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Trading Chart Patterns: The 3 Most Powerful Patterns Every Trader Must Know
BY Janne Muta
|May 28, 2024What is common among all great and successful traders? Almost all of them use chart patterns in their trading. You might know that the balance between demand and supply fluctuates constantly. This fluctuation leads markets to form price patterns that can be traded with a sufficient degree of accuracy to leverage the law of large numbers in the trader's favour. This is why trading chart patterns has allowed many traders to build a professional career out of trading.
While no single chart pattern is foolproof, with professional risk management, traders can develop strategies that have a long-term positive expectancy when trading chart patterns. This phenomenon has enabled famous traders, from Charles Dow and Ed Seykota to Larry Connors and Mark Minervini, to achieve remarkable results in their trading careers. In this article, we will study the three most powerful chart patterns used by these and other successful traders so that you can grow and learn faster in your trading career.
Key takeaways from this analysis
- Trend Analysis: Dow Theory helps traders identify potential trend reversals. By analysing higher lows and higher highs, traders gauge bullish momentum, while lower lows and highs indicate strong supply. Trend analysis offers insights into market direction and strength, essential for making informed trading decisions.
- Support and Resistance Levels: Support and resistance levels help traders time their entries and exits. These levels form during market pauses, indicating a balance between supply and demand. Properly utilising these levels enhances trading precision and potential rewards.
- Exhaustion Candles: Hammers and shooting stars, also known as exhaustion candles, signal potential market reversals. A hammer indicates bullish reversal after a downtrend, while a shooting star suggests bearish reversal after an uptrend. These patterns are more reliable on higher timeframes, offering valuable insights for trade entries and exits.
- Risk Management: Effective risk management is crucial when trading chart patterns. Key strategies include appropriate position sizing, using stop-loss orders, waiting for trade confirmations, and maintaining a favourable risk-reward ratio. Implementing these techniques mitigates potential losses and enhances overall trading performance, contributing to long-term success.
Why are chart patterns useful in trading?
Chart patterns help traders understand market momentum and direction whether they are trading forex, commodities or indices. By analysing, for instance, higher highs and higher lows, traders can gauge the strength of a bullish trend, allowing them to estimate how much risk they should accept at any given time. Simply put, if the market (when trading chart patterns) has not reversed yet it is trending higher so the trader knows to look for opportunities to trade long.
Only after a breach of one of the higher lows, the market signals a potential trend reversal. This is when bullish traders should consider reducing the risk or reversing their positions from long to short. Similarly, lower lows and lower highs indicate strong supply and often mean the market is likely to move lower.
Chart patterns are also useful as they often highlight when the market starts to lose downside momentum. This can be seen in the charts as the distance between each lower low decreases when the market nears support levels. This suggests increasing demand relative to the supply in the market at the time.
Sideways ranges on the other hand indicate that demand and supply are in a relative balance. This is when traders should favour mean-reverting strategies. Chart patterns thus help estimate the demand-supply balance, helping to identify market direction and trade timing.
This is obviously vital when looking for trade entry levels where potential gains are greater than the risk. Note that if a trader does not use leverage, he can buy the market at almost any price level during the trend but, when leverage is used, it is critical to be a buyer close to or at a support level. (When the market is trending lower traders might want to sell near resistance levels). Also, the further away from a support level the trade entry happens, the greater the risk and the smaller the potential reward.
Another highly important aspect of trading is volatility analysis, and this is where chart patterns in trading are valuable. If the market is volatile, it creates formations (e.g. ranges or triangles) that are greater in size. Why then is volatility so important for traders? Higher volatility means potential for gains (and losses) are greater when trading chart patterns. If there is no volatility, the expected value of trades is smaller, and sometimes it is better to stay on the sidelines and wait for a more volatile period.
Trend Analysis
Let's take a closer look at one of the most common price formations: the trend. By analysing price patterns during a price trend we can gain valuable insights into the demand and supply balance that underpin the trend.
If we see the market forming pattern of a series of higher lows and higher highs and the market moving steeply higher, we know that demand exceeds supply. In other words, upside momentum is strong.
