Chart patterns trading is often equated to buying and selling at the direction of technical indicators. However, although chart patterns are considered to be technical tools, they differ in many ways from indicators. If you’re in the process of becoming a market technician, then it’s important to understand the functionality, pros, and cons of both chart patterns and indicators.
A chart pattern is a formation that represents the former path of price itself. Chart patterns are constructed directly from market data that has been filtered with respect to periodicity and type. Popular intervals are tick, minute, hour, and day, and common chart types are candlestick, OHLC, and line. A few traditional formations are morning and evening stars, dojis, pennants, head-and-shoulders, wedges, and hammers.
Chart patterns trading strategies may be applied to any market using any periodicity. In fact, legions of active traders do so daily, searching for those with positive forecasting capabilities. Although chart patterns are valuable technical tools, it’s important to be aware of their unique benefits and shortcomings.
Perhaps the biggest advantage of chart patterns is that they are user-friendly. Patterns are presented in a visual context, right on the pricing chart. There’s no guesswork in identifying a pattern―it’s either there or it isn’t.
Chart patterns also function well in a predictive capacity. Distinct formations may be used to project trend extension, market reversal, or a pending breakout. Further, the chart pattern itself is frequently viewed as the basis for stop loss and profit target locations. In this fashion, traders may optimize risk vs. reward in live market conditions.
On the flip side, chart patterns trading falls short in a few areas. The main disadvantage of patterns is that they disregard a market’s prevailing state. Given that they are visual constructs, information such as traded volumes and order flow are ignored. Overlooking these factors enhances the probability of being “faked out” by a signal likely to lack any conviction and follow-through.
Also, buying and selling futures contracts in reference to patterns can be expensive. Stop losses are often sizable, especially when larger chart periodicities are being referenced. Although it’s possible to reduce risk by using charts with smaller intervals, the forecasting capabilities of most patterns generally break down.
An indicator is a technical device that is mathematically derived from pricing data. Once the calculations have been completed, the indicator may then be plotted on the price chart as an overlay or in a corresponding window. Indicators come in many varieties, including support & resistance levels, oscillators, and pivot points. A few of the most common are moving averages, Fibonacci retracements/expansions, stochastics, and moving average convergence/divergence (MACD).
Like chart patterns trading, futures market participants apply indicators to various types of periodicities and charts every day. Through their use, the direction of price may be either confirmed or challenged, prompting the development of new trade ideas. Nevertheless, indicators have a few key upsides and downsides to be aware of.
One aspect of technical analysis where indicators excel over chart patterns is in quantifying trend strength. For instance, the MACD uses two moving averages to measure the momentum behind directional price action. If the MACD’s moving averages converge, the trend’s momentum is weakening; if they diverge, the trend is gaining steam.
Also, indicators lend themselves well to managing open positions on the fly. As an example, support & resistance levels, such as Fibonacci retracements/projections, may be used as guides for stop loss and profit target locations. Methods like this offer traders a clear-cut way of managing positions in fast-moving markets.
Unfortunately for active traders, indicators have a multitude of drawbacks. One pitfall is the tendency for indicators to become “cluttered” on the pricing chart. Because indicators are calculated automatically and routinely applied, it’s easy to use too many. The result is analysis paralysis as a result of conflicting and jumbled indicators hampering decision-making.
Although there are “leading” indicators, most are classified as “lagging.” Because they are derived from price data, indicator values reflect where price was, not where it may be going. The same can be said about chart patterns trading, but patterns suggest that a specific scenario is likely to unfold; the predictive capabilities of indicators are limited because the data is subject to interpretation.