Chart patterns are the most powerful tool for making predictions in the financial markets
They always prevail over off chart indicators and even moving averages. Chart patterns are watched by all kinds of traders and even institutional traders whose collective actions immediately influence these markets. These chart patterns can be confusing enough on their own, since they too can yield conflicting and ambiguous signals, just like all other indicators, but overall they often set things clear on the charts, especially on the daily and weekly time frames. Not so much though on the hourly or shorter time frame charts.
Swing Point Patterns
The swing point patterns are the most commonly occurring ones, among all patterns. Swing points are simply highs and lows that the market made in previous days and weeks, when these highs and lows are breached by market price the trend of the market can change. Swing points are defined as highs and lows which are set at least several days apart from each other, and the actual high or low took several days to form. Highs and lows formed by a single trading day’s action, no matter how steep, do not qualify as swing points. It takes at least several days to form a valid swing high or swing low.
Trendlines
Trendlines are one kind of important chart pattern, these are simply notional lines on the chart that market price itself seems to respect, until there is a breach at some later point in time. Trendlines also come in the form of parallel channels, these are channels defined by two notional trendlines. Parallel channels are also very commonly occurring in the markets and are very useful for determining approximate support and resistance levels.
Flags
Flags are another type of interesting chart pattern, these form in the kind of formation that makes up a small parallel channel which resembles a flying flag. The theory here is that market price will likely continue in the direction that the flag pattern is showing, either up or down. Flags work quite well and define a rough exit level where market price will lose momentum and traders close their trades at that level.
There are many more patterns but they can be overwhelmingly confusing to traders unless they master these simple patterns first. Other chart patterns such as head and shoulders and triangles are even more confusing since they do not necessarily hint direction. The popular head and shoulders pattern especially is not a directional pattern, it is a consolidation pattern where the direction of market price cannot be predicted. Contrary to what many trading books would have you believe, the head and shoulders pattern cannot predict direction.
All in all chart patterns can be used to determine likely market price direction, in most cases the analysis process has to cut through confusion and false signals that create even more confusion. There is no way to completely eliminate confusion, but traders can at least establish price zones within which market price is expected to remain neutral. Below and above these price zones the market will breakout, so these zones set levels of support and resistance which are very useful in trading.
The German DAX index on a weekly chart, notice the arrows define points where market price breached a previous swing point and the trend changed. The 3rd and 4rth green arrows may appear confusing, these are points where the market actually fell, hinting a reversal to the downside, but the very next week the sell signal was negated and the whole pattern became a buy signal. Whereas in the case of the red arrow we see a valid sell signal which simply does not work out and it is a false sell signal. There are more specific rules for determining whether a signal is a false one or it has been negated into an opposite signal. There is a big difference between these two, as the false signal it is better left alone, whereas the negated (inverted) signal can be traded right away. Notice how the MACD indicator is wrong during some of these signals, and only the MACD histogram sometimes provides a rough warning by diverging in the opposite direction of the MACD crossovers.
As you can further see on the above chart parallel channels are easy to spot, and the flag on the right side is a bullish flag in this case suggesting that the DAX index will move higher from here. The actual target price is expected to be about as deep as the depth that defines the entire flag pole formation. Moreover a market will become generally more bullish once it is trading above the flag formation, and more weak once it is trading below the flag formation in the case of a bearish, upside down flag.
Flags and parallel channels are perhaps some of the most important chart patterns, and as always remember that they tend to override all conflicting off chart indicators. In the case of the above DAX index flag, the MACD indicator shows a down trend, but the flag is an upside, bullish flag, therefore the MACD is slowly becoming wrong, and only its histogram hints some loss of momentum in the downtrend. Histograms are very rough to use, since their timing can be off by many weeks, on weekly charts, so they are not very useful for trading. But as soon as the upper trendline of the parallel channel of the bullish flag is breached and the DAX settles above it for a a day or two, the trend will likely have changed from down to up. It always tends to work this way, regardless of what indicators suggest. Indicators however can be used on the daily charts, with default or custom settings, and be made to detect momentum and risky points which chart patterns will not warn you about.
