Last updated on May 14th, 2020
Trading chart patterns has been a swing and day trading approach for decades of chart pattern traders. Edwards and Magee helped bring this form of chart analysis into the public eye and it’s been a popular approach ever since.
Finding a chart pattern can be done through scanners or manually but one thing traders seem to miss is the potential the chart pattern may have.
It is one thing to spot something like a head and shoulders or a triangle pattern, but it is another thing to know if there is a probability that we can see some movement in the stock, the futures market or the Forex pair you are looking at.
However, there’s an element that is not fully understood by many traders and this is recognizing the potential of chart patterns.
How and When The Chart Pattern Forms Is Important
When trading price action and forming structure like patterns, what is crucial to look at is the moves the market had previously had.
As an example, when trading a pullback, we should see thrusting price action occurring before the pullback begins. By seeing that price movement, we increase the odds that traders expect another move up (or down) and will position to take advantage of the next leg in price.
- Strong move higher in price
- Head portion forms after the strong move higher
- Strong reversal off of the highs
Adding those together, the context where we find our head and shoulders forming, gives you a stronger edge that we may be looking at a deeper retracement and a potential longer term trend change.
Lower Probability Head and Shoulders Opportunity
In this case, there was no extended move into the reversal pattern.
This pattern was configured to break to the downside, but the move preceding the pattern had already moved price lower.
The chart pattern does exist here and there’s probably less potential for a nice move down – unless there’s an older technical level and strong move ready to be taken out.
In this case, there wasn’t anything significant that might precipitate a fast move lower and that is evident by the consolidation that formed at the hard right edge.
Strong Price Moves Can Remove The Chart Pattern Edge
Let’s consider all price movement as a build up or release of energy.
- A market that has already moved significantly lower has probably already expended a reasonable amount of selling energy (and the theory likely holds true for the reverse case)
- If a market also exhibits behavior where further probes lower struggle to precipitate strong selling, you have to consider that the market may at the very least, be starting to stabilize to the downside.
Does this mean that a market configured like this can’t move lower?
It also doesn’t mean that it won’t accelerate to the downside either but we are talking about probability. What it does mean that there’s probably less potential energy left – at least for the time being.
If we look at a market configuration in the first chart example, we would see that there was already a move higher and energy had been expended to the up side.
An example of why there could be a chance of a reversal for this configuration would be where momentum traders who’d bought in the first up leg, see support levels failing and quickly cover their positions.
Another point could be made about acceptance of value. If a market moves out of one area where lots of trading activity has taken place and fails to hold a new area, the chances are pretty decent that the first area will be retested – i.e. the market reverses direction.
I talk about using price failing to hold new levels in my article about profiting from trapped traders.
Continuation or Reversal Patterns – What Are You Looking For?
The key aspect to unlocking chart patterns by identifying which side of the pattern the greatest potential energy is, is to know which type of pattern you’re looking at.
There are reversal chart patterns such as the head and shoulders pattern we’ve looked at here and there are continuation patterns such as flag and triangle chart formations.
- Reversal patterns have the greatest energy in the direction from where they originate from.
- Continuation patterns want to break out in the same direction as they have already moved.
Chart patterns can be great if you use them well. But if you don’t, you can find yourself quickly under water when the strongest potential energy starts to take hold of the market.
Reading overall price action is vital for chart pattern traders. Don’t just look for the price pattern you want to trade but also understand the context to how the pattern formed.
In doing so, you have a greater chance of being on the right side of the market when the strong moves come back into play.