Trend Trading Report Part Nine - Trend Reversal Patterns

In this Part of the Trend Trading Report we'll cover two common trend reversal patterns. They are:

1. Wedge
2. Head and Shoulders

I introduced you to these patterns in Part Six of this Report. I'll go into more detail here.

There are three phases to note when it comes to trend following patterns. They are:

1.    The candle sticks that form the trend leading to the pattern. They may be trending upward or downward.

2.    The pattern formed by the candle sticks

3.    The candle sticks that form the trend upon exiting the pattern.

Wedge

Below is am image with a rising wedge and a falling wedge.

In the case of a rising wedge, the pattern begins with an upward trend. The pattern is wide at the left and narrows as the price moves higher with the trading range narrowing. In contrast, the falling wedge begins with a downward trend. This pattern is also wide at the left and narrows as the price action moves lower with  the trading range narrowing. The remainder of this discussion will focus on the rising wedge. It should be relatively easy for the reader to understand what is happening with the falling wedge. 

The wedge can be one of the most difficult chart patterns to accurately recognize and trade. The reason is that the price point continues to move in the original trend direction. In the case of a rising wedge the trend continues to move upward with higher highs and higher lows. In the case of a falling wedge, the trend continues downward with a series of lower highs and lower lows.

How do you trade a wedge? Looking at the rising wedge image above you'll see an entry point, a stop loss point, and a target profit level below the rising wedge. In the case of the falling wedge, the target profit level is above the wedge. In both cases the tendency is for a reversal of the original trend.

Conditions required for a wedge pattern include the following:

1.    There must be a trend in existence leading up to the wedge.

2.    The upper resistance line must touch the price action at least twice, preferably three times

3.    The lower support line must touch the price action at least twice, preferably three times.

4.    Volume should be expected to decline as prices rise and the wedge takes shape. Once the price action breaks from within the wedge pattern, the volume should be expected to increase.

Head and Shoulders

The head and shoulders pattern is one of the easier patterns to recognize once the Trader is aware of it and is looking for it. Below is an image of the head and shoulders pattern and the inverse head and shoulders pattern.

The head and shoulders pattern appears at a top in the price action. Looking at the image above, you'll see the left shoulder where the upward trend formed a peak followed by a decline in the price. When the price rises again, it forms a higher peak referred to as the head. After a price decline from the head, the price once again moves upward forming a new peak that is lower than the peak formed by the head. The formation of the head and shoulders pattern is never as perfect as the image shown above. With a little practice the Trader will be able to filter out the noise in the price action around the head and shoulders pattern.

The inverse head and shoulders pattern (see image above on the right) is formed at the bottom in the price action. The left shoulder appears in a V shape when the price moves downward and then moving higher. The upside down head is formed when the price declines to a lower level. After the price rises from the head, the price once again moves downward forming a new peak that is higher than the peak formed by the head. Once again the inverse head and shoulders pattern is never as perfect as the image shown above.

Looking at the images above, you'll see a line designated as the neckline. In the case of the head and shoulders pattern (see image above on the left), the neckline is drawn with a straight line that connects the low after the left shoulder with the low created after the head. In the case of the inverse head and shoulders pattern, the neckline is a straight line that connects the high after the left shoulder with the high created after the head.

The pattern is never confirmed until the pattern is complete.

The correct way to trade this pattern is to wait for a breakout to occur. With the standard head and shoulders pattern, the breakout will be to the downside.

Stop loss settings for the standard head and shoulder pattern should be placed just above the right shoulder or just above the head.

The profit target is calculated by subtracting the low point of either shoulder from the peak price at the head. Subtract this number from the breakout entry price to get the profit target.

Summary

Both of the chart patterns shown above are trend reversal patterns. That means that the majority of the time, the trend approaching the pattern is in the opposite direction from the trend exiting the pattern.

End of Part Nine

Part Ten of this report will be released in about one week. The topic is “Developing Your Own Trend Trading System". This will be the last report of this ten-part series. I hope you've found it to be beneficial.

