Technical analysts and traders believe that certain chart patterns and shapes provide signals of profitable trading opportunities. Many professional and amateur traders claim that they consistently make trading profits by following such signals. In this section, we introduce some types of chart patterns and the corresponding trading strategies that, according to our extensive historical tests, give the investor a strategic trading advantage.
Technical analysts and traders believe that certain chart patterns and shapes provide signals of profitable trading opportunities. Many professional and amateur traders claim that they consistently make trading profits by following such signals. In this section, we introduce some types of chart patterns and the corresponding trading strategies that, according to our extensive historical tests, give the investor a strategic trading advantage.
Moving Average Crosses
On every time scale, the evolution of exchange rates over time can be seen as a shorter-term, random oscillation, on top of a longer-term trend. Most currency rates show a rather “rhythmic” short-term oscillation with a typical cycle of about 14 to 20 periods, on top of a longer term trend typically with a circle of 30 to 50 periods. If we believe that such a cycle does exist, we should bet that the rate will continue to go through the moving average line after it is crossed, as seen in the following:
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Figure 9. Crosses down through its 20-period Moving Average with a large momentum. A likely down pattern.
For a chart in an obvious long-term trend, the 50-period moving average line usually damps out most of the shorter-term oscillations; therefore, this can be used as a reliable “moving support line.” A good trading strategy is to buy the stock if it is in an up trend and if the price bounces back up after it touches or lightly penetrates the 50-period moving average. The following figure presents such an example:
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Figure 10(a). The 50-period Moving Average is often used as a moving support line for chart in an up trend. Technical traders think that it is a strong buy signal if the price bounces back after reaching the support line.
The corresponding opposite trading strategy is to ” sell” the currency rate if it is in a down trend and if the rate drops back down after it touches or lightly penetrates the 50-period moving average.
Foreign exchange traders often consider it a bullish sign when the 21-period moving average crosses up the 50-period moving average, and consider it a bearish sign if 21-period moving average crosses below the 50-period moving average. Figure 10(b) and Figure 10(c) are such examples.
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Figure 10(b) 21-period moving average crosses up the 50-period moving average, a bullish signal.
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Figure 10(c) 21-period moving average crosses below the 50-period moving average, a bullish signal.
Candle Stick Trend Reversal
A candle stick chart is a good presentation of momentum. On a candlestick chart, one can easily see the secession of up days, down days and sudden changes in the pattern. The following figure is an example of what is sometimes called “First Sunny Day”, a typical buy pattern.
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Figure 11. A Trend Reversal pattern. After a long, long decline, the rate suddenly goes up in significant magnitude. Furthermore, it closes much higher above its open. This “First Sunny Day” sends a short-term buy signal.
The trading strategy for a “First Sunny Day” pattern is to buy the contract and hold until it recovers the range lost by the recent secession of down days, or to cut losses if it drops back to the prior day’s low. This pattern usually signals a very good profit-risk ratio.
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Figure 12. This is a short-term Trend-Reversal pattern. After a long, long rise, the rate suddenly drops; its close is much lower than its open. This pattern hints that something has suddenly gone wrong with the stock. This so-called “Sudden Cloudy Day” pattern indicates one should sell without delay.
In this example of the, “Sudden Cloudy Day”pattern, the trading strategy is to short the financial asset and hold it until it retraces the recent secession of up days or to cut losses if it breaks the previous day’s high.
For longer-term trend-reversal patterns, we often look for the “Shooting Star“; as shown in the example above. We also look for the “T-Shape” which signals a bounce-back buy signal.
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Figure 13. The price soared considerably in the past few days. At present, it shoots up, as if exhausting all its energy. This Shooting Star pattern hints that the market has lost confidence in the further potential of the underline, indicating a likely downturn.
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Figure 14. The rate dropped over several days. Presently, it drops precipitously, then bounces back to close near the open, forming a “T” shape. This may indicate that the market finally has finally decided the financial asset has dropped enough, with many bullish traders and investors coming to the rescue.
“Head-and-Shoulders”
The “Head-and-Shoulders” pattern is believed to be one of the most reliable trend-reversal patterns. The figure below shows an example of a short-term Head-and-Shoulders pattern:
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Figure 15. This is the famous “Head-and-Shoulders” formation, a sell signal.
