring to the price chart once again, we
can see that this condition was met. The prices were moving lower in a nice
stairstep manner prior to the formation of the diamond bottom.
At this point, we could move forward with preparing for a potential long
trading opportunity. If you look closely at the trendline that acts as our signal
line, you will note that there was initially a false breakout to the upside. This
then led to the price action breaching the lower right-hand trendline
temporarily, but then the prices recovered and the second breakout
opportunity provided us another buy entry. As soon as this buy order was
executed, we would have placed a stop loss at the most recent swing low
preceding this breakout.
The price target would be measured using the measured move method. We
would calculate the peak to valley length within the diamond bottom
formation and then project that upward from the breakout point. The left
vertical bracket represents the high low of the diamond bottom formation,
and the right vertical bracket shows that projection from the breakout point.
As we can see, the target was reached quite easily, and occurred prior to our
50 candle time stop exit. As such would have been able to capture the entire
price move from the entry to the target level.
Summary
We have learned that the diamond pattern can have both a bullish and
bearish implications. A bullish diamond pattern is often referred to as a
diamond bottom, while a bearish diamond pattern is often referred to as a
diamond top.
Diamond reversal patterns are seen across all different types of nancial
markets including the stock market, forex market, crypto market, and
futures markets. The diamond pattern is not seen as often as many other
classical chart patterns. However, it is important that you understand the
pattern and are able to recognize it, because when it does occur, it can
provide for an excellent trading opportunity.
Based on backtesting we have found that the diamond top pattern which
occurs after a rise in market prices tends to provide for a higher probability
trade set up then the diamond bottom pattern which occurs after a decline
in market prices. You will need to do your own testing to see if this tendency
aligns with the markets you trade.
Cup and Handle Pattern
We have discussed many different types of chart patterns to date. Today we
will talk about a somewhat lesser known pattern but one that is still highly
effective. I am referring to the Cup and Handle Pattern for Forex trading. The
following material will outline the unique structure of this pattern as well as a
strategy for successfully trading it.
The Cup and Handle pattern is a chart gure, which has a bullish potential.
The pattern could appear after a price increase or a price decrease. Of course
the pattern has its bearish equivalent, the Inverted Cup and Handle, which
we will touch upon later as well.
It is important to remember that the pattern could act as a reversal or
continuation signal. This depends on the price move prior to the pattern
formation. We could have a bullish Cup and Handle after a bullish price
move, in which case the pattern will be considered a continuation. If the
bullish Cup and Handle comes after a bearish price move, it will act as a
reversal pattern.
Structure of the Cup and Handle Technical Pattern
The Cup and Handle pattern is aptly named because this technical pattern
actually resembles a cup with a handle on the chart. The pattern starts with
a price decrease, where the Forex pair gradually changes its direction.
The change in the move is so gradual that the price action creates a rounded
bottom on the chart. The beginning of the price decrease and the end of the
price increase are approximately on the same level. This rounded structure is
the Cup portion within the pattern.
Then comes the handle, which is expressed by a bearish price move. In
many cases, the handle is locked within a small bearish channel on the chart.
Below you will see a sketch of the Cup and Handle formation:
This is the shape of a Cup and Handle pattern. Sometimes, the beginning of
the decrease and the end of the increase could diverge in terms of the level
they are supposed to be located at. However, a small discrepancy between
the tops of the two trends is admissible.
The handle should reach the mid. point of the Cup and Handle pattern. The
decrease could stop a bit before the midpoint, or could go a bit below.
Cup and Handle Formations in Forex
There are two variations of Cup and Handle chart patterns in Forex based on
their potential. There is the bullish Cup with Handle and the bearish Inverted
Cup with Handle.
Bullish Cup and Handle Pattern
The bullish Cup and Handle pattern is the one we have been discussing so
far. It starts with a bearish price move, which gradually reverses. The new
bullish move nishes approximately around the top of the prior bearish
move. Then the price action begins to create the handle, which is a bearish
channel type structure.
When you con rm the pattern, the price is likely to break the channel of the
handle, initiating a bullish move. This move has two targets. The rst target
equals the size of the channel during the handle. The second target equals
to the size of the cup starting from the moment of the breakout.
Below you will see an example of a bullish Cup and Handle pattern:
This is the H1 chart of the most traded currency pair – EUR/USD. The time
frame covered is August 10-18, 2016. In the middle of the image you see a
bullish Cup and Handle pattern, which is illustrated with the blue lines on
the graph.
