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Chart Patterns, Magnitude, Price Targets And Expiry
Trading binary options is all about technical analysis and technical analysis is all about chart patterns. Chart patterns are what we look for as technicians, they are what we measure and how we make our predictions. There are a few ways to look at patterns but today I want to stick to basic price patterns, how to use them to pick targets and why you should care about that as a binary options trader. Basically, there are three types of price patterns available to us; continuation patterns, consolidation and reversal patterns. Each of these patterns are unique but the basic rules for targeting apply to all three. Why targets? We’re not trading spot or equity options so there is no need to have an exit strategy. All you need to know is which direction to take the trade right? Wrong. You also need to choose the right expiry and that is where targets come into play. Not only that, you want to increase your success rate and the number of signals you get right?
What Is A Chart Pattern?
A chart pattern is any identifiable, measurable and predictable pattern of price movement that appears on the chart of a traded asset. For this discussion I will be using Japanese Candlesticks on my chart but this is not about Candlestick Patterns. This is about price movement and price pattern. As mentioned above price movement can make three basic patterns; continuation, consolidation and reversal. These can appear in any time frame and can be near, short or long term in implication. The good news is that the basic rules for targeting apply the same across the board. Take for example the bullish triangle as shown below. This is a chart pattern with a different signal implication than say a Head & Shoulders, Trading Range or Double Top. In order to predict where any of these may go you simply measure the magnitude of the pattern. This could be the distance of the move leading up to the pattern or the height of the pattern itself. For the H&S this might be the distance, in $, from the top of the pattern to the bottom. For the Triangle/Flag it could be the length of the Flag Pole from the start of the rally to the base of the pattern itself or the height of the Triangle from the base to its highest point. On a break out of the pattern the target would then be equal to the magnitude of the pattern that led up to it.
Magnitude – The height and/or distance of a chart pattern. This can be measured in price or time or both. This can be measured from the bottom to the top of an identified pattern such as a H&S or Trading Range or from the start to the finish of a movement preceding a pattern such as a Flag or Triangle. Once you have established the magnitude of a movement you can then use that number to predict price targets.
Looking at the chart above you can see where I have marked the beginning of a rally, the base of a triangle pattern and then some targets predicted from the magnitude of the movement. The first, and longest term target, is the one predicted from the rally leading up to the triangle. The rally lasts 4 months from start to peak, the triangle lasts for 2 so we can assume that any target predicted from the flag pole will be roughly twice as long in duration as one derived from the triangle itself. This same principal can be seen in the magnitudes of the moves. The flag pole is roughly 951 points from it’s start to the base of the triangle. The triangle is roughly 509 points from base to peak; about half the length of the rally. Extending this out we can see that targets derived from both numbers turned out to be important areas of price action.
Take note that once the triangle was broken targets derived from both the flag pole and the triangle were reached. The shorter term signal, the one derived from the triangle, were met in the first three months following the break. The second and longer term signal was met roughly 6 months after the break out, or twice as long.
Targets, Entries And Expiry
Once you have a time and price target you can easily apply those to your expiry. Remember, this method can be applied to any time frame and can be very helpful in choosing expiry. In my example I am using charts of daily prices so my expiry’s of choice will be weekly and monthly. On a confirmed break I can enter one position with an expected time horizon of my first and shorter term target and one with my longer term target. Once that is done I can then move down to a shorter term time frame, say one hour, and safely begin taking entries in the direction of my target, until that target is met. Along the way I will always be looking for additional patterns to help pinpoint the smaller movements within the larger movement. Take for example the Trading Range that formed following the initial break of the Triangle Pattern. The magnitude of this pattern is roughly 500 points, or half the expected the long term target.
Introduction to Technical Analysis Price Patterns
In technical analysis, transitions between rising and falling trends are often signaled by price patterns. By definition, a price pattern is a recognizable configuration of price movement that is identified using a series of trendlines and/or curves. When a price pattern signals a change in trend direction, it is known as a reversal pattern; a continuation pattern occurs when the trend continues in its existing direction following a brief pause. Technical analysts have long used price patterns to examine current movements and forecast future market movements.
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- Patterns are the distinctive formations created by the movements of security prices on a chart and are the foundation of technical analysis.
- A pattern is identified by a line that connects common price points, such as closing prices or highs or lows, during a specific period of time.
- Technical analysts and chartists seek to identify patterns as a way to anticipate the future direction of a security’s price.
- These patterns can be as simple as trendlines and as complex as double head-and-shoulders formations.
Trendlines in Technical Analysis
Since price patterns are identified using a series of lines and/or curves, it is helpful to understand trendlines and know how to draw them. Trendlines help technical analysts spot areas of support and resistance on a price chart. Trendlines are straight lines drawn on a chart by connecting a series of descending peaks (highs) or ascending troughs (lows). A trendline that is angled up, or an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows.