Trend Trading Report Part VIII - Trend Following Patterns

In this Part of the Trend Trading Report we'll cover five trend following patterns. A trend following patterns is continuation patterns that represents a form of consolidation that results in a continuation of the trend leading up to the continuation pattern approximately 70% of the time. The five trend following patterns covered in this report are:

1. Symmetrical Triangle
2. Ascending/Descending Triangle
3. Pennant
4. Flag Pattern
5.  Rectangle

I introduced you to these patterns in Part Six of this Report. I'll go into more detail here.

There are three phases to note when it comes to trend following patterns. They are:

1. The candle sticks that form the trend leading to the pattern. They may be trending upward or downward.
2. The pattern formed by the candle sticks
3. The candle sticks that form the trend upon exiting the pattern. 

Symmetrical Triangle

The symmetrical triangle is formed by a descending resistance  trendline and an ascending support trendline. The angle of the resistance line above the horizontal line drawn through the middle of the pattern, is approximately equal to the angle of the support line below the horizontal line. These two lines come together at the point of the triangle. The price action will move up to the resistance line and bounce off the resistance line. The price action will then proceed to move down toward the support line and bounce off the support line. Eventually the price action will breakout to the upside or the downside.

If preceded by a descending trend, the Trader should expect that the price action will break through the support line. If preceded by an ascending trend, the Trader should expect the price action to break upward through the resistance line.

Investing is a game of statistics. Traders should never expect things to go in the predicted direction. Price action can go against the odds forming a new trend direction from the previous trend direction.

Following is an image of a bear symmetrical triangle meaning that the price action was trending down leading up to this pattern and the breakout took place in the same descending direction.

Ascending Triangle

Following is an image of an ascending triangle. You will notice that the lower line, the support line, exhibits higher lows as you would expect with a bullish trend. The upper line is essentially a horizontal line that represents resistance. Within the pattern, the price action will bounce between the lower support line and upper resistance line.

The price action leading to the ascending triangle will generally be an upward trend. The price action exiting (breakout out) from the pattern will generally be an upward trend unless the pattern fails.

The price of the security moves between these trendlines until it eventually breaks out to the upside. This pattern will typically be preceded by an upward trend, which makes it a continuation pattern; however, it can be found during a downtrend.

The price action in the midst of the ascending triangle represents the battle between buyers and sellers with the buyers gaining strength, which is why we see higher lows. Because of the strength of the buyers, the price action eventually breaks to the upside.

The height of the triangle at the entry to the pattern (see the red vertical line on the left) is an estimate of the price move to the upside when price breaks out of the ascending triangle (see the red vertical line on the right).

Descending Triangle

Following is an image of an descending triangle. You will notice that the lower line, the support line, is flat. The upper line, the resistance trendline is sloped downward. This pattern is just the opposite from the ascending triangle. With the descending triangle, the price trend is generally downward where this pattern is formed and the breakout will in most cases be to the downside.. Within the pattern, the price action will bounce between the lower support line and upper resistance line.

The height of the triangle at the entry to the pattern (see the red vertical line on the left) is an estimate of the price move to the downside when price breaks out of the descending triangle (see the red vertical line on the right).

Pennant and Flag Patterns

The next two patterns, the flag and pennant patterns, are also continuation patterns. They're very similar to each other, particularly in their shape. The flag pattern is rectangular and the pennant is in the shape of a triangle.

Both of these patterns generally appear after a spike in the price action, meaning a sizeable movement to the upside or downside. After this spike in price action, there is a sideways price action that forms the pennant or the flag. The pole of the flag or the pennant in the spike in price action leading up to the flag or pennant.

As with the triangular patterns, the price will breakout in the same direction as the spike in price action leading to the flag or pennant pattern.

Generally the size of the spike in price action leading up to the flag or pennant is approximately equal to the size of the price action upon exiting the pattern.

Pennant

Following is an image of a bull pennant that exhibits a strong move upward and it breaks out to the upside.

