Everything you see on the price charts, including the trendlines, triangles, pennants, flags and … are all created by support and resistance levels that are the market’s selling and buying limit levels. In this article I am talking about these patterns in more details. I am trying to show you some strategies that you can use to take proper positions. You can use the techniques you learn here both in trading.
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What Is a Trendline?
A trendline is the direction of the price movement which is formed by the peaks and valleys (highs and lows).
Some traders only trade the trendlines. It means when they locate a trend, they take the proper position and follow the trend. When there is an uptrend, they take a long position and when there is a downtrend, they take a short position.
A trend is called uptrend when there are higher lows formed on the price chart. A downtrend forms when there are lower highs on the price chart.
Some other traders don’t trust the trendlines. They think that it is always possible that a reversing happens. So they don’t take any positions when there is a trend. They wait for a reversal. Both strategies have some advantages and disadvantages.
Below is a big uptrend on the EUR/USD daily chart. It is a big uptrend but as you see there are a lot of smaller trendlines too.
Swing traders use slow moving averages to locate the trends. A 40 simple moving average (40 SMA) is a very common tool among the swing traders. Let’s see how the above chart looks if we add a 40 simple moving average to it. I set the moving average in the way that if it goes up, the color changes to green and when it goes down, it changes to red.
In this strategy, it is time to buy when (1) the price breaks above the moving average, (2) goes down to retest it as a support and fails to break below the moving average and (3) goes up while the moving average color is green. All these three events should occur to have a trade setup, otherwise you have to wait.
As you see in the below chart, there is only 5 trading opportunities in two years (this is the real meaning of swing trading) but for swing traders it is really good because they take big positions and some of these 5 trading opportunities are really good and profitable. Another thing is that we only go long in an uptrend because going short is trading against the market. Professional traders always avoid trading against the market.
The stop loss should be placed few pips under the support line. This is the position of the stop loss in position # 3:
Using this strategy, you could make 2876 pips in two years:
trade #1: 187 pips
trade #2: 762 pips
trade #3: 500 pips
trade #4: 456 pips
trade #5: 971 pips
As swing traders trade big amounts, it could be a lot of money. For example if a bank trader, traded 1 Billion Euro, he would make about $287,600,000 for the bank. This is a huge profit but this trading system looks so boring for the traders who like to take more positions (that doesn’t necessarily mean making more profit). If you are among those traders, you can use a smaller moving average like 20 but keep in mind that you will have more false signals and your stop loss will be triggered more. Taking more positions doesn’t necessarily mean making more money. Maybe that is the beauty of trading that has made it different from the other businesses.
There is another option too: You can use the same moving average in the smaller time frames like one hour chart. However, that is not a good option too, because you can locate more trade setups, but there number of the false setups goes up when you trade the shorter time frames.
Lets try it and see how it works:
As you see, it also works on the smaller time frames. You have to be careful not to enter as soon as the moving average changes its color. You are trading the trends, and so, the trend should change its direction completely before you enter. You have to plot the trendlines and know the supports and resistance levels and take the proper positions only when both the trend direction and the moving average color are changed. If you like to be more conservative, you have to wait for the price to retest the moving average and if it failed, you take your position.
So add a 40SMA to your favorite currency pair and time frame and check the back data and see how would you trade using this system.
This strategy can be used only when we have a good trendline. It can not be used when the market is ranging. For example at this time that I am writing this article, (Feb 17, 2008), this strategy cannot be used for the EUR/USD daily chart because the market is ranging and the price is breaking above and below the 40 moving average continuously.
Another way for following the trendlines is using a combination of moving averages and an indicator which is called Moving Average Convergence Divergence or MACD. This indicator is a lagging indicator. Its delay looks like a problem but it is necessary to make sure that a trend is finished and another one is started.
You can easily set up a system with two exponential moving averages (EMA) that are set to 12 and 26 and also a MACD indicator with the traditional default settings which is 12, 26, 9. Try to use different colors for each of the moving averages. You should buy when MACD two lines have already crossed and diverged and they are moving toward the overbought area and at the same time, the 12 and 26 EMAs are crossed:
And you should sell when MACD is moving toward the oversold area while its two lines have already crossed and diverged and at the same time the 12 and 26 EMAs are crossed:
This system with the same settings can be used for all different time frames. However, you will have less number of trade setups on the longer time frames.
I don’t use any of the moving averages and indicators. I only use candlesticks, 20 Bollinger Bands, technical analysis and Fibonacci levels to find the beginning and the end of the trends. I find patterns like head and shoulders, triangles, wedges, pennants and flags and wait for their breakout and enough confirmation and then will take the proper position.
The most important advantage of my technique is that it is fast. It is not delayed. It shows you the top and the bottom of the trends. If you learn it properly and if you learn how to use it on time, it hardly hits your stop loss.
Head and Shoulders, Double tops and bottoms and sometimes triple tops and bottoms are the most important patterns. You have to learn to find and see these patterns on the charts. This is one of the most important parts of my strategy.
Head and Shoulders
Head and Shoulders form at the top of uptrends or bottom of downtrends. They are the most common patterns. They are strong reversal signals but you have to wait for them to be formed completely and show their reversal power: Head and Shoulders Pattern Explained in Details
In an uptrend, a Head and Shoulders will act as a reversal only when the price succeeds to break below the Head and Shoulders neckline. Otherwise the price will go up and may retest the neckline once again in future but nobody knows when.
