Patterns: Fact or Fiction?

Chart patterns are one thing that most traders learn about early in their trading careers. The problem is that they do not necessarily learn how to trade them properly. There are a plethora of books and websites dedicated to identifying and trading these patterns. The problem is that if you follow the "conventional wisdom," then you will be trading right along with the masses and risk entering late or entering into a trade that has a lower probability of success.

We need to think like a professional. If you want to make price move, you must first make it attractive to traders and investors to enter. You can do this by making the price move in the direction they are waiting for. But you can create more interest if you first shake out traders who were already in a position. Think about what happens to you emotionally when you are stopped out of a position only to see it go in your favor. You are tempted to jump back in! That is the trap the professionals set to use your order flow for profit.

We must keep this in mind as we are trading patterns. We want to take the professional trade, not the amateur one. Let's look at two patterns that occurred in the S&P 500 ETF, SPY. The first pattern was a failed head and shoulders from May through July 2009. This pattern was discussed on CNBC and was closely watched by many financial reporters. With too many eyes on the pattern, there became an opportunity for professionals to manipulate the amateurs.

The best entry to the pattern is to short supply on the right shoulder. In this example, SPY could not close above the highs of the first right shoulder, thus showing supply. The CCI was also failing to show strength and the MACD was confirming a downtrend. The amateurs ignored the warning signs of a failed pattern and listened to the pundits on TV telling them the market was going to correct.

At the break of the neckline, the amateurs shorted as professionals exited shorts and opened longs. There are several clues to the failing of the pattern before you would have lost on a short:

1. Price stalled before the break of the neckline and even had a green candle before breaking. This shows buying pressure.

2. Positive divergence on the MACD and CCI.

3. Lack of follow-through after the break, small candles have no momentum, bottom tails are buying pressure.

So, as a professional trader, we were already in a profitable position as the amateurs flooded in with their shorts. We can now objectively review the data and see if we should hold or book profits according to what the markets are telling us. These patterns occur regularly as noted in the current SPY chart. This pattern has not been discussed on TV.

You need to use what you learned about reading price in the Online Trading Academy Professional Trader class to be successful in the class. To further understand how to properly trade, join us in the Extended Learning Track (XLT) as we viewed and traded both of these patterns in the classes. Until next week, trade safe and trade well!