Top 7 Forex Chart Patterns
If you’ve ever traded Forex or equities, you’ve at least heard of chart patterns. While they may look like voodoo to some, they aren’t as difficult to understand as you may think. Chart patterns can be instrumental in making profitable trading calls. That said, it does take some knowledge and a little bit of experience to really get the most out of chart patterns. You’ll need to practice to get some experience, but we’ll take care of the former requirement and give you all the knowledge you need on the top chart patterns you need to know for trading Forex. Combining your own chart pattern knowledge with that of expert traders in our free telegram group can be a good exercise to improve your own knowledge. For the uninitiated, forex chart patterns are patterns formed by price action on an asset’s chart with an above-average probability of continuing in a certain direction. If this sounds too complex, think of them as mathematical prediction tools; a financial crystal ball, if you will. It's worth bearing in mind that all chart patterns can be combined with more traditional indicators, like the RSI or Fibonacci retracement. There are a few things you should know about before we discuss chart patterns.
Types of Charts
When you use forex trading tools, you’ll come across various types of charts. The three types most commonly used by forex traders are line, bar, and candlestick charts.
A line chart is the simplest form of a chart. They are an excellent choice for beginner traders while they continue to learn about other chart types. Unfortunately, they aren’t as efficient as other types of charts when it comes to giving information about a currency pair’s price movements. A line chart only traces the price from one point to the next. It can show traders the trend of the price and a general sense of how the price is moving, for a particular time-frame.
The bar chart goes a step further than the line charts and gives some useful information to the traders. In addition to closing prices, they also show high and low indications for the opening prices. For all vertical lines on a bar graph, the lower end of the line shows the currency pair’s lowest traded price for a certain time-frame, while the top end of the line represents the highest traded price for the given time-frame. You’ll also see two horizontal lines protrude out of the vertical lines. The line on the left represents a currency’s opening price for a certain time, while the line on the right represents the closing price for a certain time.
Candlestick charts are used generously by traders, and for good reason. They reveal a lot more information than the previous two types. As the name suggests, the chart is composed of candlesticks. Each candlestick represents a certain time-frame, which could be a few seconds or few hours. For a given timeframe, a candlestick reveals four values, which include the opening price, closing price, the highest price, and the lowest price. Have you heard a trader say today’s session was “bearish” or “bullish”? You can determine this using a candlestick too. If the closing price > opening price, the session was bullish, and bearish otherwise.
Categories of Chart Patterns
The chart patterns we’re going to discuss can be categorized based on the direction the price is likely to take after exiting the pattern.
Reversal Chart Patterns
A reversal chart patterns signal a change in an ongoing trend. If the price of a pair is in a declining trend, a reversal chart pattern would suggest that the prices could start to move up, and vice versa. The most common chart patterns used in this category are head and shoulders and double tops and double bottoms.
Head and Shoulders Pattern
Head and shoulders pattern occurs in two forms: straight and reverse. A straight head and shoulders pattern forms when the price is in an uptrend and makes three highs, with the first and last high forming the shoulders and a central higher high which forms the head. Connecting the lowest points of the patterns gives us a neckline. To obtain a target price after the price dips below the neckline, you must calculate the distance between the neckline and the top of the head. On the contrary, if the price is in a downtrend, the head and shoulders pattern will look like a mirror image of the one shown above. Therefore, it’s called a reverse head and shoulders pattern.
Double Tops and Double Bottoms Pattern
Double tops and double bottoms patterns are a head and shoulders pattern without the head. It has two peaks or troughs based on the current trend of the price. This pattern signals exhaustion in the market and an intention of the market to reverse the price’s prevailing trend. You can take the price targets in a double tops/double bottoms pattern as equal to the height of the formation.
Continuation Chart Patterns
A continuation chart pattern signals that the prevailing trend will continue. They generally occur when the prices are in a consolidation phase and allow you to take a position in the prevailing trend’s direction. The most commonly used continuation patterns include direction wedges, pennants, and flags.
Directional wedges may occur as either falling or rising. The pattern forms when there’s a tight scuffle between bears and bulls and the price enters a consolidation phase. For example, a falling wedge in an uptrend indicates that sellers are putting downward pressure on the price, but the higher highs are forming faster than higher lows. Therefore, it signals exhaustion on the part of sellers and the prices will ultimately break higher to continue the uptrend.