The pennant looks like a symmetrical triangle formed by an ascending support trendline and a descending resistance trendline. The pennant is generally symmetrical around the horizontal line drawn from the point of the triangle.

Flag

Following is an image of a bull flag that exhibits a strong move upward and it breaks out to the upside. You'll notice how the flag is in the shape of a rectangle formed by two parallel trendline acting like support and resistance until the breakout occurs. Usually the flag will have a slope to it in the opposite direction from the initial spike movement leading to the pattern, as shown in the image below.

Also notice that the size of the movement leading to the flag pattern (see the red dash line on the left) is approximately equal to the size of the breakout move (see the red dash line on the right).

Following is an image of a bear flag.

In both the case of the pennant and the flag, the price movement leading to the flag or pennant should be a strong sizeable move.

Rectangle

A rectangle is formed when the market consolidates in a narrow trading range moving sideways. The rectangle often is formed at the end of a trend as the market takes a breather before moving into another trend. Following is an image of a rectangle pattern.

In some cases, when the breakout takes place, you'll find the price moving back below resistance. Many traders look for price to close above or below the rectangle on two consecutive days before they consider it a breakout.

Summary

All of the chart patterns shown above are trend following patterns. That means that the majority of the time, the trend approaching the pattern is in the same direction as the trend exiting the pattern. Traders that recognize trend-following patterns generally can take advantage of the trend following behavior of the pattern.

End of Part Eight

Part Nine of this report will be released in about one week. The topic is "Trend Reversal Patterns".

Trend Trading Report Part VII - Support, Resistance, & Trend Lines

In this Part of the Trend Trading Report we'll cover support, resistance, and trend lines. Even if you have some experience trading stocks or forex, you're likely to find some valuable information in this part of the Report. Support, resistance, and trend lines are an integral part of becoming a successful Trend Trader. Don't take these subject lightly.

Support
A support line is defined as a price level that acts like a barrier preventing the price of a stock from moving lower. Support is evident in stock charts where the price is trending upward, downward, and sideways. This is important as it points out the fact that the support line can be sloping up, sloping down, or horizontal. In all cases, falling prices have a tendency to bounce off of support and move higher.

Following is a chart where price is moving higher. Note how the straight support line touches the downward dips in price movement at least five places. In each case the price bounced off of support and moved higher. Finding good entry points in your trading will improve when you can properly identify support lines.

Resistance
A resistance line is defined as a price level that acts like a ceiling preventing the price of a stock from moving higher. Resistance is evident in stock charts where the price is trending upward, downward, or sideways. This is important as it points out the fact that the resistance line can be sloping up, sloping down, or horizontal. In all cases, rising prices have a tendency to bounce off of resistance and move lower.

Following is a chart where price is moving lower. Note how the straight support line touches the upward price movements at least five places. In each case the price bounced off of resistance and moved lower. Finding good entry points in your trading will improve when you can properly identify resistance lines. Don't get too hung up by the fact that price penetrated above the resistance line as long as the price quickly retreated below resistance.

Trend Lines

Upward Sloping Trendline

• Upward sloping trendlines are a signal that the demand for the stock is greater than the supply causing a rise in the price of the stock.
• These lines are drawn below the price and connect a series of closing prices (lows).
• On the graph below, note the successively higher bottoms in an upward sloping trendline. If this is truly a trend, the trader will be able to draw a line through a minimum of 3 lows

Downward Sloping Trendlines

• Downward sloping trendlines are a signal that investors are more inclined to sell the stock than to buy it and there is likely more supply of stock to sell than investors wanting to buy it at the current price.
• These lines are drawn above the price and connect a series of closing prices (highs).
• On the graph below, note the successively lower tops in a downward sloping trendline. How many points can you see that touch this trendline? (I count more than 6).

Benefits of a Trendline

• This line makes it easier to see a trend.
• This line helps in the prediction of future price behavior for a stock.
• It helps the trader to see a level beyond which the stock price is not likely to move, a line from which the stock price is likely to bounce.

