Chart Pattern Trading Strategy — Insights and Backtest

As a technical trader, you must have encountered some chart patterns. They are an integral aspect of technical analysis, especially for discretionary traders. But what is a chart pattern trading strategy?

A chart pattern strategy is based on recognizable shapes on the price chart created by price movements. They can be identified with the help of trend lines, horizontal lines, and curves. In technical analysis, chart patterns represent a period of consolidation, which can signal a continuation of the prevailing trend or a transition from one trend to another.

In this post, we take a look at chart patterns and how to use them in trading. At the end of the article, we provide you with some data-driven statistics.

What is a chart pattern?

Chart patterns are recognizable shapes on the price chart created by price movements. They can be identified with the help of trend lines, horizontal lines, and curves. They are distinctive formations created by past and current movements of a security’s price on the chart. A pattern can be identified by a line that connects common price points, such as closing prices or highs or lows.

Chart patterns are created by price bars clustered around the same level over several trading sessions. They can indicate how the price will likely move in the near future, as they are created by the action of traders and investors as they are buying and selling their positions in different timeframes. These patterns can be as simple as two trendlines showing a triangle and as complex as double head-and-shoulders formations.

Price patterns are the basis of technical analysis. Many trading patterns are formed as price consolidations after a trend in one direction, so they may either signal a continuation of the prevailing trend or a transition from one trend to another. In chart pattern analysis, technical analysts and chartists (technical analysts who study naked price actions on charts) seek to identify patterns as a way to anticipate the future direction of a security’s price.

What is chart pattern analysis?

Chart pattern analysis is a form of technical analysis that studies the price charts to identify chart patterns and use the patterns to analyze the current price movements so as to predict how the market is likely to move in the future. The shape of the chart formation and the nature of the price movement preceding it help analysts to forecast what the price might likely do next.

These patterns can be identified in any type of chart — candlestick chart, bar chart, and even line chart — but they are better appreciated on the candlestick chart. By analyzing chart patterns, traders can spot tradable opportunities. While some of the patterns signal a change in trend, others indicate that the trend may continue in its current direction.

Traders and analysts use trendlines to delineate the chart patterns, even though the shapes of the chart patterns may be recognizable without the help of trendlines. This not only helps the chartist to properly see the shape but also marks the boundaries of the pattern for easy identification of a breakout. In fact, the essence of chart pattern analysis is to know how to trade the pattern, and in most cases, it is by trading breakouts. If you understand how to read those patterns, you can spot profitable trade setups that show how institutional traders play their game.

Are chart patterns profitable?

There is no yes or no answer to this question. Chart patterns may be subjective, and they tend to appear in hindsight — you tend to identify them after the price has moved from the pattern. They are difficult to spot as they are being formed. So, even if they work, you’ll not be able to profit from it. That is to say, by the time the chart pattern is confirmed, the price has moved away, and a good part of the profit has already been realized by those who cause the patterns in the first place.

This is why we are a bit skeptical