Recognizing the Potential of Chart Patterns

A little while ago, I went through how to spot a good chart pattern and where I think some people make mistakes. What I’ve noticed since then is that people in the trade room have progressively improved their ability to spot a clean pattern. However, there’s an element which I believe is still not fully understood. This is recognizing the potential of chart patterns.

Contextual Significance

Let’s start off with a recap of what I stated on this aspect of chart patterns in my original post: –

“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.”

In the example, the EURCAD forex pair demonstrated a head & shoulders reversal pattern with the extreme of the “head” at the high, after a significant move up.

EUR/CAD Daily Chart

This is in contrast to the head and shoulders pattern that was pointed out to me last week in Gold Futures.

Gold Futures Chart

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. Yes, the pattern exists however, 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.

Digging Deeper

If you think about it in terms of market energy things become a little clearer. 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? No. It also doesn’t mean that it won’t accelerate to the downside either. But it does mean that there’s probably less potential energy left – at least for the time being.

If we look at a market configuration more akin to the example in EURCAD above, 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.

Recognizing the Potential of Chart Patterns

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 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.

Trade well.

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