The strategy indicated by the “Head-and-Shoulders” pattern is to short-sell the financial asset as the rate drops down the second shoulder, especially if the volume also goes up. Then one can hold the position until the rate drops all the way down to the level of significant supports and consolidation. This signal also indicates that one should cut loss if the price rises above the tip of the head. A less-risky stop- loss strategy is to cut losses if the rate goes back up the top of the second shoulder.
Range Breakout
The figure below shows an example of a typical Range Breakout pattern.
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Figure 16. A typical Range Breakout pattern, a strong buy signal. Note that the rate breaks out of the trading range defined by the two range lines with large volume.
The trading strategy for a Range Breakout is just the opposite that of Head-and-Shoulders: it indicates a strategy of buying as the price breaks the upper range line with larger-than-average volume, and continuing to hold until the rate has risen a distance comparable to the height of the range. If it goes down instead, one should stop losses as it penetrates the upper range line.
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Figure 17. This is a typical Range Breakdown with large volume, a strong sell signal.
The trading strategy for a Range Breakdown is just the opposite: short as the price breaks the lower range line with larger-than-average volume, and continue to hold until the stock has fallen a distance comparable to the height of the range. If it goes up instead, one should stop losses as it penetrates the lower range line.
Triangle Breakout
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Figure 18. Triangle Breakout
This is the famous Triangle Breakout pattern, a strong buy signal. In the past two months the price shown has consolidated with declining amplitude and volume. At present, it breaks out with high volume, signaling a possible new up trend.
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Figure 19. A typical Triangle Breakdown pattern –a strong sell signal.
“Cup-With-A-Handle”
The Cup-With-A-Handle breakup pattern is a technical buy signal. The figure below shows a typical example:
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Figure 20. This is the typical Cup-With-A-Handle breakout pattern, a strong buy signal. According to statistics, prices rise 70% of the time after such a breakup.
The strategy is to buy as the rate breaks up with larger than average volume, then cut losses if it drops back to the pre-breakup level. If it goes up as expected, this pattern calls for successively raising the stop levels, giving the trade a chance to capture most of the up potential.
“Triple Top/Bottom”
Triple Top/Bottom patterns, which appear frequently in trading, are relatively easier to detect. Below are some typical Triple Top/Bottom patterns:
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Figure 21. A bounce-back from an up-trend Triple Bottom is a buy signal. Risk involved is low. One can sell if it turns back and penetrates the line.
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Figure 22(a). This is a Triple Top Breakout pattern with large volume, a buy signal. Risk is small because one can cover the sell out the position if the rate turns back down to the suggested cut loss level.
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Figure 22(b). This is a Triple Bottom breakdown with large volume, a sell signal. Risk is small because one can cover the short position if the price turns back up to the line.
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Figure 23. A bounce-back from Triple Top, a sell signal
Stochastic Combo
The Stochastic Combo trading strategy is based on the rate satisfying a combination of conditions of the various technical indicators. For the buy signal, the chart will have to show a long-term up trend, the momentum indicators will have to indicate that the contract is oversold, the RSI will have to be low, and the rate will have to be near the lower Bollinger Band, showing starting signs of bounce-back. The figure shows such an example:
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Figure 24(a). This is a buy signal from our Stochastic Combo model. The chart is in an up trend and all the indicators (RSI, K/D, MACD and Bollinger Band) show that the stock is oversold. Furthermore, it has already turned up.
For the sell signal, the chart will have to show a long-term down trend. Momentum indicators will have to signal that the stock is overbought, that the RSI is high, that the MACD is favorable, and that the rate is close to the upper Bollinger Band, showing first signs of decline. All this is illustrated in the figure below:
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Figure 24(b). This is a sell signal from our Stochastic Combo model.
The trading strategy is to ride on a general trend and at the same time enhance profits by capturing the likely short-term mean reversion. If the rate moves as expected, one should hold until it penetrates the center Bollinger Band (a 14-to-20-day moving average), or even until the rate nears the opposite Bollinger Band. If, however, the rate moves in the wrong direction, one should cut losses shortly after it goes beyond the prior day’s intra-day extreme.
“Technical Trading Strategy.” FXtrek University. . Copyright © 2001-2007 FXtrek.com. 20 Novemeber 2007 <http://www.fxtrek.com/UniversityEN/tech_tra/tech_trading_strategy01.asp>.
