Indicative Trend Setting Chart Patterns

Technical analysis takes the view that the price is the only commodity that counts. It considers that the market price is the summation of all the hopes, fears, desires and greed of its participant’s and that all future expectations are discounted back into the current price. Therefore technical analysis is really the study of psychology within the market. This means that although the external factors affecting the market may change, the human response to buy or sell does not, therefore what has happened before can easily happen again, even if for different reasons.

With this in mind, let us look at one form of Technical Analysis, and how they are best utilized:

I. Charts

This is the pictorial base from which all technical analysts begin by recording the value of the currency over time. There are two main types of basic price charts:

a. Line charts

b. Bar charts

A line chart is simply a graph of the value of a currency taken at regular time intervals based on current prices.

Altering the time intervals between minute and monthly can change the time horizon of any currency. For short-term expectations the value may be plotted every 10 minutes, for longer-term expectations it is more usual to take the closing price of the day.

A bar chart adds further information. Each bar (representing a desired minute to monthly frequency) has a closing or current price level and is improved by the addition of the open, high and low levels of the currency.

Whether we use line or bar charts, the main ways to obtaining information on future exchange rate movements are through the following:

• Trend lines
• Support and Resistance levels
• Chart patterns

A. Trend lines (Refer to Understanding Trend Analysis)

# 1 Rule to trading, always trade with the trend.

An up trend is characterized by a series of higher highs and higher lows. In bullish conditions, the trendline will be drawn upwards through the lowest prices or connecting a series of higher dips. Similarly a downtrend is exemplified by a series of lower highs and lower lows. In bearish conditions, the trendline will be drawn through the highest prices or connecting a series of peaks.

A sideways trend represents an area where prices move in a flat and narrow range for several days or weeks. This type of market movement is often termed a period of congestion. Rapid price movements usually follow a breakout from a period of congestion, most of the time in the direction of the original trend.

A trendline gains significance from its length (duration) and the number of times it has retraced (testing of a support of resistance level) back in its original direction. A trendline is assumed to remaining existent until it is penetrated. On a bar chart an intra-day (4 hours or less chart) penetration needs to be followed by a close that also breaks the trendline, otherwise it is a false break. To be absolutely certain that the trend has been broken, it is recommended that two successive closes should be outside the existing trend.

B. Support And Resistance Levels

Initially people who begin to look at the market in a technical way, but without constructing charts look for psychologically important numbers at which they think the market will look to reverse direction for a period of time. This is only one of the many approaches used in charting.

Support can be defined as the level from which prices have fallen to, made a dip in the market and then retraced. The reverse is true of resistance levels where price have risen to, made a peak before retracing back to the downside. The more often retracements happen at or around key levels the stronger the support or resistance level becomes.

In psychological terms these levels work because buyers or sellers remember that there was a sharp reaction from the same level last time it was seen. Therefore, at a support level sellers are tempted to take profits, new sellers are reluctant to take positions and buyers are keen to enter the market.

It is always noticeable however; that once a major level has been broken buying (breaking a resistance) or selling (breaking a support) will accelerate.

If a support level is broken, this will then become a resistance level for any rally, while a broken resistance will become a support level for any pullback.

Support and resistance levels take on an added significance when used in conjunction with momentum or relative strength, the latter two factors giving a good indication whether a particular level will hold or be broken. These will be covered in Universal Mathematical Models.

C. Patterns

Although charts are not predictors to the extent of future exchange rate movements, some measurement principle can be adopted relating to the recognition of certain chart patterns. There are a number of patterns, which occurs quite regularly in foreign exchange charts, and we will look at each of these in turn. In doing so, it should be remembered that the changes of a chart pattern producing the desired objective are reduced if there is a strong level of support or resistance before a breakout.

Channels

A channel is effectively two trend lines, which can be drawn in parallel to each other, the higher line acting as the resistance line, the lower line as the support. As with trends channels it can be upward, downward or sideways. In an up channel the support line is the most important trendline, in a down channel the resistance line is the most important.

Usually in a channel, the resistance and support lines will be tested alternately, though this is not essential for a trend channel to exist. If the price breaks out of the channel, then a new trend is said to have developed. This new trend can be short to medium term depending on market momentum and volatility.

Flags And Pennants

These are two short-term patterns that usually form during a brief pause in a strongly trending market. The pattern is characterized by a moderate movement in the opposite direction to the main trend. Again using bar charts this period can last from three to seven days before a sharp breakout in the direction of the original trend is seen.

A pennant is very similar to a flag, but instead of the sluggish pullback, market volatility decreases and price movement remains in line with the trend showing no evidence of retracement. Two points to note are 1) the pennant phase may last longer than the flag; 2) the pennant may take the form of triangles.

Triangles

Triangles take longer to form than pennants or flags and come in four main types: symmetrical, ascending, descending and expanding. They generally form over a period of three days to three weeks and quite often form after a major price move.

This type of pattern characterized by a series of progressively lower peaks and higher troughs is a sign of market indecision. The price usually breaks out of this pattern by an amount equal to the base of the triangle and in the direction of the original trend. As with symmetrical triangles one would expect the move from the apex to equal the base of the triangle.

There should be at least four points of contact to the two trend lines before a breakout occurs. In these patterns, where one of the trend lines is horizontal the direction of breakout can be predicted. For example with an ascending triangle the buyers are clearly more aggressive than the sellers, each attempt at a pullback stops at an earlier stage.

Expanding

This formation does not occur frequently and is likely to be detected at tops and bottoms after lengthy price moves. Again a minimum of two tracking points for each trendline is needed before a breakout.

Wedges

A wedge is basically a sloping triangle, however instead of one of the trend lines being horizontal both trend lines are sloping. In the case of an ascending wedge this suggests there are more participants selling and tends to suggest a loss of upward momentum. The breakout from a wedge is always in the opposite direction to the original move. This can be identified by a retracement that starts lower than the prior peak.

It should be noted that many major trends have come to an end with an ascending or descending wedge.

Head And Shoulders

This is probably the most famous of all chart patterns, but not always the most reliable. When it works it will always be seen as a reversal pattern and consists of four phases.

The first phase is the formation of a small peak (which is the left shoulder), retraces and then is followed by more aggressive buying to create the head, which eventually retraces and tests the support (know as the neckline), followed by another attempt at a rally, which does not produce a peak as high as the head. This is then followed by another test of the neckline.

This particular pattern is seen as a reversal, in which a break of the neckline is expected and the move should be in the amount equivalent from head to neckline.

The unreliability of this move result from the fact that the final test of the neckline does not always result in a break and the move continues in the same direction as before. This means a definite break of the neckline (say 15-25 pips) should be seen before action is taken. Based on momentum, the momentum should be higher during the formation of the left shoulder than the right shoulder to confirm that this pattern is taking place and that buying pressure is decreasing.

Conclusion

Charting is very subjective, three people can look at the same chart and arrive at three separate conclusions about what will happen next. Perhaps the best way to use charts is to:

• Look for the trendline
• Mark support and resistance levels
• Identify the relevant chart patterns

Remember that a trade strategy should always be consistently implemented based upon your prediction of chart movements and not the advice of others.