|
Classical Patterns, Do They Work?
Who Will Buy From You
In conversations with most traders, a topic that typically comes up is about all the trading books that they have read since they began their trading career. Within most of these books are the classical technical chart patterns that have been around for ages. The "Head and Shoulders Top" and the "Cup and Handle" are a couple that come to mind. If everybody is writing about them and talking about them, they must work right? Well, before we follow the crowd and use these classical setups, let's dive into this topic, start from the beginning, and ask the proper questions. How do we profit from any trade? When we buy for example, others must buy after us and at a higher price. Therefore, the last thing we would want to do is buy when everyone else is buying. In other words, if we are entering a classical "Cup and Handle" pattern the way the books tell us to, we may be in big trouble as we need many others to enter the market after us if we are to realize a profit. In other words, if we buy when the book says to buy, who is left to buy from us?? It's a simple question but at the same time, a crucial question.
Ask The Right Questions
A few weeks ago, I had a conversation with a trader who was talking about a couple classical patterns as if they were the holy grails of chart patterns. What follows are two important points in that conversation. First, I explained that though most traders buy and sell stocks and futures with the intention of profiting from their purchase and sale, few traders' entries and exits ever really convey that message. Let's get back to the conventional chart patterns. Most of them have entries that ensure you are buying after many have bought (breakouts: Cup and Handle pattern) and most have you selling after a period of selling (break of the neck line in a Head and Shoulders top). Take a look at the Head and Shoulders top for an example. The entry of this classic pattern is on a break of the neck line. Hhhmmm, I wonder why there is a neckline in the first place? When we think logically about it, there can only be one reason why prices have formed a neckline which is found by connecting the lows of the H&S pattern. If prices keep stalling and turning higher at a price level and forming this "neckline", there has to be support (demand for whatever it is we are trading). There can be no other reason. If there is support in this area, why in the world would we want to be thinking to short if the intention is to profit on this trade? Sound silly? Perhaps but if you look at the actions of the vast majority of traders, they buy into resistance (supply) and sell into support (demand). They also buy after a period of buying and sell after a period of selling. They do this for two reasons. First, because they are letting emotions (fear and greed) lead them to consistent novice entries and exits. Second, they also may be reading too many trading books written by people with theories that don't really trade. These books tend to do a good job of getting traders to follow the herd.
Use Classical Chart Patterns The Proper Way
The astute trader certainly uses conventional technical analysis, they just use it the right way and always ask the right questions, "Why do prices keep turning lower from the shoulders and head that form the Head and Shoulders topping pattern? Hhmm, again, there can only be one reason; there is resistance (supply for whatever it is we are trading). If my intention is to sell something and buy it back at a lower price for a profit, I logically would want to take a short position on the head or one of the shoulders (where resistance "supply" is and the low risk short entry) that forms. And with the Cup and Handle, ever wonder why the bottom of the cup forms??? Take a guess. If you said support (demand), you are correct. That is where the low risk / high odds entry is for that pattern, not a breakout much later and at a high price where everyone else is going to buy. Do we want traders to stop reading the classical pattern books? Of course not. Let the masses buy breakouts and short breakdowns of classic patterns any time they want; they will continue to pay those of us who are already in these trades with low risk entries. The astute trader looks to short as far away from support as possible as the distance from a short entry to support is the "profit margin". Also, they look to take a short position as close to resistance (supply) as possible as that is the only way to enter a low risk short trade. The opposite is true for longs.
The Online Trading Academy Answer
At Online Trading Academy, we teach supply and resistance first and foremost. There is a simple action you can take each and every time you see a classical chart pattern and want to enter that setup in conventional fashion (like everybody else). Make sure you LOOK TO THE LEFT! When a Head and Shoulders Top forms and price is about to break the neck line and your finger is on the trigger to short, make sure you LOOK TO THE LEFT to see if price is breaking down into support (demand, congestion) or if it is breaking down into an area of clean air (no congestion). If it is breaking down from the neck line and right into support, ignore the sell signal as that trade is likely to fail. If it is breaking down and support is much lower, go ahead and take that entry as there is room for price to fall after you have sold short. When a Bull flag shows up and you are ready to buy, LOOK TO YOUR LEFT and make sure resistance (supply) is much higher so there is room for price to rise after you buy. Taking this simple action will help remove you from the herd and get you closer to where the consistantly profitable market speculators enter markets. In the class room at Online Trading Academy, a student would never take a classical chart pattern as a buy or sell signal just because it forms on a chart, they know you must LOOK TO THE LEFT first.
Have a good day.
- Sam Seiden, sseiden@tradingacademy.com
|
|
Sam brings over 15 years experience of equities and futures trading which began when he was on the floor of the Chicago Mercantile Exchange. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated hundreds of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.