Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
How I Use Chart Patterns to Trade (Part 1)
11/30/2009 10:23 am EST
Chart patterns are often the very first introduction that traders have to charting the markets. There is something inherently familiar about chart patterns, and because of this, there is a comfort level to trading these common shapes. Triangles, rectangles, wedges, channels, and more—these are the patterns that are often identified on a chart, and through these patterns, key decisions can be made as to how and when to enter a trade. In that way, I believe chart patterns are a tremendous anchor to what we know as we venture into the unknown waters of trading for the first time.
My trust in charts begins with my belief that the news is built into price. I'd have to say that much of my success in the trading game comes from separating news from price. Knowing what has been discounted into the markets can come from chart patterns because price analysis is an effective way of taking fear and greed out of your trading. It's easier to absorb news and reports when you have a measuring stick by which to gauge the public response. That's the key benefit of being a chartist!
I started charting in high school. I didn't really know I was charting but it was the only way I could track the rise and fall of my one and only stock, IBM, and my two mutual funds. As my interest in the market grew, so did my formal education into charting and also technical analysis. It was through charting and chart patterns that the movement of the market began to take shape and make sense to me.
Fast forward almost two decades, and I've taught the same strategies and market approach to thousands of people around the world. I've noticed that something curious often happens after a trader discovers chart patterns: They leave them behind. Most often, it's in the pursuit of finding something more sophisticated or more advanced.
Somewhere along the line, we're brainwashed into thinking that chart pattern analysis is not enough. In some ways, that is both right and wrong. There are specific questions any trader can learn to ask to confirm that the pattern is a quality pattern. Without having checks and balances for "grading" patterns, there is a high likelihood that a trader will enter too many sub-standard formations and begin to lose trust in not only their own pattern identification, but also the confidence to act on specific pattern triggers.
But chart patterns can be traded in any market and on any time frame. For that reason alone, there is a lot of benefit to learning how to identify them. A picture is worth a thousand words, and if you ask me, a chart is worth even more.
We will examine a number of charts together and the main goal of this in-depth discussion is to begin training your eyes to notice the nuances within patterns. Another key to trading chart patterns is to understand the building blocks of the patterns. The building blocks of all chart patterns are trend lines, support, and resistance. All patterns are some sort of combinations of uptrend lines, downtrend lines, and horizontal support and resistance levels. If you can identify the "lines and levels" on a chart, then you can begin putting these patterns together because you—most importantly—understand how to find the building blocks of the patterns.
Think about it this way: What is a symmetrical triangle other than the intersecting of a downtrend line and an uptrend line? An asymmetrical triangle is simply the combination of one horizontal level and one trend line.
MORE: Case Studies Using Recent Dow, S&P Chart Patterns|pagebreak|
Take a look at this 15-minute chart of the Dow Jones (Figure 1):
This chart clearly shows the set up and subsequent follow through of an asymmetrical triangle as it breaks down through the uptrend line support. The pattern gives us the "boundaries" of the trading range. It identifies where the buyers support prices and where the sellers are pushing prices lower. If one of these levels is broken, it is believed that the traders who kept prices from moving beyond this boundary are "defeated," and prices will continue through that line or level. Again, the pattern gives us the visual cue, and the lines and levels offer the decision levels at which we can act.
This pattern is known as a congestion pattern as prices are squeezed into a range as they move sideways. The sideways movement is a market or chart cycle known as distribution. These are also referred to as stages. Everything has a cycle, or stage. Watching children grow up, we refer to stages and these stages have specific criteria, or features, which distinguish one stage from another. The housing market also has stages: A buyer's market, seller's market, underdeveloped, overdeveloped. The same is true of the financial markets. These cycles or stages reflect the fear, greed, or uncertainty of the market.
There are four cycles or stages: Accumulation (narrow sideways range); distribution; (wider, more volatile sideways range); mark up (uptrend); and mark down (downtrend). There is no specific order in which these markets develop, rather that each cycle/stage has features specific to it alone. Range-bound markets that develop in a narrow range moving sideways are the key to an accumulation cycle. On the other hand, distribution is also a range-bound market, but the key to distinguishing an accumulation cycle from a distribution cycle is in the price range. Distribution cycles are wider and more volatile, and the support and resistance ranges will most often develop into triangles. Ranges can also develop in markets that are trending, and when this happens, they are referred to as ascending and descending triangles and wedges.
This 60-minute chart of the S&P 500 (Figure 2) is making lower highs as it bounces within the ranges of a falling wedge.
While the asymmetrical triangle of the 15-minute Dow Jones chart occurred in a sideways market, this wedge has developed in a shallow downtrend. A downtrend is defined by the lower highs it makes. These lower highs often form a downtrend line, which is resistance. Downtrends are marked by downtrend lines (resistance), while uptrend lines mean support.
To be continued tomorrow in Part 2.
By Raghee Horner
Raghee Horner is a Traders Expo speaker and the author of High Profits in High Heels: Secrets from Today's Top Women Traders.
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