USING THIS BOOK TO YOUR ADVANTAGE

HOW TO PROCEED FROM HERE

Now that you have a solid understanding of the different patterns, a very common mistake that can lead to loosing money is trading those patterns individually using the conditions explained for each of them. Understanding the patterns is an important step, but it is not the only one.

Below we will go through the thought process of creating a money management plan for a trading cycle based on the patterns covered in this book, to illustrate that process we will breakdown -most- of our own strategy for trading using some of the patterns in the Forex market.

Please understand that we are not providing you with a “ready-to-use” trading strategy, what works for us might not work for you, the purpose of providing this information is to show you how to build your own profitable strategy for trading the standard chart patterns.

STEP 1: determine which patterns suits your trading style

The patterns in this book have different characteristics, it would be very hard and confusing to build a trading strategy around all of them, therefore the first step is to eliminate the patterns that aren't compatible with your trading style. Below is how we filtered our own list of patterns to trade:

  • We prefer trading continuation patterns, thus (head and shoulders, inverse head and shoulders, double tops, double bottoms, triple tops, triple bottoms) are removed from the list of patterns we trade.
  • The second trading preference is trading patterns that occurs more frequently in the market, that removes the cup and handle from our list.
  • Since wedges can be continuation or reversal patterns, we only trade rising wedges when the prior trend is downwards, and falling wedges when the prior trend is upwards.
  • That leaves us with the following patterns list:
    • Symmetrical triangles
    • Ascending triangles
    • Descending triangles
    • Wedges (continuation variants only)
    • Rectangles
    • Flags
    • Pennants

STEP 2: setup a strategy for trading the selected patterns

Once you have the list of patterns you are willing to trade, it is time to build a strategy for trading them. This strategy must include how to enter a trade, how to calculate take profit target, and how to calculate stop loss. Below is a -simplified- list of the conditions we use for the patterns we filtered earlier:

  • Trade entry: at the closure rate of the candle after the breakout candle.
  • Take profit target: default measurement for each pattern.
  • Stop loss: each pattern have its method(s), discussed thoroughly below in the next topic.

STEP 3: Backtest, thoroughly!

Now that we have the list of patterns to trade and the strategy for each of them set, it is time to manually backtest our plan by going through the different charts searching for all the patterns from our list that can be found, and precisely do the calculations for each finding using the strategy we have set. Of-course, the larger the backtesting sample, the more reliable the results will be. We recommend finding at least 10 of each pattern, it can be a boring and exhausting process that might take days or weeks to complete, but it lays the foundation for months or even years of successful trading to come.

STEP 4: Calculate your edge and build a money management plan around it

Using the data collected from backtesting, calculate R:R and W/L for all the backtested trades to calculate your average R:R and W/L (your edge over the market) and see if trading using those conditions will be profitable or not.

STEP 5: Be consistent

If completing the previous steps resulted in a profitable calculation and gave you the confidence to use that strategy in a real trading cycle, always remember this: “You backtested the pattern and know its performance, you have a money management plan for a trading cycle, you created your set of rules to be used in trading, now please stick to them!”.

WHY AND WHEN DO WE USE (7%, 14%, 21%) FOR STOP LOSS SAFETY

Throughout this book you might have noticed that we always use one of the three percentages (7%, 14%, 21%) of the target measurement to calculate a safer stop loss rate beyond the absolute stop loss measurement. As discussed earlier, it is important define in a trading strategy the rules to use for setting a method for stop loss and calculating its rate, and that is our way of approaching a constant method for calculating stop loss trigger rate. As for why we assigned certain percentage(s) for each of the patterns, this involved studying the basic structure and price action for each of the patterns, which is explained -briefly- below.

Generally speaking, stop loss measurements based on the breakout of a pattern -which is always the closer stop loss- will be assigned either 14% or 21% stop loss safety to give the trade room to breathe, while the further stop loss will be assigned 7% stop loss safety since it is always a structural support. Below we will explain why each stop loss measurement is chosen for the patterns, and why they are assigned their stop loss safety percentage chosen to them.

