The Secret Art of Trading Chart Patterns

Sep 10th, 2012 | By Greg Guenthner | Category: Investor Education, Trend Playbook

If you’re new to technical analysis, you’re probably learning how to trade stocks that are breaking out of reliable chart patterns.

I get questions about chart patterns all the time from friends and colleagues. They remember catchy names like “head & shoulders” and “pennants”. However, they fail to realize the behind-the-scenes forces that are at work to create these charts—and the all-important techniques involved in trading the set-ups.

There’s so much more to patterns than shapes and names. Today, I want to move beyond the basic concept of patterns and reveal the secrets to trading chart pattern breakouts consistently and accurately.

Let’s get started…

1. How to Find Tradable Patterns: Don’t Rely on Your Computer

Free stock screening software can be a big help when it comes to narrowing down your list of potential trades to more manageable levels.

Websites like Finviz.com also offer some basic pattern recognition features. On Finviz, you can click on the “Signal” drop box to find plenty of patterns to search through:

I recommend using my basic stock scan I wrote about last month as a guide to narrow down your search before you dive into the individual patterns.

Pattern recognition is a good way to begin your search if you’re new to spotting key set-ups. But I don’t recommend completely relying on pattern recognition tools. For starters, many of the charts won’t be up to snuff. There’s an art to identifying some of the more ideal patterns. And many times, computer software alone doesn’t “see” the key parts of a chart. Using scans like this one can be a great way to narrow down your search if you don’t have much time.

But I don’t recommend blindly trading any chart that happens to pop up on your screen.

Instead, you should get in the habit of sifting through your charts manually. Narrow down your list to between 50-100 names. It might take you a while to get through them all at first. But with just a little experience, you’ll quickly learn to pick out the quality setups. From here, you’ll be able to construct a decent watch list.

2. Pattern Breakouts: Confirmation is Critical

Once you build your watch list, you’ll need to determine when to trade a pattern breakout. This is a crucial step in the process—one that can be the difference between making consistent gains and draining your brokerage account.

Newer traders have a tendency to jump on every chart pattern breakout without confirming the move. This can be a dangerous practice—especially in a choppy market. That’s why you should “filter” your breakouts using both price and volume.

The secret here lies in being selective. Here are a couple of general rules:

First, don’t buy a breakout unless the stock closes above the breakout price—or penetrates resistance by a pre-determined percentage. This will help guard against intraday whipsaws.

Next, closely monitor volume on all upside breakouts. You want to see volume expand as the stock price moves higher. Don’t risk your money on breakouts that occur on weak volume. If more and more buyers aren’t willing to pay higher prices for the stock, chances are it will soon fall back below your breakout zone.

3. Don’t Hold Out for Perfection

When you’re first attempting to identify chart patterns, you might find yourself searching for the perfect set-up. That’s probably because charts you have studied were selected as examples because they were ideal specimens. In reality, not every head & shoulders patter will be perfectly formed. You might also find it difficult to draw perfect support and resistance lines on some charts.

With time, you’ll find that every pattern doesn’t need to be perfect. While you’re developing your trading instincts, you might want to add a few of these “imperfect” charts to your watch list to see how they ultimately play out.

Remember, even the most ideal chart pattern might not work out in your favor. That’s one of the risks you take as a trader (and the reason you should always set and obey your stop loss). On the flip side, some of these not-so-beautiful charts can turn into great trades.

If you come across an imperfect ascending triangle that has a clear resistance area, there’s no reason not watch it for a breakout. The same goes for an inverse head & shoulders that’s not perfectly symmetrical. Don’t obsess over the shapes. The important forces are the buyers and sellers creating these charts. If support is imperfect– yet resistance is clearly broken—there’s no reason you shouldn’t want to trade the stock.

Here’s an example:

Here we have a messy chart. But the important signs are all there. The stock was bottoming in May, it found higher lows in July, and finally broke out on strong volume later that same month. Despite the sloppy look to the chart, it still could have delivered impressive gains to an alert trader.

I’ll bring you more trading tips later this week. Send questions, comments, and suggestions for my next stock scan to trendplaybook@agorafinancial.com

Sincerely,

Greg Guenthner, CMT

August 27, 2012 -- How to Trade from a “3-Minute Scan”
January 2, 2013 -- Don’t Fear a Fundamental Filter
September 17, 2012 -- The Secret Art of Trading Chart Patterns
September 12, 2012 -- How to Trade Bullish Crossovers
November 30, 2012 -- How to Find Bottoming Stocks

Greg Guenthner

Greg Guenthner, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes. He is also the editor of Agora Financial’s Trend Playbook, a free resource for trend followers and technical traders. For close to a decade, Greg has led Agora Financial’s small-cap division, where he founded one of one of the only independent OTC research advisories in the industry. Greg specializes is classical trading techniques and combines timing strategies with his fundamental analysis of small-cap stocks.

He is a member of the Market Technicians Association and hold the Chartered Market Technician designation.