Invalidated Price Patterns

[RichardCox 10]

Forex trading with price patterns is perhaps more prevalent than what is seen in the trading of other financial asset classes (such as stocks or commodities). This is often explained by the fact that the fundamental picture for a currency (i.e. the economy of an entire country) is much more difficult to assess than the similar elements in an individual stock. Because of this, price patterns in the forex markets tend to have more force and accuracy because there is a larger percentage of the trading community that are aware of these patterns as they arise.

 

Pattern Parameters

 

From a trader’s perspective, price patterns are particularly useful because of the way these patterns define clear levels for position entries and exits. It is also relatively easy to see instances when the price pattern itself is valid or invalidated. One problem, however, is that these patterns are subjective. Some traders make the mistake of using pattern recognition software, and then use those signals as if they are accurate in all cases. The issue here is that input parameters for these patterns must be set in advance and are only as accurate as the human input that defined those parameters.

 

So, while it must be understood that any price pattern is a subjective construct, it is important to know how to set trades based on these formations so that you are well-prepared even in cases where those formations prove to be invalid. The main idea here is to take these formations from a risk-based perspective, as this area (failed structures) is one that is most often neglected. This is also the area that creates the largest number of destructive events in personal trading accounts. So, in order to build trading confidence, you will need to know the price elements that formed your trade in the first place. Then, you will need to work from your own version of those paramaters.

 

Price Targets and Invalidation Points

 

When dealing with patterns, price targets and invalidation points are some of the first parameters that must be set. Channel formations give relatively clear-cut levels here, as prices are expected to remain contained within the uptrend and downtrend lines that make up support and resistance. In the first charted example, we have a downtrend channel, which is often used to initiate short positions. Short trade entries are taken as prices reach the top of the pattern, while profit exits can be taken as prices approach the channel bottom. Stop losses can be places above prior resistance levels (as any activity above these areas would end the series of lower highs). Alternatively, the position can be exited if prices break above the downtrend line, as this invalidates the pattern.

 

Using Patterns to Mark Dynamic Support and Resistance

 

Perhaps the biggest advantage of price patterns is how they can make it easy to spot support and resistance levels. Since these are areas in which buyers and sellers start to emerge, these levels are highly valuable in determining trade entries. Further more, if these levels are invalidated, price momentum will often accelerate, as the market is now forced to re-position itself for the shifting paradigm. Pattern examples here include triangles, flags, rectangles and pennants.

 

Once these patterns are recognized, you will be able to use the defined parameters in the pattern to not only determine your directional bias (for long or short positions) but your exit and entry points as well. As with all price patterns, the most critical event that can be seen when basing trades here is to spot instances where those patterns have become invalidated. In the second charted example, we have a descending triangle, which reveals a bearish bias on the pair. Any trader that takes a position based on the assumption that the series of lower highs will generate new lows is forced to bail-out once the resistance line is broken and the overall pattern is invalidated.

 

In cases like this, the broken resistance line should have lit warning flares, prompting the trader to close any bearish positions. This is true for a few different reasons. As we can see in the example, prices rally and this could have created substantial losses for any trader in a bearish position. Of course, we have no way of knowing for sure that prices will rally this strongly. But once the resistance line is broken, it is clear that the paradigm has shifted and that the market will start viewing the currency pair’s momentum in a different way. At the same time, our original reason for entering the trade has been removed. Because of this, there is essentially no reason to remain invested to the downside, and the position should not remain open.

 

Recognizing Price Patterns

 

So while it is true that price patterns are highly subjective, over time it does become easier to recognize these formations quickly and efficiently. These structures give traders a sense of where the market is headed, even in cases where there is no clear trend or momentum direction in your chosen currency pair. But at the same time, you will need to determine the levels at which the structure (and your original analysis) is starting to break down, making positions vulnerable to excessive losses if kept open.

