A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Learn How to Analyze Chart Patterns for Your Next Trade
For newer traders, researching opportunities generally means concentrating on corporate data, like earnings reports. Advanced traders rely on technical analysis for information beyond company benchmarks, frequently consulting market data of trading activity itself. When combined with technical analysis indicators, chart patterns can help traders quantify what may seem like random market behavior – ideally finding an edge in the process.
“Indicators are simply another way to display underlying price action,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “But there are some very specific chart patterns used by traders to find opportunities, and some indicators can be used in conjunction with those patterns.”
3 Types of Trading Patterns
While many different types of price patterns show up on charts, most can be classified within the framework of 3 broad categories:
- Consolidation Patterns, which eventually are resolved by breakout moves.
- Trending Patterns that may lead to extreme overbought or oversold conditions.
- Wide-Range Patterns where prices swing back and forth.
Numerous patterns can develop within these larger categories, which means that traders can find value in chart analysis in any timeframe. Chart patterns are known to be fractal, which means that similar patterns across daily charts may be found on shorter timeframes. However, as you shorten your timeframe for observation, you introduce more noise into the chart, which could make them less reliable.
Tight Consolidation Patterns
When market indecision consolidates a security’s trading price into a very tight range, these patterns can be recognized on a chart without the help of indicators. Commonly appearing as very narrow horizontal patterns on a price chart, they eventually resolve themselves when conviction shifts one way or the other.
Unfortunately, the pattern doesn’t predict the breakout’s direction. Large gains are possible when this breakout occurs, as are large losses if read incorrectly. These breakout set-ups appear in a number of different indicators. For example, a tight price range in Bollinger Bands causes the bands to narrow into their own tight contraction and point to a situation of changing volatility conditions.
Once a security begins a directional move, it can become a trend lasting days, weeks, months and even years. Staying with this move can yield the big returns, but it’s not as easy as you may think. While most investors and traders can name a stock that would have brought them great riches had they had the fortitude to stay with it for the long term, many can also remember when they overstayed their welcome. They didn’t recognize the end of the trend and gave back a large share of their profits.
A trending pattern, once it begins to mature, appears as a persistent move in a single direction. For example, during a bullish trend it moves from the lower-left corner to the upper-right corner of a chart. Traders will often use an indicator such as the Average Directional Index (ADX) to gauge the strength of the trend, and to try to discern when that trend may be weakening.
Some trends end with what traders call a blow-off move. When a stock has been in a strong uptrend for months, it may start gapping higher as latecomers try to come aboard. Unfortunately, the “excess” price action poses the risk of an imminent sell-off, wiping out months of gains in mere days.
Statistically, markets and stocks move in trends much less frequently than they do in a range-bound fashion. However, nimble swing traders can look for a significant number of trading opportunities in both directions.
Without a discernible trend in play, traders will be looking for buy set-ups near the lower end of an established range, and sell or sell-short set-ups near the upper end of an established range. Psychologically, this can be difficult at times because the trader is buying or selling against broader market trends.
Traders who can overcome these mental obstacles have many opportunities that set up on price charts. Using a technical indicator such as Relative Strength Index (RSI), you can quantify these chart set-ups by looking for oversold zones to time buy entries (or overbought zones to time sells).
“While some traders like to stack several indicators below a price chart to validate a decision, it also creates redundancy,” said Bachelier. “Remember that all of these indicators are just derivatives of the underlying price data, and incorporate them into your research appropriately.”
Read Next: Learn more about how you might use the Relative Strength Index.
Next Step: See how candlesticks can shed light on market emotion.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
The analytical tools, examples and strategies described are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to use a specific investment tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances, and your investment objectives.
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