Learn how to recognize important trading patterns, including Head and Shoulder Patterns, double bottoms and double tops. Tom Hougaard demonstrates how to use these patterns with actual Forex trading examples.

Transcript:

Introduction:
It's virtually impossible to have a course on technical analysis without discussing pattern recognition. And in this chapter we will be looking into such esoteric names as head and shoulder patterns, double bottoms, double tops, wedges and the like.

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Let’s take a look at the axiom of an up-trend. Although Dow Theory was concerned with the overall interaction between different indices, and attempted to gauge the health of the business environment, his work on technical analysis is still applied to any chart.

A bull trend made up of a series of higher highs and higher lows. On the chart this is referred to as “rising tops and rising bottoms”. It doesn’t matter if this is on a 1-min, 5-min time frame, or whatever timeframe you are looking at.

But it raises an interesting point which I want to make sure you understand and appreciate immediately.

My own trading strategies are based on the principle of “fading the short-term trend in the direction of the long-term trend.”

It means that if I see the trend on a 15 min chart is up, I will buy the dips on the 5-min chart, even though it looks as if the market is moving lower on the 5-min chart. I am essentially fading the move on the 5 min chart in the direction of the move on the 15 min chart. Fading means I am going against the trend. I am doing this because I want to trade in the direction of the trend that I am following. We will talk about this concept in far greater detail in a later chapter. For now I want to take you through some of the most popular trading patterns.

What you should know about these trading patterns is that they can occur on any time frame, but it is important that you realise that the longer the time frame you are looking at, the more significant the result is going to be, but it may also take longer to unfold.

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The trading channel is one of the easiest patterns to trade. It is simply a question of connecting a high with the next high and project it in a straight line into the future. It gives you a projection of where the next move in the market will run out of steam. I have included two charts for you. The second chart demonstrates this concept on the EUR YEN chart on a 30-min time frame. As the trend moves lower, the parallel line does a great job in forecasting potential support for the currency pair. At this point as a trader you may either consider initiating a long position, or if you had been short the market, you may want to move your stop down tight to protect your profits on your position.


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The uptrend on this chart follows the parameters for one of the fundamental laws of technical analysis perfectly. The market is progressing higher in a series of higher highs and higher lows. What I need you to focus on though is where the market stops on the retracements. A retracement is a move against the trend.

One of the primary laws of technical analysis is that of support and resistance. It states that once an area of resistance has been broken, it should now act as an area of support. In this case you can view a previous top as an area of resistance. Once that top has been penetrated by price, and the trend is carrying the price higher, you can draw a horizontal line through the OLD high to indicate that this area may now be a place where traders will be looking to buy.

The law states that once old support has been broken, it may now become new resistance. Once resistance has been broken, it may now become new support.

I use the word “may”, simply because there are no certainties in the market. Anything can happen, so it would be wrong for me to say that it categorically will become support or resistance.

This stair step pattern is the hallmark of a trend. As you will see next, the same principle applies to the downtrend.

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The down trend is simply the opposite of the up-trend. Here we are seeing a series of lower highs and lower lows. On this chart I have shown a “trend line” break, which is often a good indication that one type of trend is over and a new trend is starting.

You should notice how the lows on the way down now define areas of resistance on the retracement moves higher. This is the hallmark of support and resistance and trend analysis. If you are looking to get “short” the market, the place to consider placing the position is in the area of resistance, as defined by a horizontal line from the old low.

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The double top is one of my favourite patterns. It is easy to spot, in that you are looking for a market which is trading at or near an old top.

In the chapter on candle charts I talked about different styles of trading. As a trader you can be aggressive, neutral or cautious. I would not like to say what I recommend. I think you should find your own trading style. For myself, I am sometimes VERY aggressive, and sometimes I am neutral or even cautious. It varies with the circumstances of how I feel about the trade or the market in general. For example if I know that a major holiday in the US is approaching I tend to be more cautious because I know many traders will leave their trading desks early and it can severely affect liquidity.

When it comes to double tops I like to be aggressive, if the market warrants it. I prefer to sell short the market at or even just above the old high, speculating that the market will reverse back down again. I need to have some compelling reasons for doing so. It could be that the larger time frame I am looking at is pointing down.

A more cautious approach would be to wait for the market to print a bearish candle after having made the double top, such as a bearish engulfing pattern or a doji, and then go short. An even more cautious approach would be to wait for a trend line break like you are seeing on the chart in front of you.

It depends on your trading style. The more aggressive you are, the more you will make when you are right, because you are getting in at a better price than if you wait. The drawback is that you are not waiting for confirmation, and you may have jumped the gun by going in too early.

It is a fine balance between risk and reward and only you can answer what is best for you.

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The double bottom is traded in an identical manner to the double top. I have printed the volume figures underneath the chart to indicate that volume is surging on the lows. Whenever I trade stock index futures, I will inevitably look at volume as well, because I know from experience that volume will surge when important highs or lows are made. Looking at it on a graph with the benefit of hindsight is one thing, but actually trading it in real-time is a different matter all together. However, if I can get you to recognise the patterns in the calm and comfort outside the trading ring, there is a much better chance you will recognise them when you are in the thick of the trading day.

