Trading chart pattern breakouts is one of the first strategies I learned when I began trading more than a decade ago. Even though it took time to determine which ones to trade, which ones to leave alone, and which ones were high probability, if you’ve read my eBook Forex Trading Strategies for Day and Swing Traders 2.0, you know that I like chart patterns (although I trade them in very different ways than what’s commonly taught). Always looking for ways to improve on trading methods, predicting chart pattern breakout direction–I call it “front-running”– is an advanced technique for trading chart patterns. It’s recommended you have trading experience before attempting these methods, and have a good sense of market direction and strength, even though basic guidelines are provided below.
I originally published this article in early 2014; traditional technical analysts provided some backlash. Yet this is a great method for getting some astronomical reward:risk ratios….and the stock/forex pair/futures contract doesn’t even need “rip;” normal market movements still produce much more favorable reward:risk ratios than trading a chart pattern in the traditional way. Charts patterns don’t always need to traded this way; sometimes the old-fashioned way is fine too…but “front-running” is definitely a method you want in your trading tool belt.
Why Predict Chart Pattern Breakout?
Two commonly discussed chart patterns are triangles and head and shoulder patterns. There are others as well (to which this method can be applied), including wedges/diagonals, flags, pennants, ranges, channels, and even the very common ‘consolidation’ (which may not have a particular shape, but is still a pattern). Through examples below you’ll get a feel for how to trade triangles and head and shoulders in a traditional way, as well as “front-running” the breakouts. You can then use this knowledge for trading other chart patterns.
Instead of waiting for a breakout, which is the traditional approach to trading chart patterns (and still on okay method), if we’re able to read the price action and come up with an expectation for the direction of the breakout, we can greatly reduce risk and increase potential profit by getting a better entry price.
The method generally applies to all markets and time frames, as the examples below show.
Predict Chart Pattern Breakout Direction
Figure 1 shows a triangle chart pattern in Apple (AAPL) stock, along with the traditional way to trade it.
Figure 1. Triangle in Apple Stock, Daily Chart
Once the pattern is drawn, the traditional method requires waiting for a breakout. In this case we enter when the price breaks below the lower trendline of the triangle. A stop loss is placed just outside the opposite side of the triangle, and a target is achieved by taking the height of the triangle (widest point) and subtracting it from the breakout price (add it in the case of an upside breakout).
This method is fine, but we don’t always need to wait for the breakout. Figure 2 shows another triangle in Apple. The stock was in an uptrend and the price was rallying aggressively prior to the triangle forming. Therefore, we can anticipate the trend will continue and the triangle breakout will be to the upside.
Figure 2. Predict Chart Pattern Breakout Direction Strategy
Based on the prior rally, as soon as we can draw the bottom line of the triangle (need two connection points or more) we have an approximate entry area. Since we’re anticipating an upside breakout and the price isn’t moving lower (it is bouncing off support), we go long near the bottom of the triangle. Our stop loss is still placed just below the triangle–although give a bit of a room. Using this method we get a better price than if we waited for the breakout. Our risk is reduced (difference between entry and stop loss), because the stop loss is in the same spot as using the traditional method, and our profit potential has also increased (difference between entry and target) because the target is still based on the breakout point (traditional target method).
Figure 3 shows a head and shoulders on a 1-minute EURUSD chart. Once again there’s a strong price run leading into a head and shoulders pattern. The head and shoulders pattern is commonly considered a reversal pattern, but if you look closely, you will often see small head and shoulder patterns that act as continuation patterns. Figure 3 is an example of this. The price rallies, forms a small head and shoulders, but then instead of breaking lower it breaks higher, resulting in a continuation of the uptrend.
Figure 3. Predict Upside Breakout on Head and Shoulders Continuation Pattern, 1-Minute Chart
Given the prior move higher, the expectation is that the price will continue to rally. Although, we can’t be sure. Therefore, once the right shoulder forms, and then makes a higher low, it’s a strong indication our expectation is correct. Following that higher low, we are looking for any opportunity to get in. The price drops a little again than starts to move higher–that’s the entry. A stop loss is placed below the lows of the head and shoulders pattern, or below the recent low. In this case, our entry is slightly better than waiting for an actual breakout higher (which would be a move above the descending trendline connecting the head and right shoulder), but still reduces risk and increases profit potential.
For this example I have provided another target method, using a Fibonacci Extension tool. By running the tool from near the start of the prior run, to the top of the head and shoulders pattern, then to the low of the pattern, several price targets are provided by the tool. By using the 100.0 level I was basically anticipating that the move higher following the breakout would be roughly equal to the move higher before the pattern.
If trading on a 1-minute forex chart, I recommend using an ECN forex broker which has a near zero spread. Here’s my preferred ECN broker (they also have normal accounts).
Guidelines for Anticipating / Predicting Chart Pattern Breakout Direction
In order to predict chart pattern breakout direction, there needs to be a strong trend underway that the chart pattern is a part of. We expect the breakout will occur in the direction of the trend. As a general rule, I want to see trending movement prior to any chart pattern–whether I end up trading it in a traditional way, or front-running it. Without a strong move prior to the pattern, there’s no evidence that traders care about the price, and therefore, breakouts are more likely to fail or not reach the target(s).
For the entry we want some minor confirmation of our expectation. In the event of a predicted upside breakout, we want to see the price hold above the support of the pattern, as it did in the examples above. In the event of a downside breakout, we want the price to hold below resistance of the pattern.
This sometimes means we won’t be able to front-run; the market simply doesn’t give us the opportunity. Refer to back to figure 1: by the time we can actually draw the triangle (we need at least two price swings) the price breaks lower before pulling back to the top of the triangle. Therefore, sometimes trading chart patterns in the traditional way is the only option.
Use traditional targets, Fibonacci targets, or “active trade management.” Fibonacci targets provide multiple target areas to look for an exit, where as the traditional method for calculating a target only gives one, and doesn’t account for strength prior to the pattern (it only factors the height of the pattern). Active trade management is an advanced technique which involves adjusting your stop loss (only reduce it, never expand it) and/or target level once a trade is underway. The benefit of active management is that if the price goes to breakout in your direction, but fails, you can still get out with a small profit.
Just because the trend was up prior to the chart pattern, doesn’t mean the breakout will be in that direction. Other factors must be considered, such as strong support and resistance levels, whether the trend is slowing down, or if the price is bucking up against trend channel support/resistance.
Predicting Chart Pattern Breakout Direction – Final Considerations
No matter how we trade, losing trades will occur. While some may argue that waiting for a breakout is safer, breakouts can fail and result in losses too. With this front-running method you may have a few more small losses, but the reward on the winners more than makes up for it. Anticipating chart breakout direction reduces the size of the stop loss required, and increases profit potential (relative to the traditional method).
Learning how to read the market, and account for all sorts of other factors–such as near-by major support and resistance levels, tendencies and short and long-term trends–will take time though. This method is recommended for advanced traders; if you find that your expectations are wrong quite often, or you’re unable to capitalize on the opportunities that come along, more practice is needed on reading price action. This is only a strategy, and like any strategy, must be combined in overall trading plan for it to be successful. It’s your trading plan that will help you determine which trades to take, and which to leave alone.
Get these types of strategies and more in the Forex Strategies Guide For Day and Swing Traders 2.0 by Cory Mitchell. It’s more than just an eBook, it’s a complete course on forex trading…building your skill step-by-step and providing 20+ strategies for attacking the forex market.
By Cory Mitchell, CMT