Using Formations To Identify Profit Opportunities

Using Formations To Identify Profit Opportunities

Using Formations To Identify Profit Opportunities The concepts and strategies discussed may not be suitable for all investors. It is important that investors consider the information presented in light of their individual circumstances and objectives, including personal risk tolerances and investment goals. Currency symbols shown herein are for illustrative purposes only. FOREX.com and/or its employees and/or directors may have positions in currencies referenced here in, and may, as principal or agent, buy from or sell to clients. Please note that the price and volume data, screen samples, and chart patterns illustrated are for illustrative purposes only. The discussions or illustrations of particular currencies herein should not be construed as an offer to sell or a solicitation of an offer to buy any currency. FOREX.com does not recommend the use of technical analysis as a sole means of investment research. At FOREX.com we recommend that investors define their goals, risk tolerance, time horizon, and investment objectives in addition to researching possible investment choices through multiple channels. Use of technical analysis may result in increased frequency of trading and, therefore, significantly higher transaction costs than a fundamental approach. Forex trading carries a high level of risk and is not suitable for all investors. Do not invest money you cannot afford to lose.

What are chart formations? Specifically, formations are naturally reoccurring patterns that appear on price charts. By understanding the behavior of specific patterns we can much better identify future break-outs in the market. These break-outs are like price explosions in the market. Remember that our entire goal is to spot big price movement before it happens. Using chart formations gives us a competitive edge in being able to recognize conditions when these big moves are about to happen. Imagine the ability to see a 200+ pip move before it happens.

Why do chart formations work? Formations are one of the simplest approaches to technical analysis. Technical analysis makes the assumption that history repeats itself. Chart formations have been in practice for as long as charting has existed. It s commonly applied to the equities, commodities and currency markets. It s the common acceptance amongst traders of how these formations work that make them work. Meaning, if the majority of the trading community understands how a particular pattern is used, and everybody trades it the same way, then you should see a predictive price move (referred to as a herding effect).

Why should I use chart formations? Two reasons: It is one of the simplest forms of technical analysis, and it helps us better understand what is happening in the market. For someone who is newer to trading Forex there are a lot of choices as to how to approach trading the currencies. Chart formations offer a simple approach to finding trading opportunities. In addition, the shape of the formation itself can tell us a lot about the current mood of buyers and sellers in the market (whether the buyers are in control, sellers are in control, or both, or neither).

What we be covered in this guide? We will focus on seeing what are considered the 5 most common and predictable types of formations in Forex trading. Rectangle Ascending Triangle Double Top Head & Shoulders Symmetrical Triangle Descending Triangle Double Bottom Inverse Head & Shoulders

Rectangles Channel or Breakout Trade Must have minimum four pivot points two on top, two on bottom Considered a period of indecision

Rectangles 1 3 Confirm top and bottom with four pivot points. Two on top, two on bottom. 2 4 You may find the rectangle has more than four pivot points, that s okay but it must have at least four.

Rectangles 370 PIPs 1.1920 1.1550 Measure the difference between top & bottom The difference is expected to be roughly the same as the potential breakout

Rectangles 370 PIPs 1.1920 1.1550 When breakout occurs enter into trade. Breakout should be obvious. Note: Rectangles rarely give us an indication as to which way the market should break. In this example the market has obviously broken into a short trade.

Rectangles 370 370 PIPs PIPs Stop 1.1920 Set stops inside the rectangle & Set target (limit) for less than the difference between top and bottom rectangle Target 1.1550 Remember target price is measured from rectangle Note: We set our stops inside of the Rectangle because as the market breaks through the previous support becomes new resistance (or Vice Versa)

Rectangles 370 PIPs 370 PIPs Stop 1.1920 Monitor the trade until exit price is achieved. 1.1550 Target Note: The breakout in this example moved just over 370 PIPs before the market changed direction.

Rectangles 370 PIPs 370 PIPs Testing resistance Stop Target 1.1920 1.1550 If the market tests the original support or resistance levels of the rectangle it can be an opportunity to reenter the original trade.

