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Trading 101

Trading 101: Chart Patterns 2: Building a Trading Plan

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After taking a look at the most common chart patterns, we will go a step further, and build simple trading strategies based on them. This process has a very important condition—traders should already understand the probabilistic nature of markets. Why? Because chart patterns will only help you if you use them as they supposed to be used; to increase the odds of success. That it is in stark contrast with the approach of a lot of beginners who treat these tools as the part of some sort of forecasting method.

But if used correctly, chart patterns might give you the edge to be profitable either if your main view of the market is correct or even if you are completely wrong. That’s right; a well-built strategy could be profitable even in a generally hostile environment, although it’s much more likely that it will “only” minimise your losses.

The Process of Building a Trading Plan Using Chart Patterns

The first thing to note about pattern trading is that these formations should be used in the context of trend (and cycle) analysis rather than as standalone trading tools. If you have a strong trend with healthy momentum, you will naturally look for consolidation and correction patterns, while if the general trend is weak or a turning point is near according to cycle analysis, you should be looking for reversal patterns.

Let’s see the exact steps of the process!

  • Trend and cycle analysis to evaluate the underlying trend
  • Pattern-recognition
  • Setting price targets and stop-losses
  • Determining the size of the position

As you can see, there is no “How much will I win?” point in the list. If that is surprising for you, you are not alone; most beginner traders start with that without considering the conditions of the trade. That is how they end up with way too big positions, which might be devastating to their portfolio. Of course, a big position can mean big profit as well, but at a certain point, a losing trade will come, and that’s when emotions kick in causing all kinds of trouble.

To avoid that, the best thing to do is to follow these steps and build a proper trading strategy that covers exit points in the case of both profits and losses.

1.  Trend and cycle analysis to evaluate the underlying trend

If you have been reading this series, you already have some idea of trend and cycle analysis, even without the knowledge of the more advanced techniques that are yet to be covered. Firstly, on the time-frame you trade, you will be looking for a healthy trend in the direction that you take the position on. What does that mean exactly? You should be looking for a series of higher highs and higher lows for a long position, and conversely a series of lower lows for a short position.

Also, you should be applying one of the most powerful approaches to trading, the multi-time-frame mindset. You see, trends are present in multiple time-frames for every asset. There could be a huge megatrend that dominates the asset’s long-term trajectory, like the positive forces behind the rise of cryptocurrencies; while short-term the asset might be in a corrective trend or even a bear market.

Short-Term Reversals in Bitcoin’s Long-Term Uptrend With Entry Points

Now, if you want to jump in the long-term trend, the best entry point is the turning point of the counter-trend on the shorter time-frame. This means a declining short-term trend (or a sideways consolidation trend) in a long-term uptrend or a rising short-term trend in a downtrend. At those points, the asset should be neutral or oversold (or overbought), ready for a short-term bounce, while the long-term trend will also be there to kick-in and give a boost to the price. You can see great examples for short-term reversals in the recent price history of Bitcoin on the chart above.

Cycle analysis will help you in finding the possible turning points in the shorter-time frame trends, but as we already stressed, trend reversals are harder to “catch” than trend continuation events. This means that you might have to try more than once before you will be able to enter the long-term trend like this. That said, the huge possible profits mean that even if it’s a lower probability trade, the expected value of it more than enough to justify the risk.

The Same Entry Points in Bitcoin With Projected Cycle Lows

2. Pattern-Recognition

This is the part where you will need some “magic“, as the rules of charts patterns are not carved into stone, in fact, sometimes your gut feeling will be more important than the rules in fact. With experience, you will have a feeling about the dynamics of a certain market, and the patterns that usually develop in it. A lot of successful traders are only trading a few assets, those that they are familiar with, know their important support and resistance levels, and the strategies that are suitable for them.

Also, as assets evolve with time, and as they do the patterns that take shape will slowly change, as the underlying market dynamics also change. A penny-stock could have completely different set-ups than the stock of a well-established global company. The basic types of chart patterns are the same, as the dynamics behind the move are similar, but the exact way they unfold are different.

What’s the Next Step?

So, let’s say that you have spotted a perfect double bottom on a short-term time-frame that could provide an entry to a huge bull-market that you expect to last for years, how do you proceed? Well, the answer depends on your strategy. These entry points can be used not just for short-term trading strategies, but for establishing long-term investment positions (while minimising downside risks) or for adding to already existing investments as well.

In these latter instances you don’t have to bother with targets and stop losses, as your target is based on value analysis, not trading set-ups, while stop-losses are not useful, as if you are confident in your investment analysis, you should actually buy more if the price further falls.

