Front-running a chart pattern increases the reward:risk of the trade significantly, gives us more options for a profitable exit, and leaves us less exposed to false breakouts compared to the traditional chart pattern trading approach.
Trading chart pattern breakouts is one of the first strategies I learned when I began full-time trading back in 2005. 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 Strategies Guide for Day and Swing Traders you know that I like chart patterns.
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 these types of patterns. It’s recommended you have trading experience before attempting these methods and have a good sense of market direction and strength. Basic directional 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, the price doesn’t need to have a big move to make a profit (like the traditional approach), and we also don’t get caught in as many false breakouts…which are the bane of the traditional approach.
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.
Which Patterns to Front Run
Use this strategy on triangles, ranges, and consolidations. Consolidations may not have a particular shape, but are still a pattern in that they are identified by a lack of volatility relative to the price moves around them. While the pattern occurs less frequently, we can also front run head and shoulders continuation patterns.
Instead of waiting for a breakout, which is the traditional approach to trading chart patterns, if we’re able to read the price action and come up with an expectation for the direction of the eventual 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 it 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 continuation on a 1-minute EURUSD chart. 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. The price rallies, forms a small head and shoulders continuation, and then moves to the upside
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 following the pattern. 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 have been a rally above the descending trendline connecting the head and right shoulder. The earlier entry 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 priot to the pattern. This tool is not a requirement. I don’t use often use it, but it is something you can play with and see if it helps you.
Novice traders hate false breakouts. A false breakout is when the price fakes us out, typically resulting in a quick loss. New traders don’t like false breakouts for two reasons.
- The false breakout typically results in a loss or the price doing something they didn’t expect/want.
- They lack the confidence to take another trade based on what the false breakout is saying to them.
When I see a false breakout, even if causes me to lose, I’m not upset. Rather, I immediately look to see if the false breakout provides me another trading opportunity. It often does…and a good one!
With front-running, we are only concerned with buying near pattern support in uptrends, or selling near pattern resistance in downtrends. Therefore, the false breakout that is typically going to result in a loss, and potential opportunity, is when the price breaks through these levels and then quickly moves back in our expected direction.
Figure 4. Front-Running After False Breakout, Daily Chart
This chart shows a stock in a strong uptrend. It then moves into a ranging period. In November the price stalls in the support area. This was an intriguing area to get long for a front-running trade. The trade quickly resulted in a loss as the price dropped below support. Not a big deal, losses happen.
Within a couple price bars the stock was already back in the support zone and moving higher. Once we saw that, we could assume the breakout lower was false. Remember, we were originally expecting a move higher because the overall trend is up. Because the move lower ended up being false, that upside premise is still intact…and is now actually stronger because the price tried to move lower and couldn’t. Buy again, once the price starts moving back above the support zone.
Many traders would be looking to enter on a traditional breakout up near $55, or even near the major high close to $58! The front-running entry gets us in near $49 to $50. That’s a huge difference. Getting in near $50 gives us more options for a profitable exit, because if the price falters at $55 and doesn’t break higher, we can still get out for a decent profit.
False breakouts are powerful and typically occur before strong moves…especially when all the other analysis lines up, such as a strong trend and the price trading near a key pattern support/resistance level.
Guidelines for 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. I then typically wait for the price to start moving up off pattern support before buying or wait for the price to start moving lower off pattern resistance before shorting.
To front-run a pattern, it should be relatively small compared to the waves around it. Look at all the examples. There were strong price waves followed by the patterns…and the patterns were smaller than the price wave leading into them. This is key. Very big patterns (relative to the waves around them) signal too much indecision. Smaller patterns indicate the trend traders are just pausing. That’s a big difference in psychology. The more you watch price action, and the more charts you look at, you’ll get a feel for what an ideal front-running pattern looks. We certainly won’t be right all the time, but because our reward:risk ratios can be so big, we don’t have to be. Pattern size, in this case, must only be measured against the waves around it. It is a relative measurement, not an absolute one.
Sometimes we can’t front-run. The market doesn’t give us the opportunity. Refer to back to figure 1. By the time we 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 prices to look for an exit at. 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. For example, you could create a front-running rule that if the price tries to break out in your expected direction but it doesn’t happen, then you exit right there for a small profit. You still capture the profit of the price moving to the other side of the pattern. With the traditional approach, this is not a possibility.
Just because the trend was up prior to the chart pattern doesn’t mean the breakout will be in that direction. Consider other factors, 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.
Like any strategy, this one takes time to get good at. It requires analysis skills, because it is those analysis skills which aid us in determining which chart patterns to front-run. Not every chart pattern is created equal.
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 will take time. This method is recommended for advanced traders. If you try the method and find that your expectations are often wrong, 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 it must be combined in an overall trading plan for it to be successful. It’s your trading plan and analysis that will help you determine which trades to take and which to leave alone.
By Cory Mitchell, CMT
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