Chart-Formations.com

Wealth Warning

Trading equities, options, derivatives, currencies and cryptocurrencies, commodities or any other financial security can offer significant returns BUT it can also result in significant losses if the market moves against your position. It requires a strong commitment to skill development, knowledge acquisition, and emotional control. It should be treated as a business with a clear business plan, proper risk analysis, and a defined set of attainable goals. The risk associated with trading the vagaries of the stock markets is probably the most important consideration as it has a profound effect on a trader's emotional control. You should not trade the stock markets with money you cannot afford to lose as there is considerable exposure to risk in any stock market transaction.

Furthermore, the past success of any trading method, strategy, or system is only indicative of future success. Under no circumstances should past success be misconstrued as a guarantee of future success!

Unless otherwise specified, the trading systems and strategies discussed on this website are intended for educational purposes only and are not meant to recommend or promote any trading system or strategy. You are expected to do your own research and testing to determine the validity of a trading method, system, or strategy on the market and instrument you wish to trade.

Trendline Patterns

In our previous lesson, we looked at basic trendline trading strategies. We focused on trading in the path of least resistance, i.e., trading in the direction of the major trend by using intermediate and minor trendlines. We learned about waiting for trendline tests and the most probable outcome of a trendline test, depending on whether we are looking at the major trendline, the intermediate trendline, or the minor trendline. In this lesson we will turn our attention to trading with chart patterns that are based on trendline breaks.

There are several chart patterns that rely on trendlines, and more particularly, trendline breaks. These patterns include the Head and Shoulders pattern, the various Triangle patterns, and the Wedge pattern.

The Head and Shoulders Pattern

The most significant chart pattern that uses trendlines is the bearish Head and Shoulders pattern, followed closely by the bullish inverted Head and Shoulders pattern. These are trend reversal patterns with fairly shallow trendlines. In our lesson on Drawing Trendlines, we mentioned that a shallow trendline is an indication of a weak trend. This is true in a Head And Shoulder pattern and an Inverted Head And Shoulder pattern. Generally, the trendline will have at least three touches formed by swing points. The first and second swing points will have a relatively moderate price movement away from the trendline, followed by a relatively large price movement up to the third swing point. This is followed by another relatively moderate price movement away from the trendline before the next trendline test, which is expected to break the trendline.

For the head and Shoulder pattern, the trendline is often referred to as the neck line and has three touches: the first two formed by the left shoulder and the third formed by the head. On the completion of the right shoulder, price is expected to break the trendline. This, however, does not always occur immediately. Sometimes the price may bounce to form a double right shoulder. On some occasions, the left shoulder may be a double shoulder.

Our entry signal would be a close on the other side of the trendline with a stop triggered should the price cross over and close on the other side again. The projection for our price target is the distance the between the trendline and the furthest point that forms the head. Here our protective stop should be close to our entry level giving us a good risk/reward ratio. However, if the price break moves too far from the neck line, giving us a poor risk/reward ratio, we could wait for a possible pull back to the trendline before entering the trade. A pullback to the neck line does not always occur, in which case, we would miss a trade opportunity. However, missing a trade is not is preferable to risking too much for too little potential gain.

The Triangle Patterns

There are three Triangle patterns that rely on trendlines: the bullish Ascending Triangle, the bearish Descending Triangle, and the Symmetrical Triangle patterns. The latter can be bullish or bearish. All these triangle patterns are classified as trend continuation patterns and they all make use of two trendlines to form the triangle. The breakout is expected to be in the direction of the current trend.

For the Triangle patterns there are two trendlines one that forms the upper bounds and another forming the lower bounds of the triangle. In the Ascending Triangle, the upper trendline is relatively flat while the lower trendline is rising; in the Descending Triangle, the lower trendline is relatively flat while the upper trendline is descending; and in the Symmetrical Triangle, the upper trendline is descending while the lower trendline is rising. Both trendlines in all of the Triangles should have at least two touches to form the trendlines. In the Ascending and Descending Triangles, the third touch on the relatively flat trendline often breaks the trendline. The same is true for the Symmetrical Triangle, though the break often occurs in the direction of the current trend.

As with the Head and Shoulders pattern, our entry signal for any of the three Triangle patterns would be a close on the other side of the trendline with a stop triggered should the price cross over and close on the other side again. The projection for our price target is the distance the between the very first touch of either of the trendlines and the point drawn vertically to the other trendline. Here our protective stop should be close to or entry level giving us a good risk/reward ratio, but again, we could wait for a possible pull back to the trendline before entering the trade if the price break moves too far from the trendline giving us a poor risk/reward ratio. And, again, a pullback does not always occur, so we might miss the trade opportunity, but missing a trade is not risking too much for too little gain.

The Wedge Pattern

The Wedge Pattern is similar to the Triangle patterns but it is classified as a trend reversal pattern that can be a bullish Falling Wedge or bearish Rising Wedge. In either Wedge there are two trendlines that define the upper and lower bounds of the Wedge with one trendline being shallower than the other. In a Falling Wedge, the lower trendline is shallower while in a Rising Wedge, the upper trendline is shallower. As with the Triangle Patterns, both trendlines in the Wedge Pattern should have at least two touches to form the trendlines. In the Wedge Pattern, the third touch on the steeper trendline often breaks the trendline.

As with the other Trendline Patterns, our entry signal for the Wedge Pattern would be a close on the other side of the steeper trendline with a stop triggered should the price cross over and close on the other side again. Our price target is the distance the between the first touch on the steeper trendline and the point drawn vertically to the opposite trendline. Here our protective stop should be close to or entry level giving us a good risk/reward ratio, but again, we could wait for a possible pull back to the trendline before entering the trade if the price break moves too far from the trendline giving us a poor risk/reward ratio. And, again, a pullback does not always occur, so we would might miss the trade opportunity, but missing a trade is not risking anything and might be preferable to risking too much for too little potential gain.

Other Trendline Patterns

There are other chart patterns that also make use of trendlines. Some, like the Double Tops and Double Bottoms rely on flat "trendlines" that do not exist until the second swing point is formed. With the Triple Tops and Triple Bottoms, the trendline has already formed. Double Top and Double Bottom patterns, as well as Triple Top and Triple Bottom patterns, are trend reversal patterns with no clear price target. Our entry for Double Top or Double Bottom pattern would be when the second swing point has formed, while for a Triple Top or Triple Bottom it would be when the price bounces off the trendline. Our protective stop loss could be placed somewhere on the other side of the trendline.

Another trendline pattern is the Channel Line, which is two parallel trendlines that the price action bounces between. Here again we would want to trade in the direction of the major trend, even when the two trendlines that form the channel are fairly flat. We would thus anticipate a bounce off the trendline in the direction of the major trend with a protective stop on the other side of the trendline and our price target in the vicinity of the opposite trendline. For a good risk/reward ratio, we would need the channel to be fairly wide.

Chart-Formations.com

Trendline Patterns

Previous Lesson

Next Module