 

Even for successful trades, it is important to look at the parameters you have set for the pattern, as this will give you an indication for when a trending move is in its mature stages and unlikely to continue. There is almost nothing worse than seeing a successful trade turn into a loss, so failing to react once your pattern parameters have been tested is a largely unnecessary mistake.

 

Risk-to-Reward Ratios

 

The final element to consider when establishing a price pattern position is the risk-to-reward ratio that is seen. Of course, it makes no sense to put $10 at risk when there is only the possibility of making $5 if the trade proves profitable. This is a recipe for failure for any long-term approach. Common advice is to risk only $1 in downside for every potential $3 in upside. Any price patterns identified should be used not only to determine entry points and direction, but profit and loss ratios as well.

 

Let’s look again at the original downtrend channel example. Here, we have a downside bias, based on a series of lower highs. The width of the channel is about 210 pips, which means this is the targeted profit. This also means stop losses should be no more than 70 from the entry. This works well in terms of the charted example, because if prices were to travel 70 pips in the positive direction after the trade is triggered, the channel would no longer be valid and there would be no reason to hold onto the trade. In other cases, these risk to reward levels do not match up. In these cases, the trade idea should be forfeited and we should look for better opportunities elsewhere.

 

Conclusion: Invalidated Patterns Remove Rationale Behind Positions

 

From these examples, we can see that price patterns are great tools for arriving at a position bias in cases where there is not even a clear trend in place. But once these patterns are invalidated, the trader must reassess the market’s activity and consider positions in another area of the market. Two traders looking at the same chart might see entirely different formations, and place trades that while well thought-out might be in complete disagreement. But at the same time, it is important to hold true to your original analysis and reconsider your position once an invalidated pattern suggests that your initial ideas are unlikely to play-out.

[tradingwizzard 10]

thank you for your post.........when trading, patterns should definitely be taken into consideration......for example when dealing with contracting triangles (as they are the most common way of consolidation), they might be reversal or continuation patterns.....so tricky but once broken you have the direction.

 

thanks again

[tradingwizzard 10]

I am always looking for patterns......seem to be lost without them, and probably the reasoning is that I am probably more of a technical trader than a fundamental one....

 

for example with the Fed....I don't doubt the power of the Fed, or the ECB, or whatever, but from my point of view price cannot fall/rise without breaking some levels on the smaller time frames....it is impossible to fly and skip them....so unless levels are broken, then the turn won't happening.....it's like looking at the downside in an upward trend without the trend line to be broken....just saying

[tradingwizzard 10]

Don't get me wrong,i'm a highly technical trader and price structure and levels are all important for me.

I just prefer to use things that are as less subjective as possible.Trendlines are drawn differently by different traders looking at exactly the same chart.You also need,in any case,several data points before they can be drawn.So I prefer horizontal lines only.

You might say fine but where do you draw those from?You can't claim horizontal lines are the holy grail.All I can say without sidetracking this thread is for me they are less problematical and only require single data points.They also do not require any future adjustment.

I'm not a fan of traditional patterns.But I guess at least with,say a H&S,you can predict the expected price level for the right shoulder.That's a more realistic prediction on a more frequent basis than a 20% drop based on subjectively drawn trendlines completely contrary to current market context.

 

you said you can predict the expected level for the right shoulder......well, IF it is a H&S,......more likely you can predict the measured move, but IF you have the right neckline....and this is not horizontal all the time....but this is off topic anyways

[gianno 10]

One problem, however, is that these patterns are subjective. Some traders make the mistake of using pattern recognition software, and then use those signals as if they are accurate in all cases.

 

I sense that you use the term "price patterns" to mean chart patterns, things like triangles, double bottoms, etc. which are indeed subjective to some extend. But when people talk about price patterns they usually mean things like inside days, island reversals, closing winning streaks, etc. which are more or less objective. See how this guy has made objective the search for price patterns and the methods he uses for their validation that include portfolio backtests, cross-validation and sensitivity analysis.