Here is a typical Head and Shoulders that succeeded to work as a reversal:
Please note that in typical Head and Shoulders, shoulders have to form lower than the head. Sometimes one of the shoulders is higher than the other one. When the shoulders’ and the head’s peaks are at the same level, they are called triple tops. I will explain it later.
At the above chart, the Head and Shoulders is formed at the top of an uptrend and when the Head and Shoulders succeeded to work as a reversal, the price went down and the uptrend became finished.
If a Head and Shoulders forms when you already have a long position, you have to close your position and collect your profit. But if you don’t have any positions, you have to wait for the Head and Shoulders to break below the neckline. Then you can take a short position and put your stop loss few pips above the neckline plus the spread:
Here is some other examples of Head and Shoulders:
A defective Head and Shoulders that failed to work as a reversal (as you see its neckline couldn’t be broken below, and so, the price kept on going up) :
Another Head and Shoulders that failed:
Another Head and Shoulders that failed:
Double and Triple Tops and Bottoms
These patterns act like Head and Shoulders. They are reversal signals but you have to wait for their neckline to be broken down in case they are at the end of an uptrend. In fact, Double and Triple Tops and Bottoms are different versions and forms of Head and Shoulders. Sometimes they look so similar to Head and Shoulders.
A Double Top that almost worked as a reversal:
A small Triple Top:
A Double Bottom that worked as a strong reversal signal:
There are three kinds of triangles: Ascending, Descending and Symmetrical: Symmetrical, Ascending and Descending Triangle Chart Patterns
There are some rules about the triangles but I recommend you not to take any positions according to these rules because they don’t work sometimes. For example they say in an uptrend, an Ascending Triangle will break above and will work as a continuation pattern. But I suggest you to wait for the break out and then take the proper position.
Here is a Descending Triangle in an downtrend that worked as a continuation pattern. As you see there is a double top inside the triangle. It means all of these patterns are related to each other and there is almost the same psychology behind their formation:
Here is a Descending Triangle at the beginning of an uptrend that worked as a continuation signal. As you see there is a Head and Shoulders pattern inside the triangle that failed. So the price kept on going up:
A Symmetrical Triangle that worked as a continuation pattern:
You just need to wait for the breakout and then you can take the proper position. This will be much safer than taking a position according to some rules that sometimes don’t work. So you don’t have to memorize the rules and the name of the triangles. You just need to find them and wait for their breakout.
A good example of a descending triangle that worked as a reversal signal:
As you see, there is a triple top inside the triangle. The first one has made a “High”; the second one has made another high which is lower than the first high (so it has made a lower high); also the last one has made a high which is lower than the second high (another lower high).
What does that mean?
It means the price failed to break the high of the previous top each time and so Bears are taking the control and it is highly possible the price goes down. Then you could go short when the price succeeded to break down the triangle support. To have a more secure trade, you could wait for the price to break even the low price of the candlestick that broke down the support. Your stop loss had to be placed above the high price of the candlestick that broke below the support plus the spread:
Now a question:
What pattern would it form if the high of the first and last top were both lower than the high of the second top? Yes; Head and Shoulders.
A good example of an Ascending Triangle that worked as a reversal signal:
As you see, you could go short when the price broke down the low price of the candlestick that broke down the triangle. And your stop loss had to be the high price of the same candlestick plus the spread.
As you see the rules are not reliable. Descending or ascending triangles in an uptrend or downtrend can work both reversal or continuation patterns. So you have to wait for the market to show you the direction.
Wedges, Pennants and Flags
These patterns are so similar to each other and can be considered the same. In most cases they work as the continuation patterns but they can also work as reversal patterns. So you have to wait for a clear breakout and then take your position.
Here below you see a Descending Wedge that worked as a continuation pattern. This Wedge can be known or called a Pennant or Flag too.
You could take a long position when the price broke the high price of the candlestick that broke the wedge resistance. Your stop loss had to be placed a few pips under the low price of the same candlestick:
A flag that worked as a continuation pattern:
A big flag that worked as a continuation:
How would you trade using the above flag?
Another Pennant that worked as a continuation pattern. As you see in the last two examples, I have placed the stop loss above the last high inside the pennant because the pennants in these two examples are a little narrow and so I wanted to have a bigger stop loss. So the stop loss will not be triggered because of the small fluctuations.
A pennant that worked as a reversal:
Let me show the above pennant with a higher magnification because there are some false breakouts that I want you to see and know how you can distinguish them.
1, 2 and 3 are showing false breakouts. As you see in all the three cases just the lower shadow of the candlesticks could break down the support line but their close price are all above the support. It means the supports couldn’t be broken and you still had to wait.
Another important thing in this example is that the price has tried to break down the support line for about 7 times whereas it tried to break up the resistance only for three times. What does that mean? Experience shows that when the market insists very hard to break down a support or up a resistance, it will succeed finally. So when you see a support or resistance has been retested for more than 4 times, you have to be ready for a breakout.
Ok! Lets keep on talking about the false breakouts. Case number 3 is also a false break down at the beginning. Let me show it with a bigger magnification:
As you see only the lower shadows could break down the support line and so it had to be considered as a false break down but then the candlestick which is surrounded by the blue ellipse in the above image tells you that the support is almost broken. The safest way is to go sh