Chart patterns are a great addition to the trader's toolbox. They help increase a trader's insight into trading sentiment and ultimately give indications as to the next likely move.
Unlike some of the newer techniques and gimmicks in the world of trading, chart patterns are a time-tested trading technique that has proven to be a solid, reliable, prediction tool.
So why is it that so many traders seem to struggle to identify chart patterns and watch them “play out” in a reliable fashion?
To help bring some clarity I’m going to address the Top 4 mistakes traders make when trading chart patterns.
This post has grown into over 3000 words so I have decided to break it into 4 separate posts which I’ll release over the next several days. Today - mistake #1.
Some of you reading this are old enough to remember when Bill Clinton was president and he famously said during his impeachment proceedings, “it depends upon what the meaning of the word ‘is’, is”.
Apparently, chart pattern enthusiasts must have been listening intently and taking cues because I’m not sure I have run across any trading technique with as many variations of definitions as there are in the world of chart patterns. What one person calls a Wedge, someone else calls a Triangle, and someone else calls a Pennant.
What IS the meaning of IS?
Chart patterns do not have to be complicated but it does make it very confusing when people mix definitions up. To make matters worse, a lot of those confusing definitions come from people who are actually well meaning and good traders - they just confuse everyone!
I saw a blog post a few years back from a company who “teaches” people how to trade the market. The writer was trying to make the point that chart patterns are unreliable and traders should use this company’s proprietary trading indicators instead.
As his example to prove how unreliable chart patterns are, this blogger chose a stock that had made a new high, pulled back nearly 50% over a 3-5 month period, then traded back to the same high over another several months, and pulled back 50% again, only to trade higher.
Uh yea, if that guy thinks that’s a Double Top he’s never going to be able to effectively trade chart patterns.
In this extreme example, the blogger totally misses the point because he is trying to categorize a double top by saying “any time a stock hits the same resistance and pulls back it’s a double top”.
On a daily chart, a Double Top will rarely take more than 3-6 weeks to develop, and the retracement point is typically about 3-5%, maybe pushing down to a 10% retracement. Trying to contend that a pattern has taken over a year to develop, and the retracement represented a 50% is a horrible interpretation of a Double Top.
Below you can see what a real Double Top looks like. Additionally, this chart presented two real Double Bottoms as well. This is a textbook picture of what Double Tops and Bottoms should look like. Notice the peaks (in the tops) and valleys (in the bottoms) are only about 4-6 weeks apart. The retracements are 3-5%, not exceeding 10%, and they trade exactly as expected on the break of the neck lines (the confirmation point).
I do want to make one point on the details of the retracements. The general rule is 3-5%, not to exceed 10%. Does that mean that if a pattern appears and it represents an 11.5% retracement but every other aspect fits the textbook definition of the Double Top that the pattern is void? No, not at all. It's a general guideline. In a similar way, if the peaks or valleys are 8 weeks apart but everything else is perfect, it's probably just fine to call it a double top or bottom.
It does, however, mean that our blogger friend who tried to say the previous example with a nearly 50% sell-off over a year - well he's just wrong. It doesn't fit ANY of the definition! In general, 3-5% upwards of a 10% retracement is acceptable. If you get much beyond that then you should be suspect. If you see a 15-20% retracement - it's probably not part of a Double Top.
By the way, in the case of that blogger, had he accurately identified the patterns, they would have played out exactly as he expected as there were several great patterns in the chart. Below you can see the same chart, accurately analyzed, and you can see at least 5 clear patterns, all of which played out according to their statistical odds.
Accurate identification of patterns is very important if we want to get the best insight from what they are telling us as traders. When someone decides to argue over the meaning of a pattern and what defines what, it can get a bit dicey and frustrating.
Every pattern fits into one of these categories and we have a fairly tight definition as to what we consider a pattern. The free Chart Patterns Flash cards will help you learn to identify them, as well as the Chart Patterns Course which you can get here.
• Thomas Bulkowski has made a career of selling chart pattern statistics. Although I do not always agree with his statistical research, his definitions are usually pretty good.
• The classic technical analysis book by Edwards and Magee, originally written in the 1930’s, has some of the best information on chart patterns and technical analysis in general. You can find an updated edition on Amazon.
Chart patterns are a great tool to help traders. But when definitions get blurred, the effectiveness of using chart patterns becomes very checkered. If you want to be really great at trading with chart patterns, learn to correctly identify the patterns so there is no confusion as to what it is you are actually looking at on the chart.
In my next post on this subject we will look at the second mistake traders often make when trading chart patterns.