SYMMETRICAL TRIANGLE:

  • Continuation pattern, the prior trend is in the favor of the trade direction.
  • Price action inside the pattern is creating lower highs and higher lows, thus not favoring or opposing the trade direction.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of a clear structural support and the steady price action inside the pattern:
    • Stop loss 1: 21% of target measurement beyond absolute stop loss, since it isn't a structural support, and may be reduced to 14% if the breakout was strong and trade entry is a bit further away from the breakout level.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

ASCENDING TRIANGLE:

  • Continuation pattern, the prior trend is in the favor of the trade direction.
  • Price action inside the pattern is semi-bullish which favors the trade direction , as the equal highs means that bears are holding their ground but not able to push back, while the higher lows means that bulls are gaining ground by pushing forward slowly.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss, since it is a structural support.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

DESCENDING TRIANGLE:

  • Continuation pattern, the prior trend is in the favor of the trade direction.
  • Price action inside the pattern is semi-bearish which favors the trade direction , as the equal lows means that bulls are holding their ground but not able to push back, while the lower highs means that bears are gaining ground by pushing forward slowly.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss, since it is a structural support.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

HEAD AND SHOULDERS:

  • Reversal pattern, the prior trend is opposing the trade direction.
  • Price action inside the pattern is semi-bearish which favors the trade direction and weakens the prior trend by three different resistances (head + 2 shoulders), with the last resistance (right shoulder) being lower than the previous one (head), which means that bears are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports when the pattern isn't skewed:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss when the pattern isn't skewed as the neckline is a structural support in that case, or 21% in skewed patterns as support in that case isn't structural.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

INVERSE HEAD AND SHOULDERS:

  • Reversal pattern, the prior trend is opposing the trade direction.
  • Price action inside the pattern is semi-bullish which favors the trade direction and weakens the prior trend by three different resistances (head + 2 shoulders), with the last resistance (right shoulder) being higher than the previous one (head), which means the bulls are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports when the pattern isn't skewed:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss when the pattern isn't skewed as the neckline is a structural support in that case, or 21% in skewed patterns as support in that case isn't structural.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

CUP AND HANDLE:

  • Continuation pattern, the prior trend is in favor of the trade direction.
  • Price action inside the pattern is semi-bullish which favors the trade direction, with the handle's low being higher than the cup's low, which means bulls are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports when the pattern isn't skewed:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss when the pattern isn't skewed as the surface is a structural support in that case, or 21% in skewed patterns as support in that case isn't structural.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

INVERSE CUP AND HANDLE:

  • Continuation pattern, the prior trend is in favor of the trade direction.
  • Price action inside the pattern is semi-bearish which favors the trade direction, with the handle's high being lower than the cup's high, which means bulls are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of two clear structural supports when the pattern isn't skewed:
    • Stop loss 1: 14% of target measurement beyond absolute stop loss when the pattern isn't skewed as the surface is a structural support in that case, or 21% in skewed patterns as support in that case isn't structural.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

FALLING WEDGE:

  • Neutral pattern, the prior trend can be in favor or opposing the trade direction.
  • Price action inside the pattern is fully bearish which opposes the trade direction, with lower highs and lower lows being formed, which means the bears are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of a clear structural support and the steady price action inside the pattern:
    • Stop loss 1: 21% of target measurement beyond absolute stop loss, since it is not a structural support.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

RISING WEDGE:

  • Neutral pattern, the prior trend can be in favor or opposing the trade direction.
  • Price action inside the pattern is fully bullish which opposes the trade direction, with higher lows and higher highs being formed, which means the bulls are gaining ground and pushing forward.
  • The pattern is assigned two stop loss methods to choose from, due to the availability of a clear structural support and the steady price action inside the pattern:
    • Stop loss 1: 21% of target measurement beyond absolute stop loss, since it is not a structural support.
    • Stop loss 2: 7% of target measurement beyond absolute stop loss, since it is already further away from entry and it is a structural support.

RECTANGLE:

  • Continuation pattern, the prior trend is in the favor of the trade direction.
  • Price action inside the pattern is creating equal highs and equal lows, thus not favoring or opposing the trade direction.
  • The pattern is assigned a single stop loss method since the breakout is the only constant support for that pattern:
    • Stop loss: 14% of target measurement beyond absolute stop loss, since it is a structural support.

FLAG:

  • Continuation pattern, the included trend (pole) is strongly favors the trade direction.
  • Price action inside the flag formation is creating lower highs and lower lows for the bullish variant, higher highs and higher lows for the bearish variant, which is opposing the trade direction.
  • The pattern is assigned a single stop loss method since the pole is usually a strong and steep price action, thus the usual breakout stop loss level isn't used in this pattern as it is too risky:
    • Stop loss: 7% of target measurement beyond absolute stop loss, since it is a structural support.

PENNANT:

  • Continuation pattern, the included trend (pole) is strongly favors the trade direction.
  • Price action inside the pattern is creating lower highs and higher lows, thus not favoring or opposing the trade direction.
  • The pattern is assigned a single stop loss method since the pole is usually a strong and steep price action, thus the usual breakout stop loss level isn't used in this pattern as it is too risky:
    • Stop loss: 7% of target measurement beyond absolute stop loss, since it is a structural support.