See that the bottom of the pattern is rounded. The two tops of the cup are
approximately on the same area. The handle starts right after the end of the
cup. Notice that it is sloped downwards.
The price action breaks upwards and we apply the two targets. The rst one
is with the size of the handle and the second with the size of the cup. They
are both applied from the moment of the breakout as shown on the image.
Bearish Cup and Handle Pattern
As we said, the classic cup and handle pattern has its bearish equivalent –
the bearish Cup & Handle, which is a mirror image of the standard Cup &
Handle. Therefore, the bearish Cup and Handle is upside down.
The bearish Cup & Handle starts with a bullish price move, which gradually
slows down and turns into a bearish move. The handle of the pattern is
slanted upwards.
The con rmation of the pattern comes when the price action breaks the
channel of the handle in the bearish direction. The rst target of the pattern
equals to the size of the bearish channel around the handle, applied
downwards starting from the moment of the breakout. The second target
equals to the size of the cup, applied downwards starting from the moment
of the breakout.
This is how the bearish Cup with Handle pattern appears:
Here we are looking at the H4 chart of the GBP/USD Forex pair for May 5 –
June 8, 2016. You will see the bearish Cup and Handle pattern on this chart.
Notice that the pattern comes after a bullish trend, which means it acts as a
reversal.
Also notice how the pattern starts with a bullish trend, which gradually
reverses. In this manner, the created top is rounded. At the end of the
reversed bearish move, the price reverses again and starts the creation of a
bullish handle.
After the price breaks the handle downwards, we see the creation of a new
bearish move. Thus, we apply the two targets as shown on the image.
Drawing the Cup and Handle
Drawing the Cup and Handle pattern might seem tricky at times. The reason
for this is that the pattern cannot be drawn with a straight line. Due to the
rounded bottom (or top) of the pattern, you should use a curved drawing
tool.
If the pattern is bullish, take the two tops of the cup and stretch a curved
line downwards until the rounded part reaches the low of the pattern. Then
take the right side of the cup and draw the shape of the bearish handle.
If the pattern is bearish, take the two bottoms of the cup and stretch a
curved line upwards until the rounded part reaches the top of the pattern.
Take the right side of the cup afterwards and draw the shape of the bullish
handle.
Cup with Handle Signal
The Cup with Handle formation has a very speci c signal. When we get this
indication, we can buy or sell the Forex pair depending on the potential of
the pattern.
The Cup with Handle trigger signal is at the break out of the handle. The
handle breakout acts as a con rmation of the pattern. When you identify
the handle breakout, you can plot the two targets of the pattern – the size of
the handle and the size of the cup.
Below you will see a valid Cup with Handle Signal:
Above you see the bearish Cup with Handle Pattern. The con rmation signal
of the gure comes at the moment when the price action breaks the handle
downwards. This is shown with the red circle on the chart. After the bearish
Cup with Handle signal, you can start pursuing the bearish potential of the
pattern.
Cup and Handle Trading System
Now that we have a better understanding of the structure of the pattern, we
are going to summarize some trade management ideas around this pattern.
Let’s take a look at a potential Cup and Handle trading system and the rules
we need to follow when trading this pattern.
Opening a Trade
As we point out earlier, you would prefer to open a trade after con rming the
Cup with Handle pattern. If the pattern is bullish, the signal should be a
bullish breakout through the handle. In this case, you could open a long
trade.
If the pattern is bearish, the signal should be a bearish break out of the
handle. In this case, you could open a short trade.
Stop Loss
As with most if not all patterns, a stop loss is needed when you trade the
Cup and Handle price pattern.
If you trade a bullish Cup with Handle pattern, you should place your stop
loss order below the lower level of the handle. If you trade a bearish Cup with
Handle your stop loss order should be placed above the upper level of the
handle.
Take Profit
The take pro t targets for the Cup & Handle corresponds to the two targets
we mentioned earlier. Your rst take pro t target should be located on a
distance equal to the size of the handle, starting from the breakout point. If
this target is completed, you can then start pursuing the next target. The
second target is located on a distance equal to the size of the cup, applied
again from the moment of the breakout.
An additional option is to stay in the trade as long as the price is trending in
your favor. You may not want to completely exit the trade, where the price
move is offering more potential to add pro t to your trade. Thus, you can
watch for price action clues in order to extend the gains from the trade.
Trading the Cup and Handle Chart Pattern
Now let’s demonstrate the bullish and the bearish Cup and Handle strategy
in action. The examples below will help clear out any questions you may
have related to trading the Cup and Handle pattern in Forex.