Summary

For more details, click on support, resistance, or trendlines.

As an optional homework assignment, look at several stock or forex price charts and see if you can identify some upward sloping trendline where you draw the support line under the prices, but where prices touch the trendline at least 3 times. Also look for downward sloping trendlines where you draw the resistance line above the prices, but where prices touch the trendline at least 3 times.

End of Part Seven

Part VIII of this report will be released in about one week. The topic is "Trend Following Patterns".

Trend Trading Report Part VI - Introduction To Chart Patterns

In this Part of the Trend Trading Report we'll cover chart patterns, what do they look like, what are they meant to communicate, and recommendations for their use.

Review: Wikipedia defines a chart pattern as " a pattern that is formed within a chart when prices are graphed. In currency pair trading. C hart pattern studies play a large role during technical analysis. When data is plotted there is usually a pattern which naturally occurs and repeats over a period."

The following chart patterns include multiple candles in different colors and shapes. Note: a black candle/black body is bearish and bearish candlesticks on some currency pair charts may use other colors (e.g. red). A white candle/white body is bullish and bullish candlesticks on some currency pair charts may use other colors (e.g. green).

The descriptions with each pattern are provided by Wikipedia with some additional comments by the author.

Head and Shoulders Pattern

Click on the heading sub-title immediately above for an image of the head and shoulders pattern.

The left shoulder is formed at the end of an extensive move during which volume is noticeably high. After the peak of the left shoulder is formed, there is a subsequent reaction and prices slide down to a certain extent which generally occurs on low volume. The prices rally up to form the head with normal or heavy volume and subsequent reaction downward is accompanied with lesser volume. The right shoulder is formed when prices move up again but remain below the central peak called the Head and fall down nearly equal to the first valley between the left shoulder and the head or at least below the peak of the left shoulder.

Inverted Head and Shoulders Pattern

Click on the heading sub-title immediately above for an image of the inverted head and shoulders pattern.

This pattern is the inverse of a Head and Shoulders. The formation is upside down in which volume pattern is different from a Head and Shoulder Top. Prices move up from first low with increase volume up to a level to complete the left shoulder formation and then falls down to a new low. It follows by a recovery move that is marked by somewhat more volume than seen before to complete the head formation. A corrective reaction on low volume occurs to start formation of the right shoulder and then a sharp move up that must be on quite heavy volume breaks though the neckline.

Triangle Pattern

Click on the heading sub-title immediately above for triangle pattern images.

Triangle Patterns can be broken down into three categories: the ascending triangle, the descending triangle, and the symmetrical triangle. While the shape of the triangle is significant, of more importance is the direction that the market moves when it breaks out of the triangle. In the case of a Symmetrical Triangle, the top line (resistance) is sloped down and the bottom line (support) slopes up.

Flag and Pennant Pattern

Click on the heading sub-title immediately above for flag and pennant pattern images.

The flag pattern is encompassed by two parallel lines. These lines can be either flat or pointed in the opposite direction of the primary market trend. The pole is then formed by a line which represents the primary trend in the market. The pattern is seen as the market potentially just taking a “breather” after a big move before continuing its primary trend.

The bull flag pattern is found within an uptrend in a currency pair. This pattern is named for the resemblance of a flag on a pole.

The pennant pattern is identical to the flag pattern in its setup and implications; the only difference is that the top (resistance) line and bottom (support line) are not parallel, but rather characterized by converging trend lines rather than parallel trend lines.

Wedge Pattern

Click on the heading sub-title immediately above for wedge pattern images.

The wedge is characterized by a contracting range in prices coupled with an upward trend in prices (known as a rising wedge) or a downward trend in prices (known as a falling wedge).

