How Understanding Price Patterns Will Benefit Your Trading Decisions
Dear Traders,
Have you ever seen a profitable trading system suddenly start behaving differently?
Perhaps this has never happened to you personally, but I'm sure you've heard the stories where traders see a profitable trading strategy turn into a losing one. This is part of the risk when trading in the markets, though traders can prepare themselves for such cases.
This article explains how traders can avoid over-relying on the short-term success of a trading strategy and how they can guard their trading results against market changes.
The short-term bias of systems
Last week's article— Are analysis and systems more valuable than trading signals?—spoke about the weakness of trading signals. In fact, trading systems do run into similar problems as signals, but why is this?
Sometimes trading systems are able to disguise their weak internal structure for a short while and perform above average. This is when traders become overly excited with the prospect of a profitable trading system within reach of their fingertips.
Unfortunately, the system will eventually start to show ever weaker performance. The long-term system results will slowly drift towards the surface. The short-term average will then decline to match the negative long-term expected performance.
Sooner or later, traders will realise that the system is not as robust as expected and they will move on to the next trading strategy.
Why trading systems break down and fail
The Forex, CFD, index, commodity and other financial markets offer traders non-stop patterns, such as:
- chart patterns
- candlestick patterns
- 123 patterns
- Fibonacci patterns
- and many more.
These patterns occur on all timeframes because the market is fractal in nature. Each smaller part of the market shows the same characteristics as the whole.
Why patterns fail
All patterns have two simple choices—they can either repeat or fail. The pattern is confirmed when price action repeats the action three or more times. However, patterns will eventually fail and this is a natural part of the market movement and cycle.
For instance, Forex trading systems are typically profitable when one particular pattern is dominant in the market, but they will fail when that pattern breaks down.
Here is a classical example: a trading system that focuses on a continuation candlestick pattern within the trend will behave poorly once the price starts to move choppily.
Why patterns change
The success of some Forex trading systems can often come down to a random pattern that works out for a while. Once the pattern changes, the success of the system will also vanish. Patterns not only fail but they also evolve and change over time.
Don't get me wrong, some type of market patterns will always continue to form and be visible. On the other hand, some patterns will also cease to exist or become irrelevant.
For example, chart patterns have proven to be a valuable part of the market movement (not expecting a change anytime soon). However, a pattern built on 10 indicators is most likely sheer coincidence and that pattern could lose its relevance quickly.
Traders with trading strategies based on the latter (complicated combinations seen in image below) are at risk. Once the pattern changes, their system performance will behave poorly as well.
Traders with strategies based on sturdy patterns (candlestick, chart, Fibs) are better prepared. At the same time, filtering out some pattern failures will help the system's performance.
How can traders solve this and build sturdy strategies?
One key point is to avoid building trading strategies that are reliant on overly complicated patterns which have a high chance of breaking down soon and are probably sheer coincidence.
Another critical method is to understand the larger market structure, such as trend, momentum, support and resistance and time frames on higher time frames (see video below). Whether patterns repeat or fail often depends, to a large degree, on market structure.
The next paragraph will explain more solutions, such as describing how long-term performance is key, how multiple simultaneous systems will provide more diversity and how understanding price patterns in more detail will offer critical insight.
How to properly use price patterns in trading systems
The first step for a trader is to make sure that their trading system performance is not reliant on short-term luck. A Forex trading system must be judged after a sufficient number of trades. Otherwise, the results could just be a coincidence.
This minimum acceptable norm could vary by trader, but 40-50 trades is typically a decent-sized number of trades. With 40+ trades in the bag, a trader can be more confident about the long-term viability of any trading system.
The second approach could be to test and demo-trade multiple systems, so that traders are not over-reliant on one specific strategy type (open up multiple demo accounts below). Generally speaking, a trader with several approaches will be more flexible when tackling the markets.
The third and, in my view, the most important aspect is to improve your pattern recognition skills. Understanding the market patterns (chart, candle, wave, Fib) within the overall market structure provides traders with a valuable skill set.
Granted, spotting such market patterns does take time to learn. However, quicker and enhanced reactions can be expected once a trader invests time into mastering the technique. In the end, every trader can learn to understand and use market patterns in their trading—it's just a question of practise.
You might be wondering, is it worth the effort?
The ability to read the charts and understand technical analysis will always retain value, even when trading systems themselves fail to perform. This skill will not only make traders more versatile but also provide them with more insight into how the system is performing.
So for me, there is no doubt—learning to read the charts is absolutely worth the effort. If you think otherwise, please share your opinion in the comment section below.
Want to learn more?
If you'd like to learn more, please check out our dedicated section on technical analysis. It's being constantly added to, so you'll always have access to the most practical, up-to-date information.
You can also join our Zero to Hero course, where we not only demonstrate a clear trading system but also discuss how traders can understand price patterns and the larger market structure.
Cheers and safe trading,
Chris