Bullish Cup and Handle Trading Example
We will start with the bullish Cup and Handle trading example. The image
below will show you how to trade this version of the pattern from an actual
chart:
This is the H4 chart of the AUD/USD Forex pair for Sep 3-21, 2016. The image
shows a bullish Cup with Handle chart gure with the blue lines on the
chart.
The con rmation of the pattern comes in at the green circle at the moment
when the price action moves above the handle. You would typically look to
buy the AUD/USD Forex pair when the candle closes above the handle.
The stop loss order of this trade needs to be placed below the lowest point of
the handle. This is shown with the red horizontal line on the image. The
magenta arrows and lines represent the two targets on the chart.
As you see, the price reached the rst target of the pattern prior to the entry,
had you waited for the candle close to enter. Sometime afterwards, the price
action reaches the second target on the chart. You have the option to close
your entire position at this second take pro t target. However, you could opt
to hold a portion of the trade for further gains if you see price action
continuing to trend upwards. The yellow line on the chart is an upward trend
line, which measures the bullish activity of the price action. You could hold
the trade as long as the price action is located above the yellow bullish trend
line. The break through the trend line is shown in the red circle on the chart,
which would signal an opportune time to close out the trade in its entirety.
Bearish Cup and Handle Trading Example
Let’s now switch to the opposite version of the pattern. Below you will nd a
bearish Cup and Handle trading example:
This is the hourly chart of the USD/CAD Forex pair for March 25-30, 2016. The
image illustrates the way a bearish Cup and Handle pattern could be traded.
The pattern is illustrated in blue on the chart. The rounded part is the Cup
and the small bearish channel is the handle. The con rmation of the
formation is illustrated with the small green circle when the price action
breaks the handle downwards. This would be an advantageous time to sell
the USD/CAD Forex pair.
The stop loss order of the trade needs to be placed above the handle. Its
location is shown with the red horizontal line on the chart.
The two targets are applied using the two magenta arrows and horizontal
lines. As you can see, the price action reaches both of these targets in the
next two hourly periods. The trade could be closed afterwards. However, if
you decided to keep a portion of the position open, how might you manage
the trade?
See the second big bearish candle, which reaches the second target. The
high and the low of this candle could be used to draw a horizontal support /
resistance zone on the chart. The trade should be closed if the price action
breaks the upper barrier. You can even adjust your stop loss order right
above the upper level of the zone.
As you see, the price action breaks to the lower level of the S/R zone, which
indicated that the price will probably continue in the bearish direction. Note
the large bearish move on the chart following the breakdown.
What are Chart Pattern Failures?
There is a wide array of chart patterns within the study of technical analysis.
Some of these are continuation patterns, and others reversal patterns. Each
individual chart pattern has a certain potential that is often achieved. But in
some cases, a chart pattern can fail and we will end up with a losing trade.
Fortunately, for the astute trader this can sometimes provide for an
alternative trading scenario. Today we will learn how to trade and pro t from
chart pattern failures.
A chart pattern failure occurs when a speci c chart pattern does not
materialize as anticipated and is unable to achieve its potential. As a result,
the price action moves in the opposite direction than expected. Many times,
this causes an in ux of stop loss orders to be triggered and can provide for a
unique trading opportunity.
Let’s take a look at an example of a chart pattern failure:
The image above shows a Double Bottom chart pattern, which is marked
with the blue lines on the chart. The magenta line is the Neck Line of the
pattern, which plays the role of a con rmation signal. In the green circle you
see that the price action breaks the neck like, con rming the bullish
potential of the pattern. However, the price action returns and initiates a
strong bearish move. The Double Bottom setup failed, which has now
caught many traders on the wrong side of the market.
Failure Patterns and Trapped Traders
Being able to understand why failure patterns occur on the chart is essential
for your success when trading a technical analysis pattern failure. Therefore,
in this section, we will discuss the reason for the occurrence of failure
patterns in Forex.
The truth is that failed patterns are usually part of something bigger. In
many cases, you will see that your failure pattern is evolving into another
pattern, either on your trading timeframe or a higher degree timeframe. Let’s
take for example of the Double Bottom pattern from the image above. If you
take a closer look, you will notice that the failed Double Bottom eventually
turned into an Expanding Triangle.
On the chart image above, we have outlined the upper and the lower level of
the Expanding Triangle, which appears to be the real pattern on the chart.
