AN INTRODUCTION TO THE CHART PATTERNS

AN INTRODUCTION TO THE CHART PATTERNS

AN INTRODUCTION TO THE CHART PATTERNS www.dukascopy.com

CONTENTS TECHNICAL ANALYSIS AND CHART PATTERNS CHARACTERISTICS OF PATTERNS PATTERNS Channels Rising Wedge Falling Wedge Triangle Ascending Triangle Descending Triangle Double Bottom Double Top Triple Bottom Triple Top Rectangle NAVIGATION IN THE TRADE PATTERN WIDGET General guidelines Design customisation Functionality customisation Finding the pattern 04 05 06 06 08 09 10 11 12 13 14 15 16 17 18 18 19 20 22 03

TECHNICAL ANALYSIS AND CHART PATTERNS Technical analysis chart patterns In finance, technical analysis is a technique which uses past market data, primarily volume and prices, to predict future movements of prices. Technical analysis is used on a wide range of financial instruments, including equities, bonds, commodity futures, and currency futures. The underlying logic of technical analysis is simple: Supply and demand determine prices; Changes in supply and demand cause changes in prices; Prices can be projected with charts and other technical tools. As long as the chart represents the action in a freely traded market, a technical analyst is not required to possess detailed knowledge of that instrument. He does not even need to know the name or type of the security to conduct the analysis. Technical analysis is based on few main assumptions: Technical analysts believe that it is unreasonable to assume that investing is the one exception where humans always behave rationally since one's behaviour is influenced by many aspects of life and that market trends and patterns reflect this irrationality; Collective knowledge and sentiment is reflected in buying and selling activities of market participants, therefore actions of the traders determine volume and price of a financial instrument. From the first assumption comes the existence of chart patterns. A chart pattern is a pattern that is formed within a chart when prices are graphed in a candlestick or bar chart and it is believed they represent the irrationality and influence of various aspects in the behaviour of traders. Chart patterns play a large role during technical analysis of financial instruments. When data is plotted there is usually a pattern of support and resistance levels which naturally occurs and repeats over a period. Chart patterns are used as either reversal or continuation signals. 04

CHARACTERISTICS OF PATTERNS Quality Every pattern has individual characteristics which can be quantified in a pattern quality and magnitude reading. Quality is a reading which quanifies a pattern s trend. It shows how well a price fits in the boundaries of a pattern's support and resistance (green and red lines in Figure 1) and how well it moves from one touch point to another (blue line in Figure 1). Calculations include the symmetry or asymmetry (depending on the pattern at hand) of support and resistance lines, the number of touch points and gaps between them, and a few other factors. Magnitude Magnitude is a reading which shows expected returns of a financial instrument which has formed a chart pattern. Calculation takes in to account minimum and maximum prices of the pair in chart and historical volatility. This helps to approximate the scale of the pair s movements and potential returns after the pair breaks the pattern s boundaries. Figure 1. Channel Up pattern with 53% quality and 65% magnitude readings 05

PATTERNS PATTERNS This section will introduce with main guidelines for patterns which can be found using the Dukascopy trade pattern tool on the JForex trade platform and provide real life examples for those patterns. Note: All patterns are from the JForex trading platform one-hour charts of various currency pairs and are used purely for illustrative purposes for this document. Characteristics and discussion of the patterns come from the books and website of Thomas N. Bulkowski. 1. Channels Characteristic Price trend Shape Trend lines Touches Crossing Breakout Discussion The price trend leading to the channel can be from any direction. A pipe tilted up or down, but not horizontal. See rectangle for horizontal channels. The two trend lines should be parallel or nearly so. Both should tilt upward or both should tilt downward. The price should touch each trend line at least twice as distinct peaks or valleys. The price should cross the pattern from trend line to trend line, nearly filling the available space. Occurs when the price closes outside the trend line boundary and can be in any direction. 06

PATTERNS Figure 2. Example of Channel Up pattern Figure 3. Example of Channel Down pattern 07

PATTERNS 2. Rising Wedge Characteristic Price trend Shape Trend lines Touches Volume Breakout Confirmation Discussion Can be any direction leading to the pattern. A narrowing and rising triangle shape. The price bounces between two up-sloping and converging trend lines. The price should touch trend lines at least five times to outline a good pattern. That's three touches of one trend line and two of the opposite. Trends downward at least 74% of the time until the breakout. Can be in any direction but is downward 69% of the time. The pattern is confirmed as a valid one when the price closes outside one of the trend lines. Figure 4. Example of Rising Wedge pattern 08