Pennants form when the price is in a strong trend and takes a brief pause. They generally form a horizontal triangular shape, but they are brief and continue the trend that prevailed before the pennant’s formation. If the price is in a downtrend, a bearish tenant will form when a brief consolidation phase is followed by a significant drop in the price.
A flag pattern forms when the price enters a consolidation phase after a sharp movement in the trend. The first sharp trending move looks like a flagpole, and therefore, is known as such. In a downtrend, a flag pattern occurs when the prices enter a consolidation phase with higher highs and higher lows. When the price breaks outside the lower trendline, you know the bears are back in control of the game.
Neutral Chart Patterns
Neutral chart patterns don’t signal any direction in which the price will continue afterward, but it does signal that a breakout may occur. The breakout may be in either direction, though. Therefore, neutral chart patterns could occur in either trending or ranging markets. There are various types of neutral chart patterns, including ascending and descending triangles, and symmetric triangles.
Ascending and Descending Triangles
An ascending triangle forms when the price consolidates and makes higher lows and equal highs. On the contrary, descending triangle forms when the price consolidates and makes lower highs and equal lows. Even though ascending and descending triangles are categorized as neutral chart patterns, there is a chance of reversal when they form. The expected reversal is equal to the size of the formation.
A symmetric triangle forms when the price makes higher lows and lower highs. The pattern emerges when neither buyers nor sellers are able to significantly influence the price. As the price keeps converging, either side will have to let go. If the buyers give in first, the price will break out downwards, and upwards if it’s the sellers that give in. As a trader, you should look at a symmetrical triangle without bias and try to join the momentum of the trend that emerges after one of the sides gives in.
Disadvantages of Using Chart Patterns
Chart patterns can give you plenty of information as you open and close trades. It’s a vital tool in your strategy formulation toolkit. However, it does have a few disadvantages that you should be aware of so you know what you need to steer clear of.
- They can sometimes create confusion: Looking at too many chart patterns for the same asset or market can create more confusion rather than help you arrive at a decision. Often, different patterns emerge that give you different signals. When this happens, you’ll need to use your experience to determine which direction the price will take and open or close trades accordingly.
- Chart patterns don’t form all the time: As a trader, patience is your most valuable asset. It may take several time periods before you can conclusively confirm signals delivered by chart patterns. This can be mentally taxing because it may feel as though you’re just letting the profits walk away while the price action plays out.
- Chart patterns are a short-term phenomenon: Chart patterns give you signals that remain relevant for a very brief time. If you don’t make your move within that short window, you can’t take advantage of the opportunity. A very short delay can cause a trade to become significantly less profitable, or even unprofitable.
- News events can rock the boat: A major news event like a central bank changing its interest rate can lead to the price diverging from what chart pattern analysis would suggest. That's why it's important to keep up to date on financial news with a forex calendar.
Do Chart Patterns Actually Work?
Assets are analyzed in two ways: fundamental analysis and technical analysis. While almost all traders will have a preference for one over the other, it’s advisable to use a combination of both. When you do this, you’ll see far better results from making decisions using chart patterns. That said, yes, chart patterns do work. They work for two reasons. First, they are a visual representation of an asset’s demand and supply. When the forces of demand and supply behave in a certain way, it creates a chart pattern that traders assign a name to for future reference. For instance, the head and shoulders pattern signifies that the forces of supply and demand are about to switch control and a trend reversal may ensue. Secondly, chart patterns are almost a self-fulfilling prophecy. Almost all traders know popular chart patterns and are likely to place trades based on this analysis. As a result, the price ultimately ends up moving in the desired direction. While some aren’t quite convinced with this theory, traders who use charts regularly argue that for a trader to initiate a trade based on a chart, the demand and supply mismatch has to occur as a precondition. Traders, therefore, are merely reacting to what the charts tell them. Regardless of why they work, the fact is they can be quite effective. If you’re about to trade forex, you should certainly have these chart patterns in your toolkit.
Chart patterns are a vital component of technical analysis and forex trading. As a trader, these chart patterns can help you make profitable decisions much more quickly. We’ve discussed the 7 most commonly used chart patterns, but there are countless more you can learn. Learning from pro traders can be an excellent way to supplement this knowledge, you can find our team in our free forex telegram group. It’s always prudent to back-test these chart patterns before you start using them for larger trades just so you have a fair idea of how to go about the process. With the help of your forex trading journal you’ll be able to improve your accuracy and find chart patterns to be a key element of your forex trading strategy.