The Truth About Stock Chart Patterns

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Bulls on Wall Street

How many times a day do you see a magical stock chart pattern on social media that can instantly turn you into a consistently profitable trader?

While chart patterns are useful for providing information about the trend of a stock, they will NOT make you a successful trader. This is one of the biggest new trader misconceptions that we are about to correct today. This blog shows you the difference between a chart pattern and an actual trading strategy and shows you what makes a successful trade with a high probability.

Here’s What You Need To Know About Chat Patterns, And The Truth About How They Work:

Understand candlesticks

Every chart pattern consists of candlesticks. Before we dive into the effectiveness of chart patterns, let’s start with the basics in case you’re new. Candlesticks are the language of technical analysis and the building blocks of any pattern. Understanding them is important in order to have a basic understanding of technical analysis:

Remember: Always give more weight to candle shapes in the HIGHER timeframe. A 1 minute doji close is 100x less significant than a doji close on the daily chart.

What are stock chart patterns?

Now that you have a basic understanding of how to read candlesticks, let’s dive into the basics of reading stock chart patterns.

Patterns are the distinctive formations created by the movement of stock prices (or any market) on a candlestick chart. Patterns can indicate the potential for price movement up or down in the markets. A classic chat pattern that many are familiar with is the flag pattern:

How do you read a stock chart?

Simple and easy to trade, right? Unfortunately, when people show you this, they pick the best. The overall context of the stock determines the likelihood that a chart pattern will work or not. The pattern itself is meaningless. The truth is, to be consistently profitable, you need to consider far more than just chart patterns.

Do chart patterns work?

While chart patterns can indicate a significant change in the supply and demand of a stock, they are NOT a reason to enter a trade on their own. Chart patterns are NOT a trading strategy. A real trading strategy takes into account several variables in the markets, not just one. Strategies are supported by data. Strategies take into account several market variables and the overall picture of a stock.

The bigger picture

Trading is so much more than just patterns. If so, nobody would be doing a regular job! There is much more to a trade than the chart pattern:

  • The overall picture trend of the stock (daily, weekly, monthly)
  • News catalysts, past or coming
  • Close to moving averages
  • Oversold or overbought indicators
  • Liquidity, spreads, volume
  • Share history of dynamics
  • Macro Market Conditions

Just to name a few. When you are a trader, you are like a lawyer creating a case. You will collect as much evidence as you can before you begin your law enforcement or defense. You don’t start with just one piece of evidence!

Look out afterwards

Chart patterns look obvious in hindsight. Just before they break out or collapse, is that that obvious? With hindsight, don’t let that stop you from believing that this was a high probability setup. The bigger picture tells you whether or not a chart pattern should work. Trading is a game of probabilities, not certainties. This one diagram of a head and shoulders pattern doesn’t mean you are short every time you see this pattern:

best chart pattern

Instead of saying the head and shoulders are a sell signal, back it up with data to include the full context of a stock. Backtest and look at past scenarios. Instead, you can find that the head and shoulders are a high likelihood of a sell signal after a stock has risen more than 100% in the past week and has risen for 3 consecutive days. This is a high probability strategy, not just a pattern. Record your trades to see which strategies are doing your best. You only need to execute ONE successful strategy to become a consistently profitable trader.

Takeaways

  • Patterns in themselves are meaningless
  • Look at the overall context of a stock
  • Don’t let yourself decide what the right course of action was afterwards
  • Track data to find the right strategy for yourself

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