Although the Double Bottom pattern (blue) gets con rmed, the price action
returns and creates another bottom on the lower level of the Expanding
Triangle. This provides us valuable information that the black horizontal
support is of great importance in accessing future price development.
Therefore, when the price action breaks the lower level of the black
Expanding Triangle you have suf cient reason to believe that the downward
move from the newly established pattern is likely. As you can see, the
triangle reaches its full potential after the breakout.
Types of Failure Patterns in Forex
There are two basic types of failed chart patterns in Forex. They can be
classi ed based on how far the price action has gone into the creation of the
pattern. There are chart patterns, which are already con rmed, but still fail,
and there are patterns, which have formed, but have not yet been
con rmed.
Non-Confirmed Patterns that Fail
These patterns are forming or formed on the chart, but actual breakout
through the trigger line of the chart gure has not yet taken place. Further
price action then proves that the anticipated pattern is false and the price
proceeds in the opposite direction than expected.
Already Confirmed Patterns that Fail
These chart patterns, have already been con rmed by their trigger line,
creating the con rmation. This means that the trader has a very strong
reason to pursue the potential of the chart formation. However, the pattern
fails and leaves many traders on the wrong side of the market.
How to Trade Failed Chart Setups
In many cases before you trade a failed chart setup, you will probably have
experienced a loss caused by the initial false breakout. This is totally normal,
and you should not worry about that as long as you follow a strict risk
management strategy. When you realize that the pattern is a fakeout or
false breakout, you can prepare to trade in the opposite direction to catch
the real price move.
Next, will now discuss some basic rules you can use when trading failed chart
setups.
Entering a Failed Pattern Trade
To enter a Failed Pattern trade, you should rst identify the point of failure in
the pattern. Typically, you will notice a weak breakout and follow thru, then a
swift return to the breakout point. You should simply notice that the price
action is beginning to return to the critical level of the pattern on stronger
momentum compared to the momentum during the initial breakout. When
this happens, then you have a good possibility of a failed chart pattern setup.
You can enter a failed pattern trade when the price action breaks and closes
beyond the original breakout level, but this time in the opposite direction.
Stop Loss on a Failed Pattern
You should never leave your failed pattern trade setup unprotected.
Therefore, you should always use a stop loss order when trading this type of
pattern or any type of forex setup for that matter. After all, nothing is 100%
certain in Forex. Even failed patterns can fail, so you must make sure to use
prudent risk management measures at all times.
You should position your stop loss order at least beyond the critical level,
which was used as the trigger line for the original chart pattern, before its
failure.
Take Profit when Trading Failed Patterns
The use of proper price action rules is crucial when trading and managing
failed patterns in Forex.
The rst thing that you should do when you consider a failed pattern trade is
to observe if the price action is likely to evolve into a new chart pattern. If this
happens, then you should simply follow the take pro t rules of the newly
created pattern to exit your trade.
However, if the price action doesn’t create a new chart pattern, you should
then rely on your price action knowledge to carefully manage the exit. This
could be in the form of channel breakouts, ascending/descending price
moves, other chart or candle patterns, breakouts from support/resistance
levels, etc. When the currency pair starts to stall, you should keep a lookout
for reversal signs and continually monitor swing highs and lows for potential
exit opportunities.
Failed Chart Pattern Trading Example
Now let’s demonstrate the way a failed pattern technical strategy might
work.
This is the H4 candlestick chart of the USD/CHF currency pair a.k.a. Swissy for
Sep – Oct, 2016. The image shows how to take advantage of failed patterns in
Forex and how you can achieve nice pro ts from this type of trading
scenario.
The image begins with a range, which comes after a price decrease. The
range is indicated with the black lines on the chart. Suddenly, the range
breaks through the lower level, creating the impression that the price action
will resume the bearish trend. However, three periods later we see that the
Swissy is back into the black channel. Only a couple of periods later we see
the Swissy breaking the black horizontal channel through the upper level on
strong momentum. This provides a high probability entry signal that is
generated after the USD/CHF fails to breakout through the lower level.
You could buy the USD/CHF as shown in the green circle, placing a stop loss
order below the lowest part of the range. The proper place for your stop loss
order is shown with the red horizontal line below the range. In this rst
example, this range trade falls into the group that attains initial con rmation
but fails after all and reverses direction.
The price action then enters a bullish trend. See that on the way up the
Swissy creates a Rising Wedge chart pattern. This is a chart formation, which
is known to have a strong bearish potential. You will need to exit the trade if
the price action breaks the wedge downwards. Furthermore, such a
breakout will coincide with a trend line breakout as well, giving you an even
stronger exit signal.
