When I find myself perusing historical price charts, from the 1920s and 30s, I’ll admit that I should probably get out more.
But the sorry truth of the matter is that I am that obsessed with price chart patterns, and – in particular – with how we human beings repeat our stories of success and failure, again and again and again.
Even though I can’t profit from these ancient market moves, I never ceased to be moved by the picture of hopes, dreams, pain and panic that these scratchy lines across the page paint. But then that’s probably just me.
But, of course, there are many lessons to be learned in these old charts – lessons that we can apply to our trading today to guide us on what markets are likely to do next.
2 price chart patterns set to be key in 2012
I think we’ll see them crop up again and again. They are each giving an important message about market sentiment… they can each tell us where the market might be moving to… and they each have little traps that you need to be careful that you don’t fall into.
But if you can get your head around these patterns, and start spotting them when they appear on your charts – AND, most importantly, know when to act on them and when not to act – you’ll be one step ahead of the crowd.
Head and Shoulders
A head and shoulders pattern is one of the most reliable reversal signals.
The pattern looks something like this:
It has three peaks, with the middle peak above the other two. The two “shoulders” should look similar and be close to the same price. Ideally, the right-hand shoulder will be lower.
The neckline is a line that runs through the two “armpits” of the pattern. And it’s important to note that confirmation only comes once the price crosses the neckline.
The image above shows a bearish head and shoulders top. But the pattern can also be flipped on its head for a bullish head and shoulders bottom. Something like this …
The Head and Shoulders Traps
There are two important things to be mindful of when you’re considering trading on a head and shoulders pattern.
The first is the likelihood of a pullback. Pullbacks on this pattern are common. The price may break through the neckline, and then pull back to the neckline, or it will often break back through the neckline.
Bear in mind that statistics show this happening about 50% of the time.
But, provided your rewards are sufficiently greater than your risk, you should be able to stomach this kind of success rate.
The second warning on head and shoulders pattern is to do with the inverse pattern…
Do not to approach a head and shoulders bottom with the same kind of enthusiasm you might show for a head and shoulders top.
Just because they are essentially the same pattern – doesn’t mean that markets behave the same way at bottoms as they do at tops.
Head and shoulders bottoms are considerably less reliable, so demand more confirmation with these signals.
Triangles and pennants
These are real workhorses of the pattern world. They appear very often in our charts, and they tend to perform pretty well.
They show the price consolidating before continuing in its original direction, so the signal comes when the price breaks out of the triangle shape, and resumes the direction of the trend.
Pennants are shorter than triangles, and should have a “flagpole”. This is an unusually steep period of trading leading into them…
Once you’re familiar with this pattern, you’ll see them popping up all over your charts.
Triangle and Pennant Traps
Again, there are a couple of common pitfalls that traders can fall into.
The first is the pullback. It is very common that after the breakout occurs, we’ll see a pullback to the line that we’ve just broken through before the trend continues. In this example, the price breaks well below the resistance level that was just breached.
The second trap comes in the shape of the most perfectly formed triangles! If your triangle is almost complete (i.e. the upper and lower lines have almost met to form the apex) – the signal loses its strength. Once the trading becomes this tight, a breakout is considerably less valid.