News & Analysis

5-point checklist for using chart patterns within your trading plan

September 4, 2019

 

Chart patterns (e.g. head and shoulders, triangles, double bottoms/tops), are commonly used to assist in trading decision making. If using these as part of your entry approach, their use should be viewed as a specific strategy, amongst others you may use, and so merit a dedicated section within your plan.

This article outlines some of the key things to consider when writing and using such in your trading plan.

General rules with trading plans revisited
The statements within your trading plan serve two primary functions, as discussed in detail in previous articles. It is important that such statements are specific enough to more effectively perform these functions, namely:
a. Facilitate consistency in trading action e.g. in the entry and exit of trades, allowing the trader, and
b. Enable measurement e.g. within a journal, to make an evidence-based judgement on how well these statements are serving you through testing.

With this level specificity, it is easier to ‘tweak’ components rather than throwing the “baby” of any strategy “out with the bathwater”. Often, many experienced traders discover the finer details can make a relatively big difference to trading results, rather than massive changes in approach.
Obviously, if there is a lack of consistency, originating from behaviours that move away from what you have planned, make it almost impossible to make any judgement on the success, or otherwise, of a strategy.
Using chart patterns adheres to all the above.

 

What about trading chart patterns?
Chart patterns are simply a representation of potential changes in market sentiment. Often combined with other indicators and can be used to indicate a potential entry into, or in some cases exit from, a specific position.
Some patterns indicate a trend reversal (e.g. head and shoulder, double tops, triple bottoms etc), others a pause (congestion) before continuing in the direction of a previous trend e.g. flags, pennants, symmetrical triangles.
Patterns may occur on any timeframe but generally speaking are more robust (in terms of potential longevity of movement) on longer timeframes (although of course they cannot indicate with any accuracy how long that move may be).
As with any entry approach, there is a chance that a trading idea based on an identified pattern will fail and so, as always, appropriate risk management should be put in place

 

And within your trading plan?
Chart patterns are not easily identifiable with most general indicator systems and are often best “sighted” so there is an element of subjectivity. Logically this could suggest that this makes it even more vital to be robust in your description of how to use these in your trading.

We have identified FIVE potential components to include within your written trading plan.

These are:
1. Your definition of the chart patterns you are going to use
2. When you are going to use them
3. Identification of when a pattern is completed
4. Other factors you may use to potentially decrease the chance of a false breakout from any chart pattern you are going to use
5. Your initial stop placement method

 

#1 Your definition of the chart patterns you are going to use
Specify which of the chart patterns you are choosing to trade. Ideally, a description of what this pattern looks like on a chart will help lock this in. For example, if we were to describe a double top it could read:
• Reversal of upwards trend.
• Creation of two upwards prongs. Around the same price level forming a ‘M-shape’.
• Breakout below the ‘confirmation point’ (bottom of “prongs” confirms reversal.

 

#2 When you are going to use them
There are two perhaps obvious, and yet important, factors to include:
a. On which timeframes you are going to use chart patterns
b. The proximity of impending economic data releases. For example, If trading a 30 minute chart you could specify “no relevant (define this e.g. specific to currency pair, sector of share CFD), significant (define this e.g. you may decide to actually state the data points) data due within the next 3 hours.

 

#3 Identification of when a pattern is completed
Experienced traders always wait until a pattern is complete before acting. However, the incidence of false breakouts (i.e. when a trading idea fails after a pattern is completed) is worth taking steps to attempt to limit.
Let’s use the break of a neckline on a ‘reverse head and shoulders’ as an example. Clearly, price moving upwards through the neckline is the desire. However, you need to articulate what are you using to determine this.
E.g. At any time within a candle period or on candle close price; and/or is there a specific distance such as using 0.5 ATR, or perhaps number of pips/points, above the neckline?

 

#4 Other factors you may use to potentially decrease the chance of a false breakout from any chart pattern you are going to use
The following may be considered:
a. Which other indicators e.g. moving average, volume
b. Intra-candle price action e.g. close within the top third of the candle if considering a long trade.
c. Agreement on other timeframes (although this may not be the pattern what constitute “agreement” e.g. price above 10EMA.
d. Minimum distance to next “key price point” e.g. next resistance price level if going long.

 

#5 Your initial stop placement method
As the structure of each pattern is different then it is important to specific your initial stop placement methods for each.
So, to use the previous example, if trading the “idea” of a breakthrough a neckline, a pre-planned exit logically could be move back through that neckline may indicate a trade failure and necessitate a risk management exit (and so of course be a determining factor in your position sizing into that trade).
As with defining what constitutes a breakout, logically again, you need to specify whether you are using an anytime touch of a price for exit or a candle period close price, and/or is there a specific distance (an how you are going to articulate this) below the neckline.

 

So now to action…
Depending on where you are now with you plan there are two potential actions.
1. If you are already using chart patterns use the above checklist to determine whether you have these components included, fill any gaps and that ensure they are specific enough
2. If you have not got part of your trading plan them this may help you get started in making it happen
Remember of course, the above is indicative suggestions only, it is YOU that must make the choice about what to include/not include and the specific parameters you are going to test and ultimately use.

 

 

Mike Smith
Educator
GO Markets

Disclaimer
The articles are from GO Markets analysts based on their independent analysis. Views expressed are of their own and of a ‘general’ nature. Advice (if any) are not based on the reader’s personal objectives, financial situation or needs. Readers should, therefore, consider how appropriate the advice (if any) is to their objectives, financial situation and needs, before acting on the advice.