Using chart patterns

Hey Joe! I’m looking for consistency. Are the classical chart patterns sufficiently consistent for trading? Can you make a few comments about reliable chart patterns and how to use them?

Chart analysis, which some people include in technical analysis, and short-term trading are truly partners. The understanding that you can make huge profits by looking for reliable chart patterns that repeat with unfailing regularity has raised many traders' outlook from hopeless desperation to excited optimism. To many beginning traders, chart patterns seem to be the elusive Holy Grail.

But the excitement soon fades as they discover that identifying chart patterns is often subjective and difficult, and that history rarely repeats itself with complete accuracy.

Chart patterns give a picture of human behavior in the market. They are not a guarantee of winning trades. Once in a trade, the meaning of the chart pattern that brought you into the trade may entirely disappear and you are left almost entirely with trade management.

Traders search for winning strategies. If a lot of books are written about chart patters, then just as with indicators, traders think they must surely bring about winning trades. And chart patterns do work to the extent that they reveal human behavior, but you must not engage in trading chart patterns in mechanically, unless you have expert management and the discipline to carry it out. It's important to fully understand how chart patterns work and how to trade them. For example, some traders place too much faith in chart patterns: They believe that if A occurs, and B occurs, then C must occur. Consider the classic head-and-shoulders pattern, for example.

The typical head-and-shoulders pattern which occurs in an advancing trend consists of a final rally of prices (the head) separated by two smaller rallies (the right and left shoulders) that occur before and after the final rally. The line joining the lows of the two rallies is called the neckline. Most trading books suggest entering a short trade at the break of the neckline, since it's at this point where the trend should start declining. If this trading pattern recurred with unfailing regularity, trading would be easy. If A occurs (left shoulder), and B occurs (head), then C would occur (right shoulder) right? And we’d all be billionaires. If only it were that simple. Some traders make the mistake of entering prematurely. They enter after B on the assumption that C will indeed occur. That is, they forecast a bearish trend based on an incomplete head-and-shoulders pattern. They impose their expectations on the market before seeing what actually happens. Yet it is vital that you trade what you see, not what you think. The right shoulder, or C, may not happen, however. A better trading strategy is to wait for C to actually occur, and possibly signal a declining trend. But it's still not that easy. The truth of the matter is that the existing trend is assumed to be in force until the weight of evidence proves it is not. An incomplete head-and-shoulders is not evidence, it is only a possibility. It's important to realize that a chart pattern may not always work out the way you expect. You must fully understand all forces that contribute to its formation. For example, it is useful to also consider volume. Volume is critical for the verification of the head-and-shoulders chart pattern. Activity is usually heaviest during the formation of the left shoulder and also tends to be heavy as prices form the head. But the strongest confirmation comes if the formation of the left shoulder is accompanied by lower volume.
It is important to fully understand the dynamics of the market forces that underlie the pattern.

Developing trading strategies based on chart patterns is useful, but it's crucial to think critically and not oversimplify. Technical analysis still requires a mastery of one's discipline, management, and personal psychology.

Chart patterns merely describe past market behavior. They summarize in a descriptive statistical sense only. There is no scientific or statistical reason to believe they forecast the markets with precision. It's important to remember that it's more art than science (not science at all actually), and that, in turn, means you must develop an intuitive feel for the markets and learn to trust that feeling. The development of intuition only comes with experience. You've got to build up your trading skills, experience a variety of market conditions, and learn the "conventional wisdom." But at the same time, cultivate healthy skepticism. Remember to question "conventional wisdom." The astute trader asks, "How is the chart pattern supposed to work," yet also asks, "Is it working under the market conditions I'm seeing right now?" In the end, it's still about developing the proper mental edge, even when studying a seemingly objective method of trading, such as classic chart patterns.