However, if the market, after such a strong period of movement higher, starts to lose momentum, we often see the angle the market changing. Also, we can see how the latest higher highs are closer to each other than earlier during the trend. This signals that the demand-supply balance does not favour the bulls so strongly anymore. In other words, the demand buyers can bring to the market is getting weaker relative to the supply the sellers are providing.
If the market then violates the latest higher low and then proceeds to create a lower swing high, we have evidence that demand is indeed weaker than supply. This is how we can identify not only the market direction but also assess the strength of the market by analysing the changes in momentum by using chart patterns.
Alternatively, if the market has been trading lower and creating lower lows and lower highs, this chart pattern tells us that supply is much stronger than demand. When the market comes to a support level, the distance between lower lows gets shorter. This is a sign that more buying is coming into the market as traders anticipate that there could be more demand at the support level.
Sometimes there is no immediate reversal in the market and we see prices moving sideways, suggesting that demand and supply are in relative balance. This is known as a range formation and is often utilised by traders who prefer mean-reverting strategies.
These are just some examples of how trading chart patterns help us to identify the market direction and the strength of the market move. In other words, chart patterns help us to estimate the demand and supply balance making trading chart patterns easier.
Support and Resistance Levels
Support and resistance levels are abundant in markets, perhaps leading to their underestimation as tools for novice traders. However, these powerful price formations help traders understand markets and time entries and exits with greater precision.
Support and resistance may not always be immediately apparent. We can only identify support if the market bounces higher from the level at least once or twice. When trading chart patterns focus on these bounces as they establish reference points that allow us to draw a horizontal trend line, also known as a support level. In an uptrend, bounces off support indicate bullish sentiment and likely higher demand than supply until the trend reverses. Conversely, a reversal with the market moving lower suggests supply exceeding demand, with lower lows and lower highs forming.
Horizontal Support and Resistance Levels
There are two main types of support and resistance levels, both valid but used slightly differently. Let's explore these types with examples of gold and USDJPY trending higher.
- Type 1: Markets naturally pause during uptrends. These pauses reflect a relative balance between supply and demand, causing sideways movement. The lower end of this range becomes a support level, exploitable by entering long trades at or near these points.
- A similar situation occurs in downtrends. The market pulses and consolidates sideways, indicating balanced supply and demand. Here, with the bearish momentum, the upper end of the sideways movement creates the Type 1 resistance level. If the market rallies to this resistance and rolls over, a short trade could be considered.
- Type 2: The type 2 support levels form during uptrends after a sideways move. The price breaks above the upper end of the sideways range, the type 2 support level. While some traders buy the breakout, others might wait for a pullback. This waiting can filter out false breakouts but risks missing the initial move if the market continues trending.
- During downtrends, Type 2 resistance levels form when the market breaks below the lower end of a sideways range. Traders can either sell the breakout or wait for a pullback to the former support (now resistance). Again, selling immediately after a breakout risks false breakouts, while waiting ensures a position if the trend continues. Conversely, pullback traders may miss some moves but avoid false breakout whipsaws.
Trading Chart Patterns: Hammers and Shooting Stars
Hammers and Shooting Stars are also known as exhaustion candles as they signal potential reversals following strong price movements. These candles can indicate that the prevailing trend is losing momentum.
A hammer candlestick is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening but rallies within the period to close near the opening price. This pattern forms a hammer-shaped candlestick, where the lower shadow is at least twice the size of the real body. The body of the candlestick represents the difference between the opening and closing prices, while the shadow shows the high and low prices for the period.
While a hammer signals a bullish reversal after a downtrend, a shooting star indicates a bearish reversal after an uptrend, with a long upper shadow and a small body near the session's low. This contrast highlights the opposite implications of the two patterns.
Exhaustion Candles in Various Timeframes
Hammers and shooting stars, (exhaustion candles), can be found across all timeframes, from one-minute charts to daily and weekly charts. These candles are pivotal in technical analysis as they indicate potential reversals following significant price movements.