Trendlines will vary in appearance depending on what part of the price bar is used to “connect the dots.” While there are different schools of thought regarding which part of the price bar should be used, the body of the candle bar—and not the thin wicks above and below the candle body—often represents where the majority of price action has occurred and therefore may provide a more accurate point on which to draw the trendline, especially on intraday charts where “outliers” (data points that fall well outside the “normal” range) may exist. On daily charts, chartists often use closing prices, rather than highs or lows, to draw trendlines since the closing prices represent the traders and investors willing to hold a position overnight or over a weekend or market holiday. Trendlines with three or more points are generally more valid than those based on only two points.
- Uptrends occur where prices are making higher highs and higher lows. Up trendlines connect at least two of the lows and show support levels below price.
- Downtrends occur where prices are making lower highs and lower lows. Down trendlines connect at least two of the highs and indicate resistance levels above the price.
- Consolidation, or a sideways market, occurs where price is oscillating between an upper and lower range, between two parallel and often horizontal trendlines.
A price pattern that denotes a temporary interruption of an existing trend is known as a continuation pattern. A continuation pattern can be thought of as a pause during a prevailing trend—a time during which the bulls catch their breath during an uptrend, or when the bears relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell if the trend will continue or reverse. As such, careful attention must be placed on the trendlines used to draw the price pattern and whether price breaks above or below the continuation zone. Technical analysts typically recommend assuming a trend will continue until it is confirmed that it has reversed. In general, the longer the price pattern takes to develop, and the larger the price movement within the pattern, the more significant the move once price breaks above or below the area of continuation.
If price continues on its trend, the price pattern is known as a continuation pattern. Common continuation patterns include:
- Pennants, constructed using two converging trendlines
- Flags, drawn with two parallel trendlines
- Wedges, constructed with two converging trendlines, where both are angled either up or down
Pennants are drawn with two trendlines that eventually converge. A key characteristic of pennants is that the trendlines move in two directions—that is, one will be a down trendline and the other an up trendline. Figure 1 shows an example of a pennant. Often, volume will decrease during the formation of the pennant, followed by an increase when price eventually breaks out.
Flags are constructed using two parallel trendlines that can slope up, down or sideways (horizontal). In general, a flag that has an upward slope appears as a pause in a down trending market; a flag with a downward bias shows a break during an up trending market. Typically, the formation of the flag is accompanied by a period of declining volume, which recovers as price breaks out of the flag formation.
Wedges are similar to pennants in that they are drawn using two converging trendlines; however, a wedge is characterized by the fact that both trendlines are moving in the same direction, either up or down. A wedge that is angled down represents a pause during a uptrend; a wedge that is angled up shows a temporary interruption during a falling market. As with pennants and flags, volume typically tapers off during the formation of the pattern, only to increase once price breaks above or below the wedge pattern.
Triangles are among the most popular chart patterns used in technical analysis since they occur frequently compared to other patterns. The three most common types of triangles are symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can last anywhere from a couple weeks to several months.
Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur—not the direction. Ascending triangles are characterized by a flat upper trend line and a rising lower trend line and suggest a breakout higher is likely, while descending triangles have a flat lower trend line and a descending upper trend line that suggests a breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle, as shown in the figure below.
Cup and Handles
The cup and handle is a bullish continuation pattern where an upward trend has paused, but will continue when the pattern is confirmed. The “cup” portion of the pattern should be a “U” shape that resembles the rounding of a bowl rather than a “V” shape with equal highs on both sides of the cup. The “handle” forms on the right side of the cup in the form of a short pullback that resembles a flag or pennant chart pattern. Once the handle is complete, the stock may breakout to new highs and resume its trend higher. A cup and handle is depicted in the figure below.
A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These patterns signify periods where either the bulls or the bears have run out of steam. The established trend will pause and then head in a new direction as new energy emerges from the other side (bull or bear). For example, an uptrend supported by enthusiasm from the bulls can pause, signifying even pressure from both the bulls and bears, then eventually giving way to the bears. This results in a change in trend to the downside. Reversals that occur at market tops are known as distribution patterns, where the trading instrument becomes more enthusiastically sold than bought. Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the trading instrument becomes more actively bought than sold. As with continuation patterns, the longer the pattern takes to develop and the larger the price movement within the pattern, the larger the expected move once price breaks out.
