Combining Chart Patterns with Supply and Demand

October 9th, 2015
in contributors

Online Trading Academy Article of the Week

by Sam Evans, Online Trading Academy

In the world of conventional Technical Analysis, there are many different approaches ranging from basic candlestick patterns to a variety of technical indicators, most of which tend to give very lagging signals to buy and sell.

Follow up:

As I have explored in previous articles, if used in the correct manner, namely alongside quality price action analysis, these tools can prove useful but only if we respect that nothing will ever give us a better signal to buy or sell than price itself. As you know, here at Online Trading Academy we focus our trading around Institutional levels of Supply and Demand first and foremost. If you can spot the imbalances between the buyers and the sellers with an objective approach, then you will start to find many low risk and high reward trading opportunities across the global Forex markets.

However, an understanding of some of the more classic charting approaches can be beneficial from time to time, especially if you don't use these methods in the traditional manner. Take charting patterns for example, like the double top, head and shoulders and wedge. All said patterns repeatedly form in the market on a regular basis and can be powerful representations of price, but only if we use them in a logical manner. Let's explore the Head and Shoulders pattern in more detail.

A little while ago I was looking at GBPUSD pairing which had been in a decent upwards trend and was beginning to lose its momentum, showing signs of weakness. In fact, according to my own analysis it was staring to form a potential head and shoulders top, meaning it may be about to break down into a downwards trend shortly. Here is what the chart looked like at the time:

head and shoulders chart

Now, I know what some of you may be thinking here: "That's not the cleanest looking head and shoulders!" Well I would agree, but I discovered very early on in my career that the chart patterns rarely look as nice in real life as they do in the textbooks. More importantly, the pattern was shaping up and weakness was being suggested. Now, using the pattern in the classic sense means we would expect a breakdown of the "neckline" area and a continuation of the downward move. This neckline and projected target can be measured in the following way:

find the neckline on a head and shoulders chart

When we look for a target on a head and shoulders breakdown, we measure the head to the neckline and then use this measured length from the neckline down to see where we expect prices to fall afterwards, as I have illustrated on the chart above.

The next thing we need to figure out is, how do we make use of this potential pattern? Notice I said potential, as there is no guarantee that a pattern will complete. You only know it's a head and shoulders when it becomes a head and shoulders after all. With this in mind, we need to be proactive and get on board the move when we get a signal. In this case there are 2 signals to get short that we could wait for. The first would be the classic entry in most books, which would instruct us to get short on a breakout of the neckline. The second entry would be the Online Trading Academy way, which would have us use a level of Supply to get short before the move happens. Let's observe the outcomes of both approaches:

find the target entry on a head and shoulders chart

As we can see from the chart above, the pattern did indeed turn out to be the expected head and shoulders formation, with prices solidly breaking down to the projected target based on the neckline measurement and beyond. But how did the 2 different entries work out? Method 1 had us selling the break of the neckline itself but there would have been a good chance of being stopped out on the retracement to the neckline, only to then watch prices fall without us. This is a common issue with the breakout trade entry as it involves selling after a drop or buying after a rally in price.

I prefer to sell before or buy before everyone else as this ensures me a better entry with larger profit potential and also puts my stop loss order in a far better place. Notice how, if we would have dropped down to a slightly smaller timeframe there was an imbalance which formed a level of supply around 1.5500. This makes for an ideal entry to get into the head and shoulders before everyone else and increases the reward and subsequently decreases the risk as well. In the realty of conventional technical analysis, we must always be informed and know how to create an edge in the currency markets which slightly tips the probability onto our side. It does not have to be huge, just enough to make the difference. By letting the price itself lead your decision making process you won't go far wrong. I hope this was helpful.

Be well and take care.

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