T2W Trading Community

Chart patterns capture the development of crowd emotion and provide potentially high
probability trade ideas with well-defined price targets and exact measures of risk
management. But patterns – by themselves – do not necessarily lead to consistent outcomes. The development of chart patterns only alerts traders that one particular type outcome is more likely to occur than another. As price moves towards a selected price point, the trader pays more attention to the stock, ready to place a buy order if prices move a few ticks above that level. In other words, chart patterns signal that trading potential and the probability to take action may exist.

Chart patterns are an invaluable aid to trading, but only when they point the way to high probability outcomes. The key feature of a chart pattern is reliability. Why should we be interested in a chart pattern that works on average only 30% of the time? We’d get a better balance of probability by flipping a coin. As a “performance filter,” we must trade patterns which provide a 70% or greater probability that the pattern will develop as expected. There are simply too many ways to lose money in the market without going out of our way to trade low probability patterns.

We use this high-probability performance filter to reduce the number of useful patterns to only a handful – which also makes them easier to identify. The danger with all pattern trading is that we build castles in the sky. Instead of seeing what is really on the chart, we
tend to see what we want to see. Although there are few effective ways to overcome this rose-coloured view – other than years of practice and strict adherence to our disciplines – we can improve our pattern recognition if we are more precise about the specific features
we look for.

As an analogy, an automobile has four wheels, an engine, and space for passengers. This broad definition excludes some vehicles and does not help us decide which SUV is best for our family. To make a better buying decision, we need a better definition of the automobile we prefer. The same applies to pattern recognition in charts. I use very exact definitions which reduce the subjectivity and filter out look-alike patterns which have a low probability of success.

Classic Bullish Flag
One of the most powerful and consistently reliable patterns is the bullish flag applied to a daily chart (see figure 1). I use this as one of my main short-term trading techniques. The flag forms when the initial Working with enthusiasm for the stock slows down. There are few sellers as most new stockholders hold onto their recently acquired positions. Buyers
collect stock from long-time stockholders who are selling into the unexpected strength and who are frightened that the rally has failed completely. Gradually, prices move downwards but as you can see in figure 1, they maintain a steady trading band.

The “flagpole” is the key initiating characteristic of this chart pattern. The flag pattern only occurs at the top of a flagpole. It is created by one to five days of extreme and continuous price action moving in the same direction. There are no significant retracements
during the construction of the flag pole. A flag is not a triangle nor is it a pennant. Like most flags, this pattern has parallel sides. Identification starts as prices start to pull back from the high created following the flagpole. We want two to three points to plot a tentative down-sloping trendline. This is the starting point for the pattern and it usually takes a minimum of three days to confirm.

Once the upper straight edge trendline is plotted, we hunt for the potential parallel trendline to define the lower boundary in this pattern. Simply take the upper trendline and plot it as a parallel line using the most recent low in the emerging pattern. We do not have to wait for two or three lows to develop before we plot the trendline. Instead, we infer the position of the lower parallel trendline and plot it from a single low. We then look for future price action to confirm the initial placement.

Why rush to draw the lower trendline? In a fast moving bull market, this pattern may develop over three to five days. Sometimes there are only two lower points in the pattern and, if we wait for validation from a third, we miss the opportunities for the bullish breakout. By plotting an inferred lower parallel trendline based on the confirmed upper trendline, we give ourselves the advantage of early recognition of the pattern.