The Patterns and our Mind
People who have no experience in trading usually try to learn as many entry signals and setups as possible. Then, they tend to apply everything they have learned to catch market movements. They see patterns everywhere. We, humans, are pattern detectors. Even when there is no pattern at all! The figure below shows curves similar to currency pair tracks, some of them with cute bullish patterns, others moving in a sideways path. But ALL of them were made by a computer simulation of a Fair Coin Toss.
Fig 1 – Random paths made by Fair Coin Tosses
This excess in patterns overload their thinking and, so, they start overtrading. This fact, together with the lack of knowledge to trade using leverage and wrong psychological attitude, is enough to break down their trading account.
Thus, instead of trying to chase every signal the market delivers, the key to success is to master one signal at a time. Once we master it we can exploit it through money management and position sizing. After that, the trader can try to learn a second one using the same procedure.
The key is focusing on just one pattern and master it.
Impulsive and reactive Legs
Identifying if the current price action is impulsive or corrective is one essential ability the trader has to master, because of the enormous difference in the probability of success. To begin this trading profession, we not only are going to focus on just one pattern. We are going to trade only in the direction of impulses, and avoid trading corrective structures.
To learn more about this subject, please read this article.
The Pattern we are going to try to master has been described here. On that article, it is called Exhaustion Candle and is one pattern of what is termed reversal patterns.
The classical patter figure is shown below. The left figure (green) describes a price movent which, beginning from its entry-level, moves down until a bottom, then recovers and closes at, or near the high of the day. The right candlestick descrives the bearish counterpart.
Fig 2 – Exhaustion candle
Let’s see two of them:
The Engulfing Pattern is a two candlestick formation which, when drawn together in a higher timeframe, will show a similar picture as the Exhaustion Candle. On this case, the figure corresponds to a bearish pattern. The bullish pattern is similar to the colours of the candles reversed.
Fig 3 – Engulfing Pattern
Morning and Evening Stars
This is a three-candlestick pattern. The Evening Star formation is like this: The first pattern is a large bullish candle. The second one is a small-bodied candle called Doji. The Third candle is a large bearish candle closing near the open of the first candle. The Morning Star formation is the reverse situation.
Fig 4 – Morning Star
All these patterns are similar. They represent market turns. Not always work. There are also false signals that are only small pullbacks of the main trend. That’s the reason we are going to trade them only when, after a pullback, show a continuation of the previous price action.
Example 1: Bitcoin, with slight Bullish bias
Fig 5 – Bitcoin 1H chart Setup
On this example, we see a slight upward trend on the BTCUSD. The price, after a lot of struggle, has settled above the 8,000 level, A very strong resistance for some time. That helped us think that the bullish bias was still in place.
Then after a green candle, there is a retracement followed by an exhaustion candle. We see that the MACD shows the price is in a bullish leg. The Stochastics is turning to the upside.
We traced a line touching the high of the green candle as the trigger for our entry and wait for the market to confirm it. We set our stop loss below 7900 and our target neat 8300 for a Reward-to-risk ratio of about 2.4. The entry took place at the piercing of the green high but retraced back. After some hours of small bodies, we got the large bullish candle we were expecting and closed when the price approached the other resistance level: 8,300.
Fig 6 – Bitcoin 1H Example Conclusion
This example shows the classical setup we wanted to practice.
Fig 7 – GBPUSD 1H Setup
On this chart we see that at about 12 o’clock there is an engulfing pattern on the GBPUSD 60-min chart, but, although the Stochastics is oversold and turning up, the MACD does not allow long entries. So we wait for a pullback to enter on the next leg of the trend.
Some hours later, after the retracement from the impulse, we see the opportunity, as a second engulfing signal wipes about eight hours of bearishness. We observe, also, the Stochastics had a crossover and is turning up. Also, the MACD is widening and in a bullish phase.
We assess the potential target and see that the reward to Risk Ratio is about 2:1 if we trade the high of the last bullish candlestick and up to the recent top, at 1.2758, and a stop-loss level at 1.2670.
Fig 8 – GBPUSD 1H Trade definition and conclusion
Figure 8 shows the setup and trade development. Our job after entering a trade is to follow the price action. Thus, at the point marked by the first circles, we observe a potential reversal signal with the Stochastics in the overbought area and turning down. At the time we are close to a reward of 1 times the risk we took. Therefore, it is wise to unload 50% of our position and let the rest run with a stop at the entry point.
At the second circle, we see that the price is close to our target, and the two candles combined seems like a bearish Harami, which is another form of a reversal pattern. The risk taken for what’s left of profit is too much, so we close the rest of the position there.
Exhaustion patterns and its cousins Engulfing Patterns and Morning and Evening Stars are good places to enter our position, as long as the signal happens after a pullback and goes in the direction of the previous trend.
We should verify that the MACD aligns with the signal and the Stochastics as well. Also, the Stochastics should not be in the overbought area for long signals or in the oversold area on bearish signals.
To decide profit targets we should look for close tops or bottoms. Also, major resistances/supports, and key levels.
We shall consider key levels round number levels, such as 8,000, 8,100, 8200 and 8,300 in the Bitcoin example. In pairs, such as the GBPUSD in the second example, round levels like 1.30, 1.29, 1.295, 1.28, 1.285, and so on.
Round numbers act as psychological levels for many traders. These levels can be powerful supports and also resistances to price action, so it is important to observe how the price behaves near them.