When price reverses after a pause, the price pattern is known as a reversal pattern. Examples of common reversal patterns include:
- Head and Shoulders, signaling two smaller price movements surrounding one larger movement
- Double Tops, representing a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level
- Double Bottoms, showing a short-term swing low, followed by another failed attempt to break below the same support level
Head and Shoulders
Head and shoulders patterns can appear at market tops or bottoms as a series of three pushes: an initial peak or trough, followed by a second and larger one and then a third push that mimics the first. An uptrend that is interrupted by a head and shoulders top pattern may experience a trend reversal, resulting in a downtrend. Conversely, a downtrend that results in a head and shoulders bottom (or an inverse head and shoulders) will likely experience a trend reversal to the upside. Horizontal or slightly sloped trendlines can be drawn connecting the peaks and troughs that appear between the head and shoulders, as shown in the figure below. Volume may decline as the pattern develops and spring back once price breaks above (in the case of a head and shoulders bottom) or below (in the case of a head and shoulders top) the trendline.
Double tops and bottoms signal areas where the market has made two unsuccessful attempts to break through a support or resistance level. In the case of a double top, which often looks like the letter M, an initial push up to a resistance level is followed by a second failed attempt, resulting in a trend reversal. A double bottom, on the other hand, looks like the letter W and occurs when price tries to push through a support level, is denied, and makes a second unsuccessful attempt to breach the support level. This often results in a trend reversal, as shown in the figure below.
Triple tops and bottoms are reversal patterns that aren’t as prevalent as head and shoulders or double tops or double bottoms. But, they act in a similar fashion and can be a powerful trading signal for a trend reversal. The patterns are formed when a price tests the same support or resistance level three times and is unable to break through.
Gaps occur when there is empty space between two trading periods that’s caused by a significant increase or decrease in price. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or other news. There are three main types of gaps: Breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps for near the end of the trend.
The Bottom Line
Price patterns are often found when price “takes a break,” signifying areas of consolidation that can result in a continuation or reversal of the prevailing trend. Trendlines are important in identifying these price patterns that can appear in formations such as flags, pennants and double tops. Volume plays a role in these patterns, often declining during the pattern’s formation, and increasing as price breaks out of the pattern. Technical analysts look for price patterns to forecast future price behavior, including trend continuations and reversals.
Understanding Point and Figure Charts
Point and Figure Charts: Calculating Price Targets
Another objective feature of Point and Figure charts is in calculating price targets. Targets may be established using two methods, vertical and horizontal. The vertical method uses the first column from any top or bottom to establish the target.
The length of the thrust determines the extent of the move, so the greater the initial thrust, the greater the target.
The horizontal method requires a top or a bottom where there has been some sideways movement and is based on the width of the top or bottom pattern to determine the extent of the move. Both methods can be used on the chart, but there are more opportunities to use the vertical method.
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Point and Figure Charting
Point and Figure Charting
Part 2: P&F Chart Trend Lines
Part 3: P&F Price Targets
Part 4: P&F Technical Indicators
Elliott Wave Theory
JM Hurst Cycles Analysis
Tom Demark Indicators
The Definitive Guide to Point and Figure
by Jeremy du Plessis
Kennys Technical Analysis
Kennys Elliott Wave Analysis is my trading plan for the week ahead with regular updates.
Technical analysis reports using Elliott waves, chart patterns, trend trading strategies, Hurst cycles and other stock market time cycles analysis.
Understanding Point and Figure Charts: Defining Price Targets
Figure 6 is a 15 x 3 Point and Figure chart of the S&P 500 showing some vertical and horizontal price targets. Notice how accurate they have been in both the uptrend and the down trend, remembering that targets are established well in advance of being achieved.
Price targets are a guide, it should never be assumed that they will be achieved exactly. They give an indication of the strength of the chart and provide a potential target area.
Because Point and Figure signals are so clear cut and unambiguous, it is easy to see where a buy signal has occurred and what is required to cancel the signal and consequently where a stop should be placed. This means you can calculate the risk reward ratio based on the price to target divided by the price to the stop. This tells the trader the potential number of points of reward for every point of risk taken on. Because the targets and stops are objective, these risk reward ratios can easily be calculated by a computer.
Figure 7 shows the same S&P 500 chart but as at 27th December 2020. The 1440 target has been established with two possible stops at 1200 and 1155 identified, because a break below these levels would generate double bottom sell signals. This allows two risk reward ratios of 2.2 and 1.4 to be calculated depending which stop level is used. These ratios help you to decide, firstly whether the take the trade and secondly where to place your stop. In this example the price rose and hit the 1440 target in September 2020.
It is important to understand that objectivity implies there is no ambiguity, but it does not mean infallibility. It means there is no argument as to whether a signal, trend or target exists or where it is positioned. So objectivity does not guarantee accuracy, but it does remove any doubt about the analysis.
Next: Point and Figure Charts part 4: Technical Indicators or Return to Part 2
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