Forex Chart Patterns Defined
Forex chart patterns are a collection of historical patterns in price behavior for a particular currency pair. Chart patterns seem tricky, lots of retail investors like to complicate their trading screens with extremely colorful lines and annotations, It's almost like a competition to see who's trading screen can look the busiest...
In reality, they are very simple and not as essential as you may think they are! Learn what forex chart patterns are, how they work, and how professional forex traders use them.
Forex Chart Patterns Explained
To understand forex chart patterns, forex traders must first grasp the idea of price charts. Any analyst, retail trader, or market watcher will use price charts to measure historical price changes of a particular currency exchange rate.
Forex price charts depict historical behavior across lots of different time frames and measures the movement between the two forex pairs, charts allow traders to essentially look into the past and according to technical analysts, this past behavior can be an insight into what the asset may do next.
How do Forex Chart Patterns Work?
Forex chart patterns are normally seen in historical data, analysts find these technical indicators and if the pattern has repeated itself multiple times with the same outcome in the historical data a trader will try to predict when this pattern will emerge again and then enter a position based on this historical data.
There are many simple methods for spotting these patterns, it is called technical analysis, traders use indicators like the Relative Strength Index (RSI) or an Average True Range Calculator (ATR) to try and determine what markets are doing, they also use Fibonacci and trend analysis as some of the most common patterns of movement shown on price charts.
The act of reading these price charts using all these strategies to determine a pair's future movement is called technical analysis.
Technical Analysis Definition - Technical analysis is the study of historical price behaviour in order to identify patterns and determine probabilities of future movements in the market.
All traders professional or retail use technical analysis as a way of determining the validity of a trade, however, they use this analysis in very different ways...
We will explore this further later on in the article but for now, let's take a look at the essential patterns every trader knows and uses regularly.
Best Forex Chart Patterns
Reversal chart patterns
Reversal patterns are those chart formations that signal that the ongoing trend is about to change course. These patterns include, but are not limited to, the head and shoulders pattern, reverse head and shoulders, rising wedge pattern, falling wedge pattern the double bottom pattern, and last but not least the double top pattern.
Continuation chart patterns
Continuation chart patterns are those chart formations that signal that the ongoing trend will resume, wedges can be considered either reversal or continuation patterns depending on the trend on which they form.
Examples of Continuation patterns include Bull flag patterns; Bearish flag patterns; Bullish Pennants; Bearish Pennants; Falling wedge patterns; and Rising wedge patterns.
Bilateral chart patterns
Bilateral chart patterns are much more complex because these signal that the price can move EITHER way. The best Bilateral chart patterns to use are the ascending triangle chart patterns, the descending triangle chart patterns, and the Symmetric triangle chart patterns.
Honorable Forex Chart Pattern Mentions
Some other chart patterns that we haven't shown you may be familiar with are...
Various candlestick patterns
A-Y trading patterns.
Different candle Doji patterns which you can read more about here!
Cup and handles chart patterns or 'teacups'
Do Forex Chart Patterns Actually Work?
By themselves, forex chart patterns do not work well at predicting the forex price chart. A common misconception with chart patterns and technical analysis is that it is a reliable way of predicting market moves.
Whilst they are still used by professionals - it is not for the same reason as retail traders and this is why we see consistent growth from. The Professionals and not so much from the retail traders.
Technical analysis and chart patterns use purely historical data to predict future market moves, they do not take into account current economic or political conditions of either of the two economies involved in the forex pair.
These economic or political events/shifts can have a huge effect on the price of a currency in real-time and in the future leaving patterns useless!
Indicators like unemployment rates, interest rates, home building, and consumer confidence all have a huge effect on currency and cannot be predicted by technical analysis.
Don’t be disheartened, forex chart patterns and technical analysis still play a role in the professional method of trading.
Real Way to Use Forex Chart Patterns
Forex chart patterns should primarily be used to time the entries into the markets and provide the best risk to reward ratio possible, after a fundamental bias.
They are a key factor in working out risk management and are instrumental in the overall management of a trade before it is even entered.
Think of the forex chart patterns as a final gateway to the opening of the position, identifying you a time and a place to enter a trade that gives you confidence and stability!
Forex chart patterns give you a route into a market but they are not the whole journey, they need to be paired with fundamental analysis, using both these methods of analysis together is what these professionals are paid for.
What is Fundamental Analysis? - Fundamental analysis is a breakdown of the underlying driving forces behind a forex pair, stock or any tradable asset. For currencies, fundamental analysis, is a study of global economies to find currency strength, wheras for stocks it usually a study of company performance.
What It Means for Retail Investors
For retail investors, forex chart patterns should be used as part of a wider forex strategy to help eliminate false signals. In the professional industry, a common strategy used is the global macro approach, which utilizes forex chart patterns in the second stage of its framework, as follows:
Value - Stage 1
The first step is to value a currency using fundamental analysis. This is the most important and probably the most complex step, we use fundamental analysis to determine whether trade idea is good or bad and equate its value.
If the fundamentals look good that means the trade is of a high value and there is huge potential for our bias to be confirmed.
If the fundamentals are not so positive or maybe even just neutral the value of that trade decreases and we put those trades on a watch list to see how the fundamentals change over time.
Optimize - Stage 2
The second step is to optimize the fundamental trade idea, using commitments of traders, indicators, and chart patterns as a timing tool we determine a viable point of entry for any trade.
This is where the technical analysis comes to the forefront of professional analysis as it provides a door into the market to allow us to enter safely and be able to move on to step 3 with confidence in our bias.
Risk Management - Stage 3
Step three is where an investor controls their risk to minimize losses if things go wrong or to maximize returns when they go right.
Professional traders also pay close attention to their risk to reward ratio, if the risk is significant and the reward is not then we do not place a trade and we go back to step two to try and find a better place to enter.