Technical chart patterns are one of the easiest ways to get started with technical analysis of the financial markets. The fact that the chart patterns are divided into either continuation or reversal patterns makes it easy to distinguish between them.
Most traders shun any price action based technical approach due to the subjectivity involved. Chart patterns are no exception to the case. While there are many successful chart patterns, the markets at times tend to throw the trade off guard. Thus, despite trading chart patterns being easy the fact remains that traders need to be cautious.
This risk, combined with the fact that chart patterns require some subjectivity keeps most traders away from trading these patterns. Chart patterns look easy to trade, especially in hindsight. A validated bullish flag or a head and shoulders pattern is always easy to identify when it has been validated. But in real time, an unfolding chart pattern comes with many risks.
One way to remove the subjectivity that comes with analyzing markets using chart patterns is to combine them with other indicator based technical analysis. Such an approach does not require any complex set ups.
By simply using a moving average and a momentum indicator, traders can already ascertain the trends and the momentum. Based on this, applying the concept of chart patterns, traders are able to trade with higher confidence.
As an example, let’s take a very simple approach of using Bollinger bands. We know that this technical indicator shows both the trend (based on a 20 period moving average) and volatility. When volatility starts to rise, price tends to move to the extremes.
The Bollinger bands also contract and indicate consolidation in price. One main concept that is common to all chart patterns is consolidation. For example, a sideways range after a strong breakout can result in a bullish flag or a bullish pennant pattern. A breakout from this consolidation suggests continuation to the upside.
The first chart below shows the chart patterns combined with the Bollinger bands.
Starting from the left, you can see that falling wedge pattern is marked by brief period of contraction (consolidation) marked by the up and down arrows. Following this, you can see the strong breakout that was led by increased volatility.
The next pattern is the bearish flag pattern that was formed at the top. Here, the consolidation was not that evident, but still you can see that as the volatility increases, price starts to “walk the band” resulting in a strong and sharp decline in price.
Finally, on the right, you can see the bullish flag pattern forming near the bottom. Here too, consolidation was brief but the resulting breakout led to the completion of the minimum price objective of the bullish flag pattern.
As you can see from the above, combining Bollinger bands along with chart patterns can offer traders an objective view of the markets. One simply has to look for the consolidation that is common to all chart patterns. The consolidation is often followed by a strong breakout in volatility leading to a sharp surge or decline in prices.
This can limit the number of failed chart patterns as a result which is common when you trade only with the chart patterns in isolation. The main benefit of using chart patterns with Bollinger bands is that traders can effectively look for strong breakouts based on the volatility signaled by the Bollinger bands indicator.
Almost all technical indicator based strategies can use this concept of chart patterns, but using this with Bollinger bands is probably the most easiest of all.