But if you are trading short-term you will have to proceed to the third and fourth steps of the planning process to limit your risk and optimise your position size. In our next article, we will do just that, and we will show real-life examples of winning and losing trades as well, with the most common mistake that you can commit in pattern-based trading.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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4.6 stars on average, based on 380 rated postsTrader and financial analyst, with 10 years of experience in the field. An expert in technical analysis and risk management, but also an avid practitioner of value investment and passive strategies, with a passion towards anything that is connected to the market.




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3 Comments

3 Comments

  1. embersburnbrightly

    June 12, 2017 at 1:10 pm

    Amazing article, thank you very much!

  2. dnyoto

    June 12, 2017 at 6:35 pm

    Very useful information. Looking forward to the next one.

  3. zhaocan1023

    February 24, 2018 at 3:50 am

    Hi Mate, thanks for your great work all these time. I have been reading through your analysis/tutorials and find them very helpful.

    This article above has some follow-ups listed, but i cant find an ensuing article. Did you leave it out?

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Trading 101

Trading 101: 4 Reliable Chart Patterns in Crypto Trading

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Graph

In our previous piece on chart patterns, we pointed out that the way to use patterns is to judge probabilities that a certain move will happen rather than to view them as some holy grail in the market (which unfortunately doesn’t exist to my knowledge).

Although they aren’t holy grails, chart patterns are some of the best tools we can use to trade the markets with a surprising degree of accuracy. For example, some estimate that a well-known pattern like the head & shoulders have an accuracy of more than 80% when it is complete. Very few indicators can match that!

In this article, we’ll go over the 4 best chart patterns to use in crypto trading, teach you how to spot them in the charts, and show you how to trade them.

1. Head & shoulders pattern

Since I already singled out the head & shoulders as the most accurate pattern, let’s start with this classic chart pattern that most people have heard about and probably have an idea what should look like.

head and shoulders

The head & shoulders pattern generally signals a reversal in the market, as it is essentially a failed attempt of a trend to move higher. As we know, an uptrend is defined as a series of higher highs and higher lows, but in the case of the head & shoulder, the last trend wave fails at making a higher high and higher low, and a new downtrend is initiated. The opposite pattern, known as an inverse head & shoulder, signals a shift from a downtrend to an uptrend.

Since the head & shoulder is so well-known by now, and the logic is based on simple trend trading, it is often considered to be the most reliable pattern in trading. It can often be easier to spot on a line chart as it can help you filter out all the clutter otherwise found on candlestick charts.

2. Bull flag

This is a continuation pattern and is also considered one of the most reliable bullish patterns we have. Sometimes also called a pennant or a wedge, these names all essentially refer to the same thing.

Bull flag

The bull flag is formed when price enters a consolidation phase following a strong uptrend. What really happens when price is consolidating is that the market is gathering momentum for the next burst up. It is a natural part of a trend where those who have been with the trend from the beginning are taking the opportunity to realize some of their profits, while new traders are entering the market and positioning themselves for the next run-up in prices.

3. Cup and handle

First introduced in William O’Neil’s book How to Make Money in Stocks, the cup and handle pattern is a bullish chart pattern that is very well-known in the stock market, but also appears to work well in other markets.

According to O’Neil, the pattern should span a period of 1 to 6 months in the stock market. In crypto, where everything moves faster, this period can safely be cut in half. For the pattern to be more reliable, we would ideally want to see a significant rise in trading volume near the end of the handle as price begins to rise. A buy order should be entered as price breaks above the high made by the right side of the cup.

The logic behind the pattern is the same as for the head & shoulder and trend waves: the cup represents the bottom in the market and the handle creates a higher low, which by definition means that an uptrend has started.

4. Rectangle

The rectangle is a similar pattern to the bull flag and trading channels, where price appears to be “stuck” between two imaginary lines on the chart. The more touches we have between these outer lines and the price, the more reliable the pattern is considered to be.

The rectangle is a trend continuation pattern, and often becomes a waiting game for traders since it is difficult to tell exactly when the price will break out of the pattern. However, the pattern is fairly reliable at predicting the direction price will break out in. The rectangle can be either bullish or bearish, depending on the direction of the preceding trend.

The pattern can be traded either by placing an order when price is close to the lower end of the rectangle with a stop just below the lower line and then waiting for price to break out. Alternatively, you can place a buy order just above the upper end of the rectangle in hopes of catching the trade as the price breaks out. The danger with the last option is that fake-outs where price spikes up just to fall back down do occur quite frequently. As always in trading, taking a slightly more conservative approach may serve you well over the long-term.

