Trading 101: Chart Patterns 2: Building a Trading Plan
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
- 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
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.