When it comes to analyzing markets and planning future trades, there are two major ways to predict currency prices. In addition, you can use both of the methods simultaneously. One way for analyzing the markets is to learn about economic and political factors that can affect currency valuation. Method that takes into account current economic events such as inflation, trade deficit, interest rates, unemployment, political situation, etc. is called fundamental analysis. Method that studies charts and past price performance to predict the future prices is called technical analysis.
Price patterns that have presented themselves many times, are highly valuable to technical traders. In this guide, we’ll discuss what they are, why they form, how to identify them and how to trade them.
Forex patterns explained and how to make money using them
There are various patterns that can be found in the world of trading. Some patterns signal trend continuation and they are called continuation patterns, while others predict reversals and they are called reversal patterns.
Forex patterns are an essential part of technical analysis. When price moves on the charts, it leaves certain shapes behind. Analysts that are looking for price patterns, study these shapes. And the shapes that occur many times, become highly valuable patterns. Technical analysts base their predictions on the belief that what has happened many times before, will likely happen in the future. The core idea of pattern recognition is not to tell you what will happen exactly. The idea of technical analysis is to tell you what is most likely to happen, without any guarantees. And therefore, a trader should never risk everything in a single trade. You might have already heard that risk management is the key to successful trading. This example shows that this is very much true.
There are two ways to consistently make money in the markets. The first way is to have a trading strategy that helps you predict prices more precisely. In other words you need to have more winning trades than losing ones. For instance, if you make 10 trades and statistically speaking, 6 out of the ten result in profits, you will consistently earn money even when the risk to reward ratio is 1:1.
The second way of making money doesn’t require high win rates. However, winning trades need to be large in size to cover the losses. For example, let’s say you make 9 losing trades out of 10, statistically. And if this single win can generate more money than what was lost in 9 trades, you will make money consistently.
When you have a trading strategy that promises mathematical advantage, in other words, trading edge, all you have to do is to manage your risks properly. Proper risk management enables traders to place 9 losing trades and still have funds to finance the 10th trade, which will statistically be a winning one. What’s more, professional position traders only risk 1% to 5% of their trading capital per trade. Now that we understand how statistics and trading edge works, we can look for trading patterns that can produce that edge for us.
The best forex patterns are not the ones that can give you clear answers about where the price will go next. The best forex patterns are the ones that can give you the best trading edge. To be more specific, even if your pattern produces 50% winning trades, if the risk to reward ratio is good, the outcome after a large number of trades will undoubtedly be account balance growth.
Types of forex patterns
Now that we know what to value in a forex pattern, let’s see what types of patterns are there. The most common and widely used patterns are chart patterns and Japanese candlestick patterns. In this guide, we are focusing on chart patterns.
As we have already mentioned, there are continuation and reversal patterns. In addition, there are chart patterns that signal indecision. In other words, there’s a 50% probability that the price will go in a certain direction. Patterns that show indication, can be highly profitable if the risk to reward ratios are great.
Forex chart patterns
Forex chart patterns are easy to spot using a naked eye as they do not require use of technical indicators. Once novice traders learn how they look, identifying forex patterns becomes easy. However, chart patterns can be highly precise and symmetrical on forex patterns guides and trading books, but keep in mind that the real world is not perfect. Actual patterns might be slightly deformed. For instance, in head and shoulders, one shoulder might be slightly larger than the other. And therefore, traders should not look for perfection, they should make their own judgment.
Understanding forex patterns is important for learning how to conduct technical analysis. Let’s take a look at some of the most common chart patterns and learn how to trade them.
Head and shoulders
Head and shoulders is a highly popular chart pattern. The reason is simple, the pattern appears quite often on the charts and offers a great risk to reward ratio. It’s easy to spot and easy to trade. In addition, there might be chart patterns that have 4 similar shoulders and 1 head in the middle. In the example below, you can see the head and shoulders pattern and inverted head and shoulders pattern. They are polar opposites of each other, but once you understand how to trade one, you’ll be able to use the same type of thinking to trade the other one.
Head and shoulders consists of two shoulders with a relatively smaller price hike and one relatively larger price hike in the middle. The pattern gets the name due to its shape. In order to trade this pattern, you should wait for the price to break the neckline. Keep in mind that if the neckline is not broken, the pattern is unfinished and all the mathematical advantages are gone. Many beginner traders make this mistake and finish patterns in their imagination, which is a wrong way to trade patterns.