Featured image from Pixabay.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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4.3 stars on average, based on 37 rated postsFredrik Vold is an entrepreneur, financial writer, and technical analysis enthusiast. He has been working and traveling in Asia for several years, and is currently based out of Beijing, China. He closely follows stocks, forex and cryptocurrencies, and is always looking for the next great alternative investment opportunity.




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Trading 101

Lessons from The Turtle Traders

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turtle traders

For those of you who haven’t heard about the so-called turtle traders before, I’ll give you a brief recap here: “The turtles” were a group of laymen traders who were chosen more or less randomly to be coached by two of the pioneers in trend-following trading; Richard Dennis and William Eckhardt.

While Dennis, who had already made more than $100 million in the markets, were convinced that anyone could learn to trade, Eckhardt argued that Dennis was a gifted trader and that it would be extremely difficult for someone else to replicate his success. Unable to come to an agreement, the two men figured that the only way to settle the dispute would be to conduct an experiment where they would teach ordinary people their own trading system, and then measure the results.

As the story goes, the turtles became hugely successful, and Dennis was proven right.

Their story became known to world mainly through Michael Covel’s books Trend Following and The Complete Turtle Trader, where he shared some previously unknown details about the very simple trading strategies and methods used by “the turtles.”

Although the turtle experiment took place back in the early 1980s, the lessons learned from the experiment are as valid in today’s crypto market as they were in the commodities market Eckhardt and Dennis were trading in back then. In this post, I therefore wanted to share some of methods used by the turtles that can hopefully help you improve your own trading performance as well.

If you are interested in learning more about the methods the turtles used, I recommend reading Covel’s book to get the full story.

ATR as stop-loss

Using the Average True Range (ATR) indicator as a trailing stop-loss is something I learned from Covel’s book about trend following and that I’ve used successfully over the years, as I wrote about in another post about a trend following trading strategy.

Generally, the idea of using trailing stops in trading is that it allows you to ride the trend for longer, without taking on unnecessary risk. It is also in the very essence of trend following trading that traders should not try to predict where a trend will start or stop, but instead simply react to what the price is telling them. In this context, if the price breaks through the ATR line you have drawn up on the chart, it is telling you that the trend has ended and it is time to get out of the trade.

The ATR is calculated based on the volatility of the asset, which means that perfectly normal market movements will be classified as noise, and only extraordinary movements to either side will lead to price breaking through the ATR line.

TradingView has a very useful built-in indicator for using the ATR as a trailing stop called “ATR Stops.”

Maximum 2% risk on each trade

Since the turtles used the ATR as their stop-loss, the risk in terms of pips on each trade would naturally vary depending on the asset they traded. However, by adjusting their position size, they still managed to keep their risk at no more than 2% of their trading account on any one trade.

Pyramiding

Pyramiding is the concept of adding to a winning trade as time passes. This is pretty much the opposite of conventional value-based investing wisdom, where it is usually preached to buy low and sell high. The turtle traders, on the other hand, were not afraid to buy high and sell when things were moving against them (buy high, sell low).

The turtle traders usually didn’t move in with the full position size that their risk management allowed on the first order, but would instead spread out their orders and buy more as the trade moved in their favor. For example, they would enter an order with a position size that kept their risk at 0.5% of their capital as a trend started to form, and then enter new orders as the trend continued until they reached the 2% risk that their system allowed for.

This protected their downside if the trade moved against them from the start while at the same time enabled them to ride the trends until the end.

Reduce risk during losing streaks

The turtles were very aware of the emotional drawdown that follows a loss in the market, and they understood that because of this, losses tend to follow each other and create losing streaks from which traders sometimes never recover.

Because of this, Dennis and Eckhardt introduced a rule saying that if an account is down by 10%, the trader must adjust his risk as if he has lost 20%. With a smaller trading account left, the trader would then be forced to reduce his risk on each trade in order to stay within the maximum 2% risk allowed on each trade.

Not only did this save the turtle traders’ trading capital, but it saved their emotional capital as well.

Keep it simple

Lastly, it is important to remember that the exact trading system the turtles used was relatively simple and straightforward. Trend following trading is often like this, and it has been proven over and over again that simple and robust systems beats complicated strategies. As Richard Dennis was quoted as saying in the Market Wizards book:

“I always say that you could publish my trading rules in the newspaper and no one will follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80% as good as what we taught our people. What they couldn’t do is give them the confidence to stick with those rules even when things are going bad.”

Featured image from Pixabay.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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4.3 stars on average, based on 37 rated postsFredrik Vold is an entrepreneur, financial writer, and technical analysis enthusiast. He has been working and traveling in Asia for several years, and is currently based out of Beijing, China. He closely follows stocks, forex and cryptocurrencies, and is always looking for the next great alternative investment opportunity.