DOUBLE TOP / DOUBLE BOTTOM:

  • Reversal pattern, the prior trend is opposing the trade direction.
  • Price action inside the pattern slightly favors the trade direction, as the trend prior to the pattern formation faced two resistances (two tops or bottoms) and had only one support (middle retracement) that got broken on the first test.
  • The pattern is assigned a single stop loss method since the breakout is the only constant support for that pattern:
    • Stop loss: Although it is a structural support, it is assigned the 21% of target measurement beyond absolute stop loss, and may be reduced to 14% if the breakout was strong and trade entry is a bit further away from the breakout level.

TRIPLE TOP / TRIPLE BOTTOM:

  • Reversal pattern, the prior trend is opposing the trade direction.
  • Price action inside the pattern may slightly favor the trade direction when the second middle retracement is longer than the first, or slightly oppose the trade direction when the second middle retracement is shorter than the first.
  • The pattern is assigned a single stop loss method since the breakout is the only constant support for that pattern:
    • Stop loss: Although it is a structural support, it is assigned the 21% of target measurement beyond absolute stop loss, and may be reduced to 14% if the breakout was strong and trade entry is a bit further away from the breakout level.

A FEW POINTS TO CONSIDER

The below points are general facts or observations related to Forex trading -and trading in general-, they just scratch the surface of their respective topic, we thought it would be better to include them in this book so you can take them into consideration while trading.

  • Be strict with stop loss, don't move it around.
    • Before you enter a trade, know where exactly is your loss threshold for a trade and don't extend it unless it -really- is a calculated risk that doesn't involve any emotion reaction. A trade is a plan, when that plan fails there is no logical reason to continue hoping for the plan to change its output.
  • If the trade setup's R:R can afford it, give a few pips to the market by shortening the target measurement a bit.
    • There is no thing as 100% precision when trading in the market, a successful trade may change direction just before or after hitting its target. When a trade's R:R is higher than your threshold R:R for a trading cycle, it won't hurt to sacrifice a few pips to the market to earn the probability of your order getting filled in the not-so-rare case of the market reversing direction just before hitting the original calculated target.
  • Mind the spread when calculating rates for a trade setup to increase the probability of the order getting filled.
    • Although it looks negligible on the chart, but the spread does have its impact on any trade. A 2 pip spread in a trade with 50 pip range, is 4% of that trade's range, you can't neglect that. Obviously, trades with wider range will be less impacted by spread, but still it should be accounted for when creating and calculating a trading setup.
  • Volume isn't as reliable in Forex market.
    • Forex isn't a centralized market like for example the stock market. Brokers do have they way of representing volume to their traders, but it will always be a best effort method, never representing the actual trading volume.
  • The common duration for the different patterns' formation isn't written in stone.
    • The Forex market tends to be a lot faster than other trading markets, don't limit yourself to the common duration for a specific pattern. As long as you backtest the pattern(s) on the time-frames you are willing to trade them on, you are good to go!
  • Did we mention the importance of backtesting, money management and trading management ?
    • Yes! yes we did, and here we are again emphasizing on the importance of trading management and money management. Acquiring the skill of identifying patterns is a huge addition to your trading arsenal, but as said earlier, it is a part of a whole.
  • A pattern's R:R alone or W/L alone isn't a reliable indicator of its performance.
    • It is the multiplication of the two factors that calculates the “edge” of that pattern over the market, where an edge over 1 means the pattern is profitable, and an edge over 2 is considered strong and very profitable, for example:
      • R:R=1.25 and W/L=0.75: Edge = 0.94 (not profitable)
      • R:R=1.50 and W/L=1.00: Edge = 1.50 (profitable)
      • R:R=1.50 and W/L=1.50: Edge = 2.25 (very profitable)
  • Being consistent doesn't mean being robotical in your trading.
    • If your trading strategy can be 100% systematic, then it can be coded into an expert advisor, right ? There is always room for your own best judgment when it comes to trading, being consistent means respecting your own money management rules and respecting your plan for entering and exiting trades. Choosing which trades to enter and which trades to pass is where your own trading skills are really put into test, and it definitely makes all the difference.
  • Losses are a part of the game.
    • Backtesting and having a strategy empowers your psychological readiness to accept losses. A trader who tries to find a way around closing a losing trade when its loss is at the maximum risk planned, is eventually going to lose much more than the loss he/she tried to prevent.