Decoding Chart Patterns: A Systematic Approach to Advanced Technical Analysis
Welcome to the world of technical analysis, where Chart Patterns play a pivotal role in shaping trading strategies. This is an ultimate guide designed to help users objectively identify the existence of Chart Patterns, define the characteristics and classify them. In this discussion, we will mainly concentrate on
Understanding Chart Patterns
Chart patterns are visual representations of price movements on a chart, which can help traders identify potential trading opportunities. These patterns are formed by the interaction between supply and demand in the market and can indicate the continuation or reversal of a trend.
There are various types of chart patterns, including:
- Trend Continuation Patterns: These patterns suggest that the current trend is likely to continue in the same direction. Examples include the flag pattern, pennant pattern, and triangle pattern and all other trendline pair based patterns that we are going to discuss today
- Consolidation Patterns: These patterns suggest a period of indecision in the market, where the price is range-bound. Examples include the rectangle pattern, symmetrical triangle pattern, and ascending/descending triangle pattern.
- Trend Reversal Patterns: These patterns indicate that the current trend is likely to reverse. Examples include the head and shoulders pattern, double top pattern, and double bottom pattern. These patterns also include rising and falling wedge type of patterns that are based on trendline pairs
Instruments and Timeframes for Applying Chart Patterns
Chart patterns can be applied to a wide range of financial instruments and timeframes. Here are some considerations for applying chart patterns:
- Forex (Currency Pairs)
- Commodity and metals
- Intraday (e.g., 1-minute, 5-minute, 15-minute)
- Short-term (e.g., hourly, 4-hourly)
- Medium-term (e.g., daily, weekly)
- Long-term (e.g., monthly, quarterly)
It is important to note that the effectiveness of chart patterns may vary depending on the instrument and timeframe. Traders should consider the characteristics and volatility of the specific instrument and choose the appropriate timeframe for their trading strategy.
Basic Principle of Identifying the Chart Patterns
It is crucial to apply a definitive set of rules when identifying chart patterns to avoid biases or fitting them to our opinions. To understand the risks of overfitting chart patterns to our bias, please visit our other blog post on overfitting chart patterns.
To objectively identify chart patterns, it is important to establish ground rules or follow a well-defined technique. Here is the technique we employ to identify chart patterns.
Step 1 - Apply Zigzag indicator on the chart
Tradingview has plenty of free community scripts for Zigzag indicator. For this demonstration, we are going to use our Recursive Zigzag implementation.
Once the indicator is loaded on the chart, goto indicator settings and perform these modifications.
- Disable the Labels : The Labels contain information that is needed for this exercise.
- Set the Highlight level to 1 or 0 : We can iteratively increase the level and check next levels on the go.
You can also adjust Zigzag Length and Depth Parameters.
Step 2 - On each level, mark the last 5 zigzag pivots.
For example, in today's BTCUSDT 1h chart, level 0 zigzag of Length 5 is displayed as below where we have marked last 5 Zigzag pivots.
Step 3: Draw trendlines
As part of this step, draw two trendlines.
- The first trendline will join pivots 1 and 5 marked in the previous step.
- The second trendline will join pivots 2 and 4 marked in the previous step.
Step 4: Inspect and identify if there is a Chart Pattern
On visual inspection, this looks like a Diverging Triangle Chart Pattern. However, the only issue is that pivot (3) is nowhere near the trendline. This makes the upper trendline not reliable, and so is the derived Chart Pattern.
Step 5: Repeat the process on next zigzag levels
You may not find any Chart Patterns on the base zigzag level. However, repeat the process on next zigzag levels.
On further inspection, we identified a valid Chart Pattern on the level 3 zigzag.