In the previous article, we discussed the subject of Japanese candlesticks, which are one of the foundations of modern technical analysis. We analyzed some patterns but focused on one or very few candlesticks. Today we are going to talk about larger chartist patterns and how to trade them.
Trend reversal patterns
The double top
This is a chartist pattern in the shape of an M. The bottom of the letter is the neckline or support line. The asset hits the resistance zone twice with the first support point on the neckline after the first top. After the break of the neckline, which validates the chartist pattern, the price moves towards the next support. Furthermore, a pullback is possible towards the neckline which will act as resistance. The probability of success of this pattern is around 75% This type of pattern is quite simple to trade, in fact, when prices break their support and validate the pattern, this level will turn into resistance. We can then anticipate a retest or pullback, and open a short position on this level. If this happens in the form of an inverted hammer or bearish engulfing and on high volume, it will increase the probability of success. The shoulder-head-shoulder The SHS is an iconic chart pattern of technical analysts. It is composed of three highs and two lows. It indicates in 90% of the cases, an exit by the bottom and thus a possible reversal of the trend downward. The first and third peaks are the shoulders while the second represents the head. The first shoulder is often accompanied by significant volume. Then, a new top forms with volumes often lower than the first shoulder. This should already give us a hint! As I have already discussed in other articles, when prices form highs and volumes do not follow, this is a very bad sign. Finally, the second shoulder shows buying weakness and will break the neckline with strong volumes. There are several ways to trade this type of chartist pattern, the first being to wait for the break of the neckline and a possible pullback to go short. This is the safest way to trade this type of pattern, but the pullback may not occur and you are left without a trade. This happens and we will focus on the next trade. The other way to trade a shoulder-to-shoulder pattern is to short the second shoulder using Japanese candlesticks, volume, and technical indicators to take a position. The risk is that since the pattern is not finished, it may not happen at all and your trade may turn into a loss. This is best done by advanced traders.
Bearish continuation pattern
These are chartist patterns that appear when the trend is neutral. As a result, prices get stuck in a price range. Often, the exit of the stock price from the rectangle depends heavily on the previous trend. When it is visible on your screens, a pullback cannot be ruled out. Again, there are several ways to trade rectangles, which are nothing more than trading ranges. If you feel comfortable and have experience, then a strategy of buying the bottom of the range and shorting the top of the range will pay off. You can use oscillators to make it easier for you. If you are more of a beginner, then it will be more advisable to wait for the breakout of the range and take a position on the pullback, in this case, we play the continuation of the trend which is less risky.
There are two main bearish continuation triangles which are the symmetrical triangle and the descending triangle. These are chartist figures that appear when volatility decreases, leading to a compression of prices. Buyers and sellers are on equal footing with volume declining as the tip of the triangle approaches. This type of pattern often leads to an explosion of volatility on the way out of the pattern, much like a pressure cooker, too much compression leads to an explosion and often an impulsive move in the direction of the trend.
This type of triangle is formed by a downtrend line and an uptrend line in a symmetrical fashion, the best way to trade it is to wait for a bottom exit and enter on a pullback. Descending Triangle It is formed by a horizontal support line and an oblique resistance line, in 2/3 of the cases it gives an exit from the bottom. This reinforces the current bearish trend. Here again, the best way to trade this pattern is to wait for a downward exit and go short at the resistance.
Chartist figures are a great tool to add to your palette, but as with each of the methods we cover on this blog, they should not be used alone. I emphasize that it is only a tool. In the end and at the risk of repeating myself, discipline, rigorous backtesting of your strategy, and control of your emotions will remain the key to your trading success.