M's and W's, the pattern trader

In a recent class, the students kept asking me to explain how to locate and trade chart patterns. While finding some of these patterns may be useful, the key focus for a trader to be successful has to be trend, supply and demand. If you are able to read those key things in your charts, you will likely be ahead of most other traders, or on the opposite side of them when the pattern and their trades fail.

An uptrend is defined by price making higher highs and higher lows. The higher lows are the most important part of that definition. A downtrend is price making lower lows and lower highs. In this case, the lower highs are most important. Chart patterns attempt to identify points where price is likely to reverse and change trend. These patterns usually fail unless they occur at a supply or demand level. A trader looking for patterns identified by a screening software or website may miss this critical point unless they take the time to inspect price action beyond the pattern itself.

Let's examine a head and shoulders pattern. This is a very popular pattern to signal trend reversal. Prices in an uptrend rally to a point and correct, forming a left shoulder. Price rallies again to a higher high continuing the uptrend before correcting once more. This has formed the head. Finally, prices try to rally again, but are not able to reach past the high of the head before starting to fall. Most traders looking for the Head and shoulder pattern would trade this pattern short as soon as prices break the neckline that connects the two lows between the shoulders.

Often, traders will not recognize the pattern until well after the neckline is broken. Some people cannot see patterns at all. This is the lament of the newer trader. The good news is that even if you do not recognize the patterns, if you simply remember the definition of trends, you can trade the patterns or even understand when the pattern is likely to fail.

In the case of the head and shoulders pattern, the right shoulder failing to reach higher than the head gives the chart a lower high. While that does not in itself break the uptrend, it is closer to the downtrend definition. Once the neckline has been broken, a lower low has been completed.

As long as prices make higher lows, you should look to buy pullbacks to demand levels. Once a lower high AND a lower low are made, then the trend is over and you should focus on shorting rallies to supply. The same is true for ending a downtrend. Once the price makes a higher high AFTER making a higher low, you are no longer supposed to be shorting. Be a bull again and buy the dips into demand.

It is important that you do not fight the trend. Identify it and trade with it at the proper entry levels, supply and/or demand. Doing this will put you on the path to trading success even if you can't see the patterns.

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