PATTERNS 3. Falling Wedge Characteristic Price trend Shape Touches Volume Breakout Confirmation Discussion Can be any direction leading to the pattern. The price follows two down-sloping and converging trend lines. The price should touch trend lines at least five times to outline a good pattern. That's three touches of one trend line and two of the opposite. Trends downward 72% of the time until the breakout. Can be in any direction but is upward 68% of the time. The pattern is confirmed as a valid one when the price closes outside one of the trend lines. Figure 5. Example of Falling Wedge pattern 09

PATTERNS 4. Triangle Characteristic Price trend Shape Trend lines Crossing Touches Volume Breakout Discussion Can be any direction leading to the chart pattern. Triangular. Prices move between two converging trend lines. Two trend lines bound prices; the bottom trend line slopes up and the top one slopes down. The price must cross the pattern from side to side, filling the triangle with price movement, not white space. The price must touch each trend line at least twice, forming distinct valleys and peaks. Trends downward 86% of the time. Upward 54% of the time and 75% of the way to the triangle apex (upward breakout) and 73% of the way for downward breakouts. Figure 6. Example of Triangle pattern 10

PATTERNS 5. Ascending Triangle Characteristic Price trend Shape Trend lines Crossing Touches Volume Breakout Discussion Can be any direction leading to the chart pattern. Triangular. Prices move between two converging trend lines. Two trend lines bound prices; the top trend line is horizontal and the bottom one slopes upward. The price must cross the pattern from side to side, filling the triangle with price movement, not white space. The price must touch each trend line at least twice, forming distinct valleys and peaks. Trends downward 77% of the time. Can be in any direction but is upward 70% of the time. Figure 7. Example of Ascending Triangle pattern 11

PATTERNS 6. Descending Triangle Characteristic Price trend Shape Touches Crossing Volume Breakout Confirmation Discussion Can be any direction leading to the pattern. A price pattern bounded by two trend lines, the bottom one horizontal and the top one sloping downward. The price should touch each trend line at least twice as distinct peaks or valleys. This is important: the price must cross the pattern from trend line to trend line, nearly filling the available space. Avoid descending triangles with abundant white space. Recedes 83% of the time and gets quite low just before the breakout. Can be in any direction but is downward 64% of the time. The pattern is confirmed as a valid one when the price closes outside one of the trend lines. Figure 8. Example of Descending Triangle pattern 12

PATTERNS 7. Double Bottom Characteristic Price trend Shape Peak Bottom price Confirmation Volume Discussion Downward leading to the pattern. Two distinct valleys that look similar. Eve bottoms are wide and of a more rounded appearance. Adam bottoms are narrow, V-shaped, sometimes with one long price spike. Spikes that appear tend to be numerous and short. The rise between bottoms should measure at least 10% of the move leading to the first bottom, but allow variations. The price variation between bottoms is small, usually between 0% and 6%. The two valleys should appear to bottom near the same price. The double bottom confirms as a true double bottom once the price closes above the peak between the two valleys. Usually higher on the left bottom. Figure 9. Example of Double Bottom pattern 13

PATTERNS 8. Double Top Characteristic Price trend Shape Valley Top price Confirmation Volume Discussion Upward leading to the pattern. Two distinct tops that look similar. An Eve top is rounded and wide looking, but sometimes has several short spikes poking out. Adam tops are narrow, inverted Vs. The valley between the tops should measure at least 10% of the move leading to the first top, but allow variations. The variation between price peaks is small, less than 3%. The two tops should appear to peak near the same price. The double top confirms as a true double top once the price closes below the valley between the two peaks. Usually higher on the formation of the left peak. Figure 10. Example of Double Top pattern 14

PATTERNS 9. Triple Bottom Characteristic Price trend Shape Bottom price Confirmation Volume Discussion Downward leading to the pattern but should not drop below the first bottom. Three distinct valleys that look similar. The price variation between bottoms is small such that it appears the three valleys bottom near the same price. Allow variations. The pattern is confirmed as a true triple bottom once the price closes above the highest peak between the valleys. Usually higher on the first bottom than on the last, trending downward 67% of the time, but it may peak beneath each valley. Figure 11. Example of Triple Bottom pattern 15

PATTERNS 10. Triple Top Characteristic Price trend Shape Middle peak Volume Bear market Confirmation Discussion Upward leading to the pattern. Three peaks near the same price with a downward breakout. Sometimes the middle peak is priced marginally below the other two. Trends downward 59% of the time, but is usually high beneath the formation of each peak. More triple tops appear in a bear market than in a bull one. The pattern becomes valid when the price closes below the lowest valley in the pattern. Figure 12. Example of Triple Top pattern 16

PATTERNS 11. Rectangle Characteristic Price trend Shape Trend lines Touches Volume trend Breakout Discussion The price trend leading to the pattern can be from any direction. Prices have flat tops and flat bottoms, crossing the pattern from side to side following two parallel trend lines. Two near horizontal trend lines bound the price action. The price should touch each trend line at least twice using distinct peaks and valleys. Trends downward at least 66% of the time. Opposite to the price trend direction 55% of the time. Figure 13. Example of Rectangle pattern 17