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Trading 101

Trading 101: Determining and Trading Trend Strength

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Trend-following trading remains the most popular approach to trading in the retail segment, both in crypto and other markets. However, before taking positions in the direction of a trend, it is crucial to determine if the trend is gaining or losing strength. As trend traders, we need to make sure we are only taking trades in trends that are building up, and not those that are fading.

While we have covered the basics of trend-following trading in the past, and also revealed several trend-following strategies, we will here focus on how you can determine if a trend is worth trading, using both systematic and discretionary tools.

Trend waves and pullbacks

Studying trend waves and pullbacks during a trend forms the basis of a discretionary approach to determining trend strength.

In a trending market, small pullbacks signal strength in the trend. If each pullback is getting increasingly smaller as the trend continues, we can say that the trend is picking up momentum. Another thing we often see in strong bullish trends in that the pullback is not really a pullback, but rather a sideways consolidation of the price. This indicates that bulls are strongly in control of the market, buying up even the smallest dip in prices.

On the other hand, as pullbacks get larger and occur more frequently, we can take it as a sign that the trend is losing momentum and the price may reverse into the opposite direction soon.

Moving Averages

Moving Averages are probably some of the best-known tools for trend traders, and for good reason. They are incredibly simple to use, and can provide powerful signals in almost all markets.

The most common way to determine trend strength with Moving Averages is to apply two Moving Average lines to the chart; one slower and one faster. For example, combining the 20 and 50 period Moving Averages is a common strategy among swing traders in both forex, stocks, and crypto (the lower the period setting of the Moving Average is, the faster it reacts to changes in the price).

In a strong uptrend, we should have the faster moving average staying consistently above the slower Moving Average. If the distance between the two moving average lines grows, it means that the trend is gaining momentum, and if the distance between them shrinks, the trend is losing momentum.

If the two lines cross over each other, this is often taken as a sign that the trend is about to reverse. Many successful trend-following strategies follow the simple logic of buying an asset when the faster Moving Average crosses over the slower one, and selling an asset when the slower Moving Average crosses over the faster one.

Price rejection

What we call rejection of higher or lower prices in technical analysis is most easily spotted using traditional candlestick charts and looking for long wicks sticking out either above or below the “body” of the candles, as in the screenshot below.

Price rejection

In this chart, we can clearly see that we had a strong bullish trend and that the price attempted to extent the trend further, but repeatedly got rejected by the market. After four attempts at going higher, this market lost all bullishness and went into an extended downtrend.

Relative Strength Index (RSI)

As the name implies, RSI is an indicator that measures strength. In just the same way as we define an uptrend in price as a series of higher lows and higher highs, the RSI line should also make higher lows and higher highs when the market is trending up. In non-trending (range-bound) markets, the RSI generally moves sideways and stays between readings of 30 and 70.

As trends come to an end, we sometimes see divergences between the trend of the RSI and the price itself. For example, price may be making a new higher high, while the RSI line fails at making a new high, or even makes a new lower high, as we have two examples of in the screenshot below:

RSI divergence

Average Directional Index (ADX)

This is the classic trend indicator that many traders still use. The indicator consists of a red line and a green line and it basically says that a green line above a red line means we are in an uptrend. In the opposite case, a red line above a green line would mean that we are in a downtrend. If the two lines are close together it means that the market is not clearly trending, but rather stuck in a range.

Trend-following strategies sometimes make use of the ADX indicator in combination with Moving Averages to find strong price trends to ride. The ADX could then help determine the strength of the trend while for example cross-overs of two Moving Averages could serve as entry and exit points.

Which one should you use?

Perhaps unfortunately, which specific indicator to use in your trend-following trading really comes down to personal preferences. There is no right or wrong indicator to use, nor is there any right or wrong way to combine indicators and create your own trading strategy.

That said, most traders try to avoid combining indicators that are measuring the same thing. For example, ADX, Moving Averages and MACD are all considered trend indicators, while RSI and Stochastic are considered momentum indicators. In other words, you could combine Moving Averages and RSI, but should avoid combining Moving Averages and ADX with each other.

Experimentation is also fine, but instead of trying to learn how to use lots of different indicators, a better strategy is generally to use a few and become an expert at them. They are all powerful in their own way, it just comes down to the trader to master them.

Featured image from Pixabay.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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4.3 stars on average, based on 37 rated postsFredrik Vold is an entrepreneur, financial writer, and technical analysis enthusiast. He has been working and traveling in Asia for several years, and is currently based out of Beijing, China. He closely follows stocks, forex and cryptocurrencies, and is always looking for the next great alternative investment opportunity.




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