A wedge pattern is considered to be a pattern which is forming at the top or bottom of the trend. It is a type of formation in which trading activities are confined within converging straight lines which form a pattern. It should take about 3 to 4 weeks to complete the wedge. This pattern has a rising or falling slant pointing in the same direction. It differs from the triangle in the sense that both boundary lines either slope up or down. Price breaking out point creates another difference from the triangle. Falling and rising wedges are a small part of intermediate or major trend. As they are reserved for minor trends, they are not considered to be major patterns.

Double Top and Double Bottom Patterns

Click on the heading sub-title immediately above for double top and double bottom pattern images.

The double top is a frequent price formation at the end of a bull market. It appears as two consecutive peaks of approximately the same price on a price-versus-time chart of a market. The two peaks are separated by a minimum in price, a valley. The price level of this minimum is called the neck line of the formation. The formation is completed and confirmed when the price falls below the neck line, indicating that further price decline is imminent or highly likely.

A double bottom is the end formation in a declining market. It is identical to the double top, except for the inverse relationship in price. The pattern is formed by two price lows separated by local peak defining the neck line. The formation is completed and confirmed when the price rises above the neck line, indicating that further price rise is imminent or highly likely.

Triple Top and Triple Bottom Patterns

Click on the heading sub-title immediately above for triple top and triple bottom pattern images.

The formation of triple tops is rarer than that of double tops in the rising market trend. The volume is usually low during the second rally up and lesser during the formation of the third top. The peaks may not necessarily be spaced evenly like those which constitute a Double top. The intervening valleys may not bottom out at exactly the same level, i.e. either the first or second may be lower. The triple top is confirmed when the price decline from the third top falls below the bottom of the lowest valley between the three peaks.

Most of the rules that are applied in the formation of the triple top can be reversed in the formation of triple bottom. As far as volume is concerned, the third low bottom should be on low volume and the rally up from that bottom should show a marked increase in activity

Price Channel

Click on the heading sub-title immediately above for price channel images.

A price channel is a pair of parallel trend lines that form a chart pattern for a currency pair. Channels may be horizontal, ascending or descending. When prices pass through and stay through a trend line representing support or resistance, the trend is said to be broken and there is a "breakout".

Summary

Chart patterns are fairly easy to recognize. With a little practice you'll be able to recognize them as well. It's important to keep in mind that channel patterns fall into two categories: Continuation Patterns and Reversal Patterns. We'll cover those in parts VIII and IX of this report.

End of Part VI

Part VII of this report will be released in about one week. The topic is "Support, Resistance, and Trend Lines"

Trend Trading Report Part V - Complex Candlestick Patterns

In this Part of the Trend Trading Report we'll cover complex candlestick patterns, what do they look like, what are they meant to communicate, and recommendations for their use.

Review: Wikipedia defines a candlestick pattern as "a movement in prices shown graphically on a candlestick chart that some believe can predict a particular market movement. The recognition of the pattern is subjective and programs that are used for charting have to rely on predefined rules to match the patterns. there are 42 recognized patterns that can be split into simple and complex patterns."

The following patterns are referred to as complex patterns. In all cases below, these complex patterns are multiple candles in different colors and shapes. Note: a black candle/black body is bearish and candlesticks on some currency pair charts may use other colors (e.g. red). A white candle/white body is bullish and candlesticks on some currency pair charts may use other colors (e.g. green).

Complex Candlestick Patterns

Recommended Use Of Candlestick Patterns

Use of the above candlestick patterns is complicated by the fact that there are so many different patterns. If I were buying and selling currency pairs every day I might have memorized these various candlestick patters, but I don't trade currency pairs every day. Therefore, I recommend focusing on up to 5 of your favorite candlestick patterns. Get to know them well, and use them when they appear.

When trading currency pairs live, it's somewhat cumbersome to have to study all the candlestick patterns to remember what they are and interpret what they mean. My personal preference is the following:

1. Pick a small set of candlestick patterns that are very effective, and stick to them. 2. Focus more on chart patterns for predicting what price-action will do next. Chart patterns will be covered in depth in the next three posts.

End of Part V

Part VI of this report will be released in about one week. The topic is "Introduction To Chart Patterns"

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