NAVIGATION IN THE TRADE PATTERN WIDGET Navigation in the Dukascopy Trade pattern widget This section provides guidelines on how to use the Dukascopy trade pattern widget on the JForex trade platform. General guidelines Figure 14. Default window of the Dukascopy trade pattern widget on the JForex trade pattern The Dukascopy trade pattern widget can be found on the JForex trade platform. The icon to open the widget ( ) can be found on the right hand side of the upper part of the trading platform (highlighted by the red square). It will open the trade pattern tool s main window which can be seen in Figure 14. Besides this main window, the tool has two secondary windows dedicated to design and functional customisation of the tool. 18

NAVIGATION IN THE TRADE PATTERN WIDGET Design customisation Figure 15. The Dukascopy trade pattern widget's design customisation window First, the design customisation window can be opened by pressing the icon which can be found in the tool s upper right corner. It will open the window which can be seen in Figure 15. In this window you will be able to customise: Widget Title checkbox turns on/off text on the top left corner of the tool; Font drop down list allows you to choose font and colour of the text used in the widget (Dialog font and yellow colour by default); Background drop down list allows you to choose the transparency level and colour of the tool's body (60% solid and grey colour by default). 19

NAVIGATION IN THE TRADE PATTERN WIDGET Functionality customisation Once you have customised the design of the tool to suit your needs, you can confirm the changes made by pressing the icon which can be found on the top right corner of the tool as well. Then you will be redirected back to the main window of the tool (Figure 14) which now will have the design features you selected. Figure 16. The Dukascopy trade pattern widget's function customisation window 20

NAVIGATION IN THE TRADE PATTERN WIDGET Second, the functional customisation window can be opened by pressing the icon which can be found in the tool's upper right corner. It will open the window which can be seen in Figure 16. In this window you will be able to customise: Detect patterns by allows you to choose between two options: Closing price a pattern of support and resistance levels will be searched by the closing price of each bar. Based on the assumption that closing prices reflect the most information about a financial instrument and that movements in the bar (high and low prices) are irrelevant. High/low a pattern of support and resistance levels will be searched by the high and low prices of bars. Based on the assumption that not closing prices, but price movements in the bar (high and low prices), reflect the most about what's underlying a financial instrument. Quality (a detailed description can be found in the second part of this document); Magnitude (a detailed description can be found in the second part of this document); Patterns you wish to search for (a detailed description can be found in the third part of this document). Once you have customised the functionality of the tool to suit your needs you can confirm the changes made by pressing the icon which can be found on the top right corner of the tool as well. Then you will be redirected back to the main window of the tool (Figure 14). 21

NAVIGATION IN THE TRADE PATTERN WIDGET Finding the pattern Once you have customised your widget tool for personal use you can start searching for patterns which you are interested in. A search will start in the tool's main window which can be seen in Figure 14. At first you are faced with three search options under Scan mode : All pairs this is the mode which is turned on by default once you open the tool. It will scan all the currency pairs (despite what pair or chart you are currently in) for currently emerging patterns in (an example of a drop down list of findings can be seen in Figure 17). Current pair this tool will scan the current pair s chart for currently emerging patterns. Current pair history this tool will show all the patterns that have ever emerged in the current pair and chart type. Figure 17. The Dukascopy trade pattern widget result drop down list 22

NAVIGATION IN THE TRADE PATTERN WIDGET Your search results, despite what search option you have chosen, will be shown in the Found patterns drop down list. An example of results under all pairs can be seen in Figure 14. Results in this drop down list can be arranged using several options ( Sort by ): Time patterns in the list will be arranged according to the date when they started; Size patterns in the list will be arranged according to how many bars create a pattern; Quality patterns in the list will be arranged according to their quality rating (detailed description of what is a pattern's quality can be found on the page number 5); Magnitude patterns in the list will be arranged according to their magnitude rating (a detailed description of what is a pattern s magnitude can be found on the page number 5); Instrument patterns in the list will be alphabetically arranged according to the instrument's name (AUD/CAD at the top, XAU/USD at the bottom of the list). Period patterns in the list will be arranged according to the time frame of the chart (patterns on 10 sec. charts will be at the top, patterns on monthly charts will be at the bottom of the list). After you choose the pattern, the button will open the chart you selected from the list. From there you can carry out analysis and plan your trades. Sources: 1) Encyclopedia of Chart Patterns. SECOND EDITION. Thomas N. Bulkowski. ISBN-13 978-0-471-66826-8; ISBN-10 0-471-66826-5 2) Personal website of Thomas N. Bulkowski (http://thepatternsite.com/) 23

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