|
     |
| How to Detect a Trading Pattern |
|
(first appeared in June 2003 edition of 'Leverage' in Shares Magazine) Effective trading is an acquired skill. It’s so easy to become frustrated when we are seeking to develop an understanding regarding pattern detection. Over time you will acquire this ability and be capable of trading all types of market conditions. By recognising the common macro patterns that are used in technical analysis, you are more likely to accurately interpret future share price action. These patterns combine well with other components of technical analysis such as support and resistance and the use of indicators. They are applicable on charts of any time period such as daily or weekly charts. Over the next few articles in Leverage we will look at each of these patterns, discuss the location and psychology behind the formation, as well as the strategies you can use when you notice these patterns in the future. You will get a chance to study the graphical representation as well as the location and psychology behind the pattern. I cannot promise that
you will make money by reading this series of articles. But I can tell
you that you’ll at least be a big step closer to improving your
trading results. It will be up to you to use the information provided to
deal with the psychological principles inherent in trading. Let’s kick
off with some of the more common macro patterns with which you may come
into contact. Double
Top Description Double top patterns form during an existing uptrend. These patterns are characterised by a strong level of resistance that is touched on two separate occasions by subsequent price action. For each of the patterns discussed, the peaks or troughs may not necessarily be exactly symmetrical. Real life rarely translates into perfectly formed patterns, so accept a degree of variation from the stylised diagram below.
Location This is a significant top reversal
pattern. Support is formed at the ‘neckline’. When support or the
‘neckline’ is broken, the reversal pattern is confirmed. Trade in
the direction of this break of support. These patterns can be seen on weekly or
daily charts and even intra-day charts. The most valid patterns are
derived from weekly charts over a medium-term time frame. If a double
top forms in an existing downtrend, this can be considered a
continuation pattern, and adds strength to the downward momentum. It
reveals an unwillingness of buyers to buy at higher prices, and this
must be taken into account to trade this pattern effectively. Psychology The market has tried to rally two
significant times. It has struggled unsuccessfully to close above the
price shown at the level of resistance. When support at the neckline
fails, the market is flooded with fear, so the sellers outnumber the
buyers. However, if the share price trades above the resistance, this is
bullish. The majority of technical analysts tend to be ‘trend-followers’. They wait for a trend to display a particular direction, prior to taking action. For trend-followers, there are a few simple rules. The first rule is that if a share is trending up, then buy it. The second rule is if it’s going down, then sell it. Many people over-complicate trading, but in essence, if you become good at reading the direction of a trend, you are well on your way to trading like a professional. Technical analysis is part art and part science. The more you use it, the better you will be able to interpret the signals. Strategy After you have completed your analysis, you will need to work out the appropriate strategy to use in order to profit from your findings. This involves deciding which type of vehicle is appropriate to make money from your observations, eg shares, derivatives or futures. Each strategy needs to be firmly based on the findings of your analysis or you will be destined to lose money. Some markets will move more slowly, thus are ‘easier’ to trade. The returns to be expected from these markets are lower in comparison to more leveraged areas. Other markets are incredibly volatile and require a different method of monitoring in order to protect your capital but the returns can be very impressive. There is no reward without risk. To obtain exceptional rewards you must be prepared to accept a higher level of risk. If you notice a double top pattern that
is in the process of forming, and you were planning on buying the share,
it may be wise to wait and see whether the pattern is going to be
confirmed before allocating capital towards it. If there is trading
above the level of the double top, you can consider this signal to have
‘failed’, and your purchase of the share can go ahead. When you notice that a share is in the
process of forming a double top, this can act as an ideal set-up for a
short sold position. Alternative choices could be to enter a written
call position, or a bought put position. Any of these alternatives will
capitalise on a downtrending stock. Waiting for the neckline to ‘break’
and for share price activity to appear below the support of the neckline
could act as a trigger. This trigger is especially potent if the share
price drops through support on a long bearish candle with increased
volume levels. (A bearish candle, often shown as black, is characterised
by a closing price being located below the opening price) This provides
unequivocal evidence that the tone of the market has changed from
bullish to bearish. If support holds however, the double top could be a
continuation or a holding pattern that could only be considered bullish
when the share trades above the level of resistance formed by the two
peaks. Double
Bottom Description During an existing downtrend, this pattern is characterised by a strong level of support that is touched on two separate occasions by the share price action.
Location This is a significant bottom reversal pattern. Resistance is formed at the ‘neckline’. When the share price closes above this level of resistance, particularly on heavy relative volume, the reversal pattern is confirmed. Trade in the direction of this break of resistance. If the level of support is broken, this is bearish. Psychology The market has tried to continue the existing downtrend on two significant occasions. When the neckline fails on heavy relative volume, the market becomes very bullish, so the buyers outnumber the sellers, and an uptrend is initiated. Strategy Waiting for the neckline to break on a
white, bullish candle (that shows a closing price above the opening
price) with heavy volume could trigger you to initiate a bought call
option position, a written put position, or you may choose to buy the
share. You would need to identify other indications to prompt you to
choose between these potential strategies. For example, there is no
point in entering into a written put option trade that contains
unlimited risk unless the set-up is ideal. The risk must justify the
rewards. The
perfect combination that would encourage me to write a put option,
rather than employ an alternative strategy, would be where the option
had a limited time to expiry in a highly liquid share and option series.
Ideally the volatility set-up would suggest that the option is
over-priced, and that the option is likely to decrease in value.
Comparing the implied and historical volatility levels will assist you
in this quest. It would also be wise to consider the expected strength
of the move. If a strong move upwards is expected, writing a put does
not often represent significant profit potential. It will result in a
small fixed profit, regardless of the strength of the ensuing move in
the expected direction. Buying a call, or the share itself, would
capitalise on a strong move upwards. Triple
Top Description During an existing uptrend, triple top patterns are characterised by a strong level of resistance that is touched by the price action on three separate occasions.
Location This is a
significant top reversal pattern. Support is formed at the
‘neckline’ where the lows of this pattern align. When support or the
‘neckline’ is broken, the reversal pattern is confirmed. Trade in
the direction of this break of support. Psychology The
market has tried to rally three significant times. It has struggled
unsuccessfully to close above the price shown at the level of
resistance. When support at the neckline fails, the market is flooded
with fear, so the sellers outnumber the buyers. If the share price
trades above the resistance, this is bullish. Strategy Trade
these patterns in the same manner you would a double top formation. Triple
Bottom Description During an existing downtrend, triple bottom patterns are characterised by a strong level of support that is touched by the price action on three separate occasions.
Location This is a significant bottom reversal pattern. Resistance is formed at the ‘neckline’ where the highs of this pattern align. When the share price closes above this level of resistance, particularly on heavy relative volume, the reversal pattern is confirmed. Trade in the direction of this break of resistance. Psychology The market has tried to continue the existing downtrend on three occasions. It has struggled unsuccessfully to close below the price shown at the level of support. When the neckline fails on heavy relative volume, the market becomes very bullish, so the buyers outnumber the sellers, and an uptrend is initiated. Strategy Trade
these patterns in the same manner you would a double bottom formation.
|
|
|
Copyright