Symmetrical Triangles Very common forex pattern Represents period of indecision Usually a continuation of overall trend

Symmetrical Triangles 35 PIPs Must have lower highs & higher lows. Triangles represent a battle between buyers & sellers. Note: Symmetrical triangles tend to breakout in the direction of the previous trend. In this example the previous trend is up, therefore we expect the breakout to be to the up side.

Symmetrical Triangles 35 PIPs 280 PIPs Measure the base of the triangle. The price difference should be the same amount as the breakout. Note: We measure the base of the triangle by taking the price difference between the highest high and the lowest low once the triangle has started to form.

Symmetrical Triangles Target 280 PIPs 35 280 PIPs PIPs Stop Once breakout occurs enter trade. Set stop inside triangle. Set target (limit) for less than amount of the triangle base.

Symmetrical Triangles Target 35 280 PIPs PIPs 280 PIPs Stop Monitor trade until exit price is achieved. Note: Breakouts from triangles tend to occur very quickly.

Symmetrical Triangles Monthly Chart As of 9/7/06 6700 PIPs Current trading opportunity USD/JPY 11 Year old triangle Note: This long term triangle represents a long term forecast on the USD/JPY. When the market breaks we should see a long term trending market.

Ascending Triangles Bullish Pattern Usually a pause during a longer trend Easy to identify

Ascending Triangles Weekly Chart As of 9/7/06 Note: Ascending triangles work best when the previous trend in the market is to the upside. Notice how in this example the previous trend was up. Must have flat highs & higher lows Ascending triangles are bullish because the buyers are able to maintain a high price, but sellers can t maintain a low price

Ascending Triangles Weekly Chart As of 9/7/06 30 PIPs Measure the base of the triangle. The price difference should be the same amount as the breakout. Note: We measure the base of the triangle by taking the price difference between the highest high and the lowest low once the triangle has started to form.

Ascending Triangles Weekly Chart As of 9/7/06 Target Once breakout occurs enter trade. 30 PIPs Stop Set stop inside triangle. Set target (limit) for less than amount of the triangle base. Note: Breakouts from triangles tend to occur very quickly.

Ascending Triangles Weekly Chart As of 9/7/06 Target 30 PIPs Stop Monitor trade until exit price is achieved Note: This trade was a day trade where the ascending Triangle took over 4 hours to form, but less than 1 hour to achieve target price once breakout occurred.

Descending Triangles Bearish Pattern Usually a pause during a longer trend Easy to identify

Descending Triangles Must have flat lows & lower highs Note: Can you see the two other formations on this chart? One we ve covered, one we haven t (you ll see this chart again). Remember, formations can occur inside formations. Descending triangles are bearish because the sellers are able to maintain a low price, but buyers can t maintain a high price

Descending Triangles Measure the base of the triangle. 1000 PIPs The price difference should be the same amount as the breakout. Note: We measure the base of the triangle by taking the price difference between the highest high and the lowest low once the triangle has started to form.

Descending Triangles Once breakout occurs enter trade. 1000 1000 PIPs PIPs Stop Target Set stop inside triangle. Set target (limit) for less than amount of the triangle base. Note: A good rule of thumb to make sure that a currency has broken out of a pattern is to see it close outside of the pattern.

Descending Triangles 1000 1000 PIPs PIPs Stop Monitor trade until exit price is achieved Target Note: While this is a long term chart, Descending Triangles are very common pattern used by day traders. This pattern is especially useful after a strong downward move.

Double Top Bearish Pattern Reversal after an upward trend Easy to identify

Double Top Double Tops occur after a strong upward Trend. Must have two flat tops & one common low price Note: Double tops are similar to rectangles, except double tops typically occur at a relatively new high.

Double Top 650 PIPs Measure the difference between top & bottom of Double Top Breakout should be same as the difference. Note: Double tops should look like a M when complete.