Once the neckline is broken, trade can be entered. Stop loss order is typically placed behind the neckline, in this case, above the support neckline. The price has the potential to make as large a move as the distance between the head and the neckline. When traders try to avoid false breakouts, they wait for the breakout candle to close below the neckline and they enter the trade once confirmation candle starts forming below the neckline.
The inverse head and shoulders can be traded the same way. Once the neckline resistance is broken, traders can open long positions and place their stops and take profits accordingly.
Head and shoulders patterns reverse trends or begins new ones. Usually volume increases when price nears breakout. In general volume indicators are highly beneficial when traders are making predictions on whether breakout will happen or not. Breaking significant levels requires energy and volume.
Double top and double bottom chart patterns
Double top and double bottom chart patterns are opposites of one another. However, if you learn how to trade one of them, learning how to trade another will not be an issue.
As you can see from the example below, the patterns reverse trends and therefore, they are called reversal patterns.
Let’s see how to trade the double top. As you can see from the example below, both price hikes need to be the same sizes. If one is smaller than the other, we do not have a double top. When the pattern appears, traders should wait for the price to break the neckline support and open short positions. Traders that are avoiding false breakouts, wait for the confirmation candles and join trades later. Stop loss can be placed above the neckline. Potential price movement can be as large as the distance between neckline support and resistance levels. The pattern offers good risk to reward ratios and appears quite often on the charts.
The double bottom is being traded similarly, but in the opposite direction. The pattern predicts the price to hike after the neckline is broken. Traders should go long and place stop loss orders below the neckline resistance. Potential profit can be as high as the distance between the support and the neckline resistance.
Triangle chart patterns
There are 3 types of triangle patterns in trading. The patterns get the name thanks to their shape. Symmetrical triangle signals indecision. There’s no clear indication of where the price will go next. However, as we have mentioned above, it’s not important to be correct in trading to make money. It’s important to have an edge. A symmetrical triangle produces that edge by offering a great risk to reward ratio. Once the price breaks the trendline, potential price hike is as large as the distance between the maximum and minimum price points within the triangle. The same is true for the Ascending and Descending triangles. However, there are some differences between these triangles. Ascending triangle appears in an uptrend. The pattern predicts that the price will keep rising after the resistance is broken. And therefore it is a bullish, continuation pattern. Descending triangle is traded in the similar manner but in the opposite direction. Descending triangle is known as a bearish continuation pattern.
Ascending and descending triangles are more powerful than symmetrical triangles. The reason is simple. They show clear direction and trend continuation.
In addition to these triangles, there are pennants that look very much like the Ascending and descending triangles, however, they are not the same. Pennants are created in fast moving markets and traders have much less time to enter them.
Flag chart patterns
Flag is another common chart pattern in Forex. There are bullish and bearish flags as you can see below. Once the trendlines are broken, traders can join trends and expected profit targets are as large as the size the flag poles.
The main takeaways
To sum everything up, chart patterns are essential for conducting technical analysis. It’s not important the patterns to give you precise answers on where the price might go next. The most important thing in trading is to have an edge. In other words, the best patterns should guarantee your account balance growth after a large number of trades. There are a large number of chart patterns. Among these patterns, the most famous are Head and shoulders, Double top and double bottom chart patterns, Triangle chart patterns, Flag chart patterns. In addition to chart patterns, there are candlestick patterns. Keep in mind that in order to trade the patterns the right way, traders should always wait for the culmination and only enter the trades once the pattern is complete and entry point is clear. Some traders wait for the confirmation candles to avoid false breakouts. Others jump in as soon as trendlines are broken in order to gather the maximum profits.
FAQs on patterns in Forex trading
What is the best pattern for forex?
It’s hard to say which pattern is the best. As trading conditions are different for every instrument. The best patterns are not the ones that can predict the future prices with accuracy. The best patterns are the ones that produce a good trading edge. Some of the most famous patterns are: Head and shoulders, Double top and double bottom chart patterns, Triangle chart patterns and Flag chart patterns.
How do you read forex patterns?
Once you learn how they look on sketches, you’ll be able to spot them easily on the charts as well after some practice. Keep in mind that in the real world, patterns do not look perfect. And therefore, for instance in head and shoulders, one shoulder might be slightly different than the other one. It’s your job as a trader to make a decision whether to trade or not certain patterns. Patterns should only be traded when they offer clear entry points.
Do forex patterns work?
Many traders trade patterns profitable while others fail to do so. To find the answer to this question, it’s best to select the patterns that make the best sense to you, backtest them and see if they can work for you.