However, the Rising Wedge pattern fails to break the downside as
anticipated. The good thing is that the pattern fails before any bearish
con rmation, giving us no reason to close the trade.
This Rising Wedge falls into the group of non-con rmed patterns that fails to
materialize. In this particular case, the pattern failure is in our favor because
we are already in a long position.
The bullish trend resumes afterward. The price creates another big bullish
impulse. Then a new corrective move appears on the chart. This correction
has the shape of an Ascending Triangle (yellow) and breaks the trend line
sideways.
Here, based on the current price action clues, it would be wise not to close
the trade at the time of the trend line breakout, but instead hold it until the
triangle breaks downwards. Unfortunately, the yellow triangle breaks
downwards indeed, generating a strong exit signal.
Soon thereafter, the price action quickly reverses and moves above the
triangle. So the initial downside move was a false triangle breakout.
Therefore, you should reopen the trade after the upper level of the yellow
triangle is broken and you should place a stop-loss order below the lowest
point of the yellow triangle as shown on the image.
The price action creates another bullish impulse, which on rst sight
con rms the resumption of the bullish trend. However, the price action
creates a couple of unsuccessful attempts to return above the green bullish
trend line. And this is a strong signal that the bullish trend is probably done
after all.
Also, the blue bearish channel at the end of the chart shows that the price
action is descending, giving you further reason to exit the trade.
This is a very good example of how to effectively trade failed chart patterns in
combination with price action. The image demonstrated three chart
patterns that failed. Two of them were con rmed patterns that eventually
failed. One of them was a non-con rmed pattern that failed which we used
to recognize the real potential direction of the trend.
Useful Indicator for Trading Forex Failure Patterns
Although trading Forex failure patterns using pure price action analysis is
very effective, I will also show you a valuable indicator to con rm a pattern
failure. And this is the Volume Indicator.
There are two simple rules when trading with the Volume indicator.
If a breakout occurs on high or increasing trading volume, then the
breakout is most likely authentic.
If a breakout occurs on low or decreasing volume, then the breakout is
probably false.
These two rules are extremely helpful when distinguishing real patterns
from fake patterns.
By using the Volume Indicator, you will reduce the number of cases where
you become trapped inside a failed chart pattern. Furthermore, if a pattern
fails, then you will be able to identify it easier and position yourself to take
advantage of the actual move afterward.
Trading Failed Chart Formations with the Volume
Indicator
And now we will demonstrate how exactly to combine the Volume Indicator
with chart pattern failures to achieve better accuracy in our trades.
Above we have the daily chart of the EUR/USD for the period is Aug – Dec
2015. The image shows a chart pattern failure, which transitions into an
opposite move. At the bottom of the chart, we have the Volume Indicator,
which helps us to gauge market conditions better.
The chart begins with a price consolidation, which has the shape of a
Symmetrical Triangle. As you can see, the pattern makes a clear breakout
through the upper level. However, the volumes at this time are decreasing,
which is shown with the red line on the Volume Indicator.
After the price breaks the triangle upwards, it creates a top and reverses. The
price moves below the original breakout point of the Symmetrical Triangle.
At the same time, the Volume Indicator prints a big bar, which breaks the
downward sloping red line showing the progressively decreasing volume.
This gives con rmation for the price drop, creating a nice opportunity to
short the EUR/USD.
You could sell the EUR/USD in this case, placing a stop-loss order at the top
created through the upper level of the triangle.
As you can see, the price of EUR/USD decreases afterwards. The trend is
relatively sharp compared to the previous price action and it is easy to
distinguish. However, the bottom formations begin to slow down and
consolidate. This creates another pattern on the chart, which is marked with
the yellow lines. It is a Falling Wedge formation. This pattern is known to
have a strong bullish potential. Therefore, your rst thought when the price
action breaks the wedge upwards should be to exit your trade.
But is this wedge a real or a false chart pattern? Well let’s take a look at the
Volume Indicator. Notice that volume is increasing at the time of the
breakout through the upper level of the wedge. This implies that the
breakout is likely real and should have a good follow thru. Therefore, based
this assumption, you should use this breakout to close your trade. Notice the
sharp price reversal out of the falling wedge.
The handy Volume Indicator helped guide us during three breakouts. The
rst breakout happened during decreasing volume, which indicated that it
was probably false. The second breakout occurred on high volume, revealing
that it was likely real, and the third one happened on increasing volume,
con rming that it was most likely going to be a real breakout as well.