Double Top 650 PIPs 650 PIPs Stop Enter trade once breakout occurs to the downside. Target Set stop above breakout line. Note: We measure our target price (limit) from the bottom of the double top. Set target (limit) for less than difference between top & bottom

Double Top 650 PIPs 650 PIPs Target Stop Monitor trade until exit price is achieved Note: The second high in a Double Top is usually the buyers last stand before a major drop.

Double Bottom Bullish Pattern Reversal after an downward trend Easy to identify

Double Bottom Double Bottoms occur after a strong downward trend. Must have two flat bottoms & one common high price Note: Double tops are similar to rectangles, except double tops typically occur at a relatively new high.

Double Bottom Measure the difference between top & bottom of Double Bottom 350 PIPs Breakout should be same as the difference. Note: Double tops should look like a W when complete.

Double Bottom Enter when breakout occurs. Set stop below high price of Double Bottom. 350 PIPs Target Stop Set target (limit) for less than difference between top & bottom Note: Remember, Double Bottoms are a reversal of the previous down trend, therefore the strategy is to make profit on a breakout to the upside.

Double Bottom Target Monitor trade until exit price is achieved 350 PIPs Stop Note: The second low in a Double Top is usually the sellers last stand before a major upward run.

Head & Shoulders Bearish Pattern Reversal after a upward trend More common in long term trends

Head & Shoulders Head Left Shoulder Right Shoulder Neck Line Right Shoulder Define head, right & left shoulder and neck line. Must have a previous upward trend. Shoulders should be equidistant from head. Note: In this example the neck line is not perfectly even, that s okay. If the neck line isn t perfect it is preferable to lower between the head and right shoulder, as is above.

Head & Shoulders Right Shoulder Head Neck Line 75 PIPs Measure the difference between top of head & neck line. Breakout should be same as the difference. Note: This strategy should only be employed after the Head and Shoulders pattern has completed, as seen above.

Head & Shoulders Right Shoulder Head 75 PIPs75 PIPs Stop Enter when breakout occurs. Set stop above neckline. Neck Line Target Set target (limit) for less than difference between head & neckline Note: Head & Shoulders formations are easier to find on long term charts (monthly, weekly, daily), this chart is a short term 15 minute chart.

Head & Shoulders Head Right Shoulder 75 PIPs75 PIPs Neck Line Stop Monitor trade until exit price is achieved Target Note: The Head and Shoulders pattern above took 14 hours to create, and less than 1 hour to move from breakout to target.

Head & Shoulders Head Right Shoulder 75 PIPs75 PIPs Stop Neck Line Example of a current long term Head & Shoulders pattern. (as of 10/5/06) Target Note: This is a weekly chart of the EUR/USD, the neck line is at 1.1725. If this level breaks it should move to a price of 0.9400, or 2300 PIPs.

Inverse Head & Shoulders Bullish Pattern Reversal after a downward trend More common in long term trends

Inverse Head & Shoulders Head Left Shoulder Right Shoulder Neck Neck Line Line Right Shoulder Define head, right & left shoulder and neck line. Must have a previous downward trend. Right Shoulder Head Right Shoulder Note: The above example occurred after a long downward trend. Shoulders should be equidistant from head.

Inverse Head & Shoulders Head Left Shoulder Right Shoulder Neck Neck Line Line Right Shoulder 100 PIPs Measure the difference between bottom of head & neck line. Breakout should be same as the difference. Head Note: This strategy should only be employed after the Head and Shoulders pattern has completed, as seen above.

Inverse Head & Shoulders Head Left Shoulder Right Shoulder Right Shoulder Enter when breakout occurs. Target Set stop below neckline. Neck Neck Line Line Stop 100 PIPs Set target (limit) for less than difference between head & neckline Head Note: This strategy should only be employed after the Head and Shoulders pattern has completed, as seen above.

Inverse Head & Shoulders Head Left Shoulder Right Shoulder Right Shoulder Neck Neck Line Line Target Stop Monitor trade until exit price is achieved 100 PIPs Note: The Head and Shoulders pattern above took 15 hours to create, and less than 12 hour to move from breakout to target. Head