Looking for and trading chart patterns are very popular. In nearly every trading book you can find a section on how to trade these chart patterns. The problem with trading according to the book is that you will be trading right along with the masses and risk entering late or entering into a trade that has a lower probability of success.
We want to trade like professionals and that means we must think like a professional. Professional traders do not blindly jump into trades without having fully evaluated them. Many chart patterns can and do fail. We should rely on something to assist us in deciding whether or not to take the pattern trade.
Chart patterns are either trend reversal or continuation signals. The reversal patterns include things like head and shoulders, double tops and bottoms, wedges, and others. They signal the end of a trend and the start of a new one. Continuation patterns like flags and triangles are usually pauses and minor corrections of the trend.
So what tells us if the pattern is likely to be a pause or reversal? Supply and demand zones of course. One thing we should never stray away from in our trading is our focus on the trend and supply and demand zones for our entries and exits into trades. By relying on these core concepts, we are more likely to find success in the markets.
We must look at something else as well: the big picture. When I refer to the big picture I mean the larger time frame as well as the broad market’s direction. Stocks will tend to take a lot of their direction from what the S&P or Nasdaq are doing. If those broad market indexes are reversing at supply or demand, then the pattern on the stock is more likely to follow through too. When a stock is consolidating in a continuation pattern, it should continue the trend if the market is also moving in that direction.
When I refer to the larger time frame, I want to see that we are at a fresh supply or demand zone on a larger time frame than the one I am trading on. For instance, if I am trading on a 15 minute chart and I see an inverse head and shoulders pattern, it is more likely to work if the 60 minute chart is showing price at a fresh demand zone. If there is no demand or supply being tested on the larger time frame at the time you are seeing the chart pattern, it is more likely to fail.
It would be just the opposite for a continuation pattern. We would not want any larger time frame supply or demand in the way when trying to break out of the pattern and continue the trend. If there was, then the pattern would also be more likely to fail.
This is not a perfect scenario for trading. Patterns will and can fail even when confirmed by the market and/or larger time frame. The best thing to do is to use this knowledge as an odds enhancer for your trading and to keep stops to prevent large losses in your trading account. Trading safe and trading smart is the key to trading successfully!