Last updated on December 19th, 2016
All too often, I see traders who fail to understand the meaning of a price chart. They look at different types of candlesticks and candlestick patterns in isolation without attaching any meaning to them in terms of trading activity and context. Inevitably, this type of trader will identify patterns where really there are none and will suffer the consequences
– often they then turn into traders who no longer “believe” in patterns.
So I will attempt to demonstrate to you that with appropriate application they do work and that you can incorporate patterns into you methodology.
Patterns, Patterns, Everywhere
The Human mind is excellent at pattern recognition. From our earliest hunter-gatherer days where quickly recognizing situations that might put us in mortal danger, to finding a mate, pattern recognition is hard-wired in the form of instinctual drives.
Whilst this might have served us well in our caveman days and perhaps even in other careers today, the trouble is that it’s not always appropriate in financial trading. There’s an endless stream of what on the face of it might look like patterns, but really have very little significance.
The problem comes when we act on patterns, as we’re hardwired to do and they don’t come to fruition. Fleeing where there was not really a predator or misreading the signals of a potential mate, are unlikely to have the same level of impact as trading a candlestick pattern where there isn’t one (especially if you’re prone to holding on to your losers).
Back to Basics
The real reason patterns exist is because of imbalances in supply and demand. If you don’t recognize this fact, then it’s going to be difficult for you to know when a pattern is valid or not.
Take for example the Bund on 7/30/14. At 08:30 EST, the US Q2 GDP was released and surprised the markets with a reading of 4.0% where 3.0% had been expected.
Taking a look at the 233tick Trend Jumper trade plan chart below, you might not have initially recognized a candlestick pattern.
But if you understood that heavy supply came into the market, moved it quickly lower and then it struggled to make a retracement of any significance, you’ll have realized that this is the basis for an inverted flag continuation pattern.
Switching to a 3 min chart revealed the pattern.
A key facet to whether a pattern has any genuine significance is what the market has done beforehand. The fairly recent head & shoulders pattern in the EURCAD currency pair occurred after a strong move higher in the preceding months.
Given that it’s a reversal pattern, the location demonstrated the intent of the pair to explore lower prices further and attempt a deeper retracement.
Unlike the EURCAD, the H&S ‘pattern’ highlighted in the AUDNZD is rather less significant. True, it did try a little lower, but the likelihood is that you’d have struggled to find a profitable trade here.
And as much as after the event it looks like nothing, I know that there are plenty of traders out there who, without the benefit of the subsequent action that I’ve included in this chart, would have jumped at the chance of trading this highly dubious pattern.
Finally I’d like to point out that as Mark Douglas says in his trading psychology book, Trading in the Zone:
Anything Can Happen
So it’s important to identify the best and highest probability point of trade entry to begin with. I see numerous traders taking trades at what they anticipate as the right shoulder of a H&S pattern or within what they are seeing as the “flag” of a flag pattern.
The trouble is, unless you have another genuine reason to take these trades, you can’t know whether the full pattern will form.
Once a pattern does form and you take your trade, you must know what you want to subsequently see. If you see a break of the H&S neckline for example and strong buying meets it, the chances then are elevated that you’ll see at least a test of the right shoulder area.
This is because with a break of the neckline, the expectation is that there is a strong probability of long liquidation entering the market. Knowing this can give you an edge even when the pattern fails.
When do Candlestick Patterns Really Work?
So when do candlestick patterns really work?
All candlesticks are is simply a historical representation of trading activity. Patterns can help you tip the odds of a successful trade in your favor if you’ve understood what is happening in the market in terms of the context of the current situation, you stick to relatively clear patterns and you recognize that no matter what, nothing will work in the markets 100% of the time.
Identifying situations where there’s a high probability of some sort of directional move is what helps us to form our edge in trading the markets – candlestick patterns, if used correctly, can be a method/supportive method for doing so.