While exhaustion candles appear in all timeframes, they are more frequent in smaller timeframes due to the increased number of price fluctuations within shorter periods. For instance, one-minute or five-minute charts often exhibit hammers and shooting stars because of the constant ebb and flow of trading activity. However, not all these candles have predictive value. The smaller the timeframe, the higher the likelihood of false signals and failures. This is because shorter timeframes are more prone to market noise, random price movements, and lower overall reliability.
In contrast, exhaustion candles on higher timeframes, such as daily or 4-hour charts, are highly valuable to those trading chart patterns as these candles are more reliable. These higher timeframe candles often indicate a more sustained market reversal because they represent longer periods of market activity and sentiment. Also, while a minor timeframe exhaustion candle could be created by a relatively small number of retail traders it takes institutional participation to reverse the price moves to such an extent that e.g. a daily exhaustion candle is created.
A hammer on a daily chart signifies that despite initial selling pressure, buyers managed to push the price back up significantly by the end of the day, suggesting a strong potential reversal. Similarly, a shooting star on a 4-hour chart after an uptrend can indicate that buyers' momentum is waning, and sellers are taking control, potentially leading to a trend reversal.
To enhance the reliability of trading signals from exhaustion candles, traders can combine pattern analysis across multiple timeframes. By doing so, they can confirm the presence of significant patterns on higher timeframes with similar patterns on lower timeframes. For example, identifying a hammer on a daily chart and a confirming pattern on an hourly chart can provide stronger evidence for a potential reversal, improving trade entry and exit decisions.
Risk Management When Trading Chart Patterns
Incorporating risk management when trading chart patterns simply cannot be ignored if we are looking for long-term trading success. Let's quickly cover the basics to get you started.
- Position Sizing and Leverage: Carefully consider the amount of capital you allocate to each trade to avoid excessive leverage. Even when e.g. a hammer or shooting star provides a strong signal, over-leveraging amplifies losses when the market moves against your position. Obviously, if the market moves in your favour it feels great but sooner or later the opposite will happen and the high-leverage approach backfires.
- Stop-Loss Orders: Always use stop-loss orders to protect against unexpected market movements. For hammer patterns, place a stop-loss below the lower shadow to limit downside risk. For shooting stars, set the stop-loss above the upper shadow to guard against continued upward movement.
- With support and resistance levels you might want to use an ATR stop. For long trades subtract the ATR value from the support level and set your stop there. Conversely, when looking to trade against a resistance level in a downtrend you can add the ATR value to the resistance level to avoid random market fluctuations triggering your stop before the market continues to move lower.
- Confirmation: Wait for confirmation before entering a trade. This reduces the risk of false signals. A bullish confirmation for a hammer occurs when the next candle closes above the hammer's close. For a shooting star, a bearish confirmation happens when the next candle closes below the shooting star's close. When you are trading against support (resistance) levels confirmation comes when the market crosses back above (below) the level. In uptrends the price crossing above the support level acts as a confirmation while in downtrends price crossing back below the resistance level provides a confirmation signal.
- Risk-Reward Ratio: Ensure a favourable risk-reward ratio for each trade. Aim for a minimum ratio of 2:1, meaning the potential reward should be at least twice the potential risk. This helps maintain profitability even if not all trades are successful.
By integrating these risk management strategies, you are better off when mitigating potential losses and enhance their overall trading performance when utilising powerful trading chart patterns like hammers and shooting stars.
Conclusion
In trading, understanding and effectively trading chart patterns is crucial for predicting market movements and making informed decisions. The three powerful patterns discussed— trends, support and resistance levels, and exhaustion candles—provide traders with insights into the market direction, momentum, and potential reversals. Implementing these patterns, along with robust risk management strategies such as appropriate position sizing, using stop-loss orders, waiting for confirmations, and maintaining a favourable risk-reward ratio, enhances the likelihood of trading success. By combining pattern analysis across multiple timeframes and adhering to disciplined risk management, traders can navigate the complexities of the market and achieve long-term profitability.
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Janne Muta holds an M.Sc in finance and has over 20 years experience in analysing and trading the financial markets.
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