Pattern recognition is the basic and primary ability any trader should develop in technical analysis. It may be basic development, but the perfection of pattern recognition takes extensive practice and repetitive exposure. The expert recognition of patterns helps traders to quantify and react to the changing market environment. Chart patterns are categorized into continuous and reversal patterns. These categories are further classified as simple and complex patterns. The complex patterns consist of a collection of simple patterns. The knowledge of this classification of pattern recognition and its properties gives traders greater potential to react and adapt to a wider range of trading conditions.
Successful pattern trading requires the knowledge of pattern formation, its arrangement and its market manipulation. Pattern manipulation is achieved when pattern recognition becomes a reflex action for the traders. When a trader is knowledgeable about patterns, it is difficult not to see patterns within other patterns, or imbedded patterns. The recognition of patterns within patterns and its body of knowledge of how to react and what to expect helps a trader’s success.
Traders benefit by using smaller patterns’ support and resistance levels as entry and stop levels to trade larger patterns. Examples of embedded patterns include a series of bullish and bearish triangles in a symmetric triangle or bear flag setups in rectangle channels. When a pattern dimension is large, the risk implied by its trading range may also be large. When this appears, traders should then look for smaller congestion patterns inside the large pattern near key support and resistance levels to reduce risk and provide an early entry opportunity into a position. Multiple patterns inside a larger pattern is a cause to change trading behavior, price targets and time frames.
“Signals within signals” (below) shows four imbedded patterns inside larger patterns that may alter a technical trader’s reaction to the broader pattern.
- ABC bullish pattern with rectangle channel: This pattern shows trading ABC bullish pattern and rectangle channel price levels as trail stops. Also, the breakout of rectangle channel’s upper trendline signals continuation of ABC bullish pattern trade.
- Inverse head and shoulders pattern with embedded ABC bullish pattern: Inverse head and shoulders patterns are traded (from long side) only when price closes above neckline. Most inverse head and shoulders patterns also have an embedded ABC bullish pattern. These patterns can be traded first as ABC bullish pattern (ABC entry is much lower than neckline). The confluence of multiple bullish patterns usually adds additional confidence in the pattern trading.
- Rectangle channel with key triangle support and resistance levels: This pattern shows a rectangle channel with bull and bear flag setups showing both price and time basis support and resistance levels.
- Bullish Gartley pattern with bearish ABC pattern: Bullish Gartley patterns are five-point harmonic patterns that often have an embedded ABC bearish pattern. Gartley patterns can be traded using the confluence levels of ABC bearish pattern (target levels) coupled with Gartley pattern retracement levels (at D).
Patterns within patterns
“My dragon has a megaphone” (below) shows a daily Goldman Sachs (GS) chart with a dragon pattern (see: “How to trade your dragon,” Modern Trader, January 2017). You can see a double-bottom pattern set up in July 2016 and then price rises from $138.20 to $252 (82%), confirming a dragon pattern. Using dragon pattern trading rules, a long trade entry was entered in late September 2016 above the hump level at $169 with a target range of $187 to $200 and second target range of $239 to $267. GS reached its first target zone in November 2016 and its second target range in December 2016. Since December price has consolidated and is forming a smaller megaphone pattern in the second target zone. (Also see “Trading megaphone patterns,” Modern Trader, February 2017). It is not uncommon for prices to consolidate and test some key support ranges in large patterns, especially after a steep rise in price from July 2016.
Trading the imbedded pattern
The GS dragon pattern already provided great returns as it rose from an entry of $169 to $252. What does the imbedded, megaphone pattern, which usually provides two trading opportunities — continuation or reversal — indicate?
- Trading the megaphone breakout as a continuous pattern.
To trade the megaphone breakout pattern as a continuation of its up-trend, trades are taken in the direction of the breakout/breakdown from the pattern. When a price bar closes outside the pattern (above upper trendline) in the direction of the breakout, a long trade is triggered.
If GS breaks above the upper trendline at $254, it is signaling the continuation of bullish dragon pattern trend. Enter a long above the high of the price breakout bar ($254) and place a stop at the third swing high at $247. Targets are placed at $268 (as first megaphone target range) and $294 (as dragon pattern target range).
- Trading the megaphone reversal pattern.
When prices reach the last swing point and fail to continue higher, the megaphone pattern is indicated to short on a reversal. Once price starts to decline from the last swing point, enter a short trade as prices may test the lower trendline.
If GS price fails to break above the upper trend line, it may be presenting a smaller opportunity within the megaphone pattern. Enter a short trade below $247 with a stop at $253 (upper trendline breakout level). Targets are placed at $236 (mid megaphone level) and $225 (lower trendline levels).