Technical traders can easily get mired down in the sheer volume of information available today. There are hundreds of different chart patterns and literally thousands of indicators. It is extremely difficult for a new and even many experienced traders to determine what tools to use and when to use them.
We took a long hard look at this dilemma to determine the optimal way to use technical analysis for profits.
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Pattern breakouts are perhaps the next most popular form of breakout trading for stock traders. I am speaking of Technical Analysis patterns like double-top, descending/ascending triangles, double bottoms, head and shoulders, diamond patterns and a myriad of others.
The simplest to describe is the double top. You wait for a double top pattern to form on whatever time frame chart you are trading. A double top is two consecutive highs; it looks like an M formation on the chart. Traditional Technical Analysts consider this bearish; however, it can be a great set up for the breakout trader. Simply draw a line across the two tops on your chart, when price breaks above this line by 3 minutes for example, you go long. After entry, the line can act as your stop loss point if it’s broken by a predetermined time on the way back down.
A Double Bottom is the reverse of a Double Top. It occurs after a down trend signaling the end and reversal of the down trend. A Double Bottom serves as an exit point for a trader who was short during the downtrend and an entry point for the trader looking to catch the next up move. The pattern is described as price forming a new low, bouncing up, consolidating, dropping again, then bouncing up again past the high in between the two bottoms. Descriptively, the pattern looks like a valley, a small hill or mountain, then another valley leading to another larger hill or mountain.
The entry or close signal is given when the price of the second bounce exceeds that of the middle mountain or hill between the two bottoms. Ideally,volume will be increasing on the final bounce up prior to entry when long on the pattern.
The next critical patterns you need to know are called Reversal Patterns. Reversal Patterns on stock price charts are patterns that occur at or near the end of a trending price move. These patterns are thought to foretell the end of the trend and provide the technical analysis trader a signal to close the position or enter a trade in the opposite direction of the trend.
Rising and Descending Wedge patterns are common reversal patterns found on financial charts. They are more open to interpretation than the double tops I mentioned earlier. None the less, they can be important reversal patterns that every chart reading technical analyst should understand.
The Descending Wedge can be found in both up trends and down trends. It is normally a continuation pattern when it appears in an uptrend.
When a Descending Wedge is seen in an uptrend, its normally called a Bull Flag or a Pennant.
If it is seen in a downtrend, it’s regarded as a reversal pattern. A Descending Wedge, in a downtrend, looks like a triangle sloping downward on the price chart. It is formed by a shrinking trading range per bar. It is drawn on the chart with two trend lines, the upper line connecting the highs, and the lower line connecting the lows forming a triangle like pattern within the downtrend. When the point of the triangle indicates the maximum price contraction per bar, is where the reversal is thought to occur. If this contraction, at the triangle point, is combined with increasing volume, a break out to the upside is believed to be imminent.
The theory is that the contracting range will suddenly expand and combined with a surge in volume will push the stock upward changing the trend for a period.
The Rising Wedge pattern is often a reversal signal when found in an uptrend. It looks like a triangle sloping upwards on a price chart. The price bars show a contracting range with an upward tilt, cumulating in the point of the triangle where the trend changes to down at least temporally.
There can be multiple Rising Wedges in an uptrend with each one ending with a sharp decent, then the uptrend continuing. When located within a downtrend, it is considered a continuation pattern and is called a Bear Flag. It is drawn on the chart with two trend lines. The steeper one connecting the lows with the less steep one on top connecting the highs. The lines cumulate at the tip of the triangle where the breakdown or change of trend is thought to occur. Just like the Descending Wedge pattern, an increase of volume near the point of the triangle is thought to add to the likelihood of a trend change. Here is a visual example of the pattern resulting in a change of trend.
A Poweful Technical Trading Tactic
The Opening Range Break Out or ORB, was first popularized by Toby Crabel, in his coveted and long out of print book, “Day Trading With Short Term Price Patterns and Opening Range Breakouts”. Tony became a billion dollar hedge fund manager after writing this book in 1990, and many other hedgees learned from him, so take that for what you think it’s worth when considering why ORB strategies work.
The ORB is briefly described in the first line of his book, “A trade is taken at a predetermined amount above or below the opening range”.
Several somewhat complex mathematical formulas have been developed to nail down the optimal level to enter after the breakout; however it all boils down to buying above the ORB or selling below it. Here is a simple example on the 15 minutes stock chart. Mark the high and low of the first 15-minute candle formed on the chart. Now switch to a 1-minute chart with the high and low of the first 15 minutes marked with horizontal lines across the chart. Wait, patience pays in the trading game, for a full one-minute green candle to close above the upper line, or a full one-minute red candle to close below the lower line. When one of these two scenarios occurs, go long on the break above the upper line, or short on a break below the lower line. This is ORB trading at its most basic.
Take the time to develop your own interpretation of technical patterns in the time frame that you trade. Remember, discretionary trading is some science and much art.
The true key to success with technical analysis is experience. Experience isn’t something you can learn in an article, book, or even course. Time is required observing patterns develop in concert with volume to correctly choose the right time to enter the trade. It is critical to note that the edge provided by technical analysis is based on a series of trades of the same pattern. Any single trade can be close to random in outcome. However, over a series of trades, the experienced technical analysis trader can definitely increase the odds of success.
Add patience and perseverance to the above patterns and it is as close to the Holy Grail that can be expected in the financial markets.