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The head-and-shoulder pattern is perhaps the most widely recognised pattern in the financial markets. I have heard die-hard journalists on CNBC talk about this pattern, and it is true that the forecasting power of the H&S pattern is powerful. It is easy to spot but it may not be so easy to trade. It depends on how aggressively you want to trade it.

Lets have a look at the setup. The market is making a series of higher highs and higher lows, so we know the trend is up. The first real alert you receive that a Head and Shoulder pattern is forming comes when the trendline, which has connected all the lows, has broken. The patterns often forms a horizontal or near horizontal support line.

On the head and shoulder pattern this is called the neckline, and it is an important ingredient in the pattern because if the neck line break, the head and shoulder pattern has been confirmed.

The right shoulder is the place where I as an aggressive trader will be looking to place a short position in this pattern. I will be looking for the market to make a candle pattern, indicating that the market is headed lower.

Most patterns come with a target price. For the head and shoulder pattern the target is calculated as the distance the market has travelled from the top of the head to the base line or the neckline. The target is found by adding this distance to the base of the neckline, projecting a target to the downside.

The much less aggressive approach to trading the head and shoulder pattern is to place a short sell order near or at the base line or neckline, and hope that the market will come back to fill your order. Sometimes the market simply runs away when the pattern has been confirmed, and you may not get filled.

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The inverse head and shoulder pattern will signify that a low is in the making. It can be traded exactly like the head and shoulder pattern and the warning will, like the H&S pattern, come when the trend line has been broken.

One important aspect of the head and should pattern and the inverse head and shoulder pattern is that the volume tends to decrease on the middle part of the pattern. If you are trading a stock or an index, you should take a look at the volume and get a sense of the declining volumes for confirmation of the pattern.


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Some of the patterns that I frequently trade are nothing more than continuation trades. It means that I am looking for patterns where I feel the market have gone into a temporary sideways range before continuing in the direction of trend it had before entering into the consolidation.

A typical bullish flag tends to go into a channel, and within the channel you will find 3 peaks and 3 troughs. When you trade what you perceive to be a bullish flag you have several choices.

You can be aggressive, or you can wait for confirmation. An aggressive stand would be to attempt to buy point E, where the market is touching the lower end of the channel, before it pushes higher. Point E is the most optimal place to trade from, but you are also at a point on the chart where there is absolutely no confirmation that the bullish flag is about to materialise.

If you wish to wait for confirmation, you will wait for point C to be broken. This is the point where the market breaks through the trend line created by the 3 lower peaks, within the trading channel.

The unique feature of the bullish flag is that it comes with a price target. On the price example the base is made at 85 and the top of the first leg higher is at 90. Once the market has traced out the sideways trading range, it breaks out from a trend line at 89. Given the first leg up was 5 points, we would expect a bullish flag to at least move another 5 points higher from the point where it breaks the trend line.

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The bearish flag is exactly the opposite of the bullish flag. We are again expecting the market to trace out a sideways range of 3 waves up and down, within a channel, before resuming the downtrend. The initial move lower on this example was from 1.50 to 1.45. Once the market breaks the lower trend line, I will again expect it to move the same distance as it did before coming into the channel.

The use of targets is only a guide. The trader will have to asses the market and move their stops as they see fit. My personal feeling about trading is that I want to move my stop-loss to break-even as soon as I reasonably can. My view is that the sooner I can get a free trade, the better I am positioned.

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In the field of pattern recognition you will encounter pennants, symmetrical triangles as well as ascending and descending triangles. All of those will appear on the screen while I explain how they are traded.

But remember, they are all very much identical in nature. All of them make use of trend. They are all considered holding patterns before the original trend continues, whether it is to the upside or the downside. As such you can view these patterns as a temporary pause in an existing trend.

Like all patterns they can be traded on any time frame. It doesn’t matter if you use them on a 5-min chart or an hourly chart or even a daily chart. The principle behind them is the same. There is a pause in the trend, and this pause tends to play itself out in the form of 3 legs up and down, before the trend resumes.

Of course this is a rather stale way of viewing the markets, and if anything, you will have realised by watching these tutorials that I firmly believe that the markets are fluid, and as such your approach to the market should be fluid too. The ability to change one’s mind in the face of changing circumstances is one of the primary traits of the winning trader, if not the most important one.

All the patterns shown here have the ability to forecast the end of the move. The theory for pattern recognition states that the length of the move going into the pattern will be the length of the move coming out of the pattern.

You may recall how the head and shoulder pattern measures the length from the top of the head to the base line or neck line, and then projects the length of this line from the point where the market penetrates the neck line. Well, the same holds true for the patterns discussed in this section. It can be a useful tool for traders to have some idea of how far the market is likely to move, but there is also an inherent danger in having too rigid a mind set about how far the market will go.

If you cast your mind back to the chapter on trend analysis, you will remember how much emphasis I put on the merit of trends, and how they tended to move a lot further than most people anticipated.

The best thing you can do for yourself and your education in pattern recognition is to learn these patterns off by heart. They will not take very long to commit to memory because they are all so similar in nature. From then on it is a question of beginning to recognise them in real-time and begin to observe their behaviour.

What you have been presented with here are the typical patterns, but don’t forget that in the financial markets, things rarely pan out exactly as it is described in the text books, and as such, it is a good idea to keep and open mind, and above all always to have a stop-loss in place when you are trading the financial markets, because in this game, anything can happen.