Chart patterns are essential tools that traders leverage to find opportunities at entry and exit points. They are part of the technical analysis breakdown of the market, focusing on prices and volume to predict value movements.
Although understanding chart patterns alone isn’t that complicated, keeping up with additional information based on previous patterns is pretty challenging, as the market moves at a fast pace. At the same time, making the right decision without the involvement of emotions, also known as biases, contributes to poor trading strategies.
Luckily, there are many other tools, such as pattern volumes, through which traders can improve their market analysis. These can add a layer of trust before taking the next step in trading, so let’s see what it’s about.
Why are chart patterns so important?
Chart patterns represent price movements and future market behavior, whether they showcase a bearish or bullish tendency. There are plenty of chart patterns to learn and identify, but here are some of the most common:
- The Head and Shoulders pattern has three peaks that reveal a bearish moment. The higher peak stands between two lower peaks, and determines a movement from uptrend to downtrend.
- The Ascending Triangle represents a continuation pattern following an uptrend. Its features include a horizontal set of highs accompanied by a set of lows, with the horizontal one being the resistance level and the lower one being the support.
- The Flag pattern can be either bullish or bearish, depending on the trend. The flags are small rectangular forms that indicate a brief period of consolidation (bullish) or a pause in a downtrend, which continues declining (bearish).
What’s the volume of trade about?
Leveraging volume is the most important way for a trader to understand chart patterns. The index represents the number of shares of contracts between buyers and sellers. The volume of trade shows the market activity and liquidity during the trading day or even over a longer period.
When the volume of trade shows higher peaks, the market experiences more liquidity and better order execution, so lower trading volumes are not productive. Trade volume reports are provided hourly to traders, but they’re only estimates. The actual figures appear the following day, which is why it might be tricky to enter or exit a trade.
All chart patterns reveal something about volume; for example, the Head and Shoulders pattern is often followed by increased volume, especially in a breakdown. However, it’s important for traders to learn about false signals that happen in low-volume trading patterns.
What other indicators are important in trading?
Reading chart patterns and volume trading would be incomplete without the other indicators of the market’s path. For example, the Relative Strength Index (RSI) is a momentum index that measures the speed and depth of a security’s price, through which traders detect overbought or oversold tendencies.
In other words, RSI is an oscillator that goes from zero to 100. Traders find the RSI helpful when it shows a trend of 70 or above, as this indicates an overbought condition, while anything below 30 reveals an oversold trend. Therefore, the RSI is important because:
- It can help traders predict a security’s price behavior;
- It validates trends and trend reversals;
- It’s best for short-term traders with buy and sell signals;
Another important indicator is MACD (Moving Average Convergence Divergence), which identifies the relationship between the security’s price and two exponential moving averages (EMAs). While the indicator is a bit more complex, it reveals interesting trading market tendencies.
What are some challenges in reading chart patterns?
Reading and identifying changes in prices and trends in charts can be difficult, especially with the numerous factors influencing the market. Inflation, investor sentiment, and liquidity all contribute to shifts in the stock market, so keeping up with changes is definitely challenging.
Since chart patterns are part of the technical analysis, people assume this method is free of flaws.
However, the strategy can be pretty subjective when not paired with fundamental and sentiment analysis. Fundamental analysis is important for long-term investors, as they must look into the company’s stocks from an income perspective. On the other hand, sentiment analysis analyzes
how traders feel about the market or a particular financial asset.
Therefore, traders must create a robust system for their own productivity that includes the following aspects:
- Trade management;
- Risk management;
- Stop loss;
- Exist;
- Entries;
- Continuous improvement;
How to trade objectively and without bias?
Subjective trading is common, as traders can be subject to emotional factors in the heat of the moment. Considering how difficult it is to handle FOMO (fear of missing out), traders are sometimes prone to making experiential choices and being biased.
In trading, bias can be of many forms:
- The confirmation bias is a person’s tendency to favor the information that confirms their preexisting beliefs. This means they reject any contradictory evidence;
- The recency bias happens when people undervalue historical data in favor of the most recent events. Therefore, they impulsively trade, affecting their long-term strategies;
- The overconfidence bias makes traders believe they’re more skilled than they actually are, so they might engage in risky trading;
- The correlation-causation bias makes traders mistakenly interpret trends as they assume a cause-and-effect relationship between an asset and an event based on correlation;
Fighting trading biases can be difficult if traders are unable to identify them. However, they can try to overcome them by finding diverse information sources to learn from and practicing analytical rigor. Considering historical data, long-term trends, and thoroughly evaluating risks are important strategies for keeping good records.
Ready to trade?
Trading in the modern market means being wary of the fast-paced trend of changing prices. Learning how to interpret the market requires a thorough understanding of chart patterns, trading volumes, and other indicators like the RSI and MACD. Of course, market analysis must be based on technical, fundamental, and sentiment analysis to get an idea of how asset prices move. In addition, traders should learn how to be objective and not subject themselves to biases in trading that can cloud their judgment.