Several chart patterns are very useful in controlling risk while capitalizing on profitable opportunities. Two of these are the triangle and wedge. But other chart patterns can also be used to create profits if traded in a logical fashion.
Chart patterns such as the triangle are traded by entering when the lines drawn to create the chart pattern are penetrated by price action. Before this occurs the chart pattern has already provided us with a profit target. The profit target is generally based off the thickest part of the chart formation.
Stops are generally set just outside the other edge of the chart pattern. If a break downward occurs, a stop is placed just above the upper resistance of the chart formation. In the case of a triangle, the lines move towards each other over time, eventually coming to an apex. This means that over time, and the closer prices move towards the apex, the less we need to risk in order to achieve the potential reward (profit target). Wedges can be traded in a similar way.
Because of the nature of the chart pattern the risk will always be less than the reward, and while risk (as determined by how far away our stop loss is from our entry point) diminishes over time, our profit target is fixed.
In order to be a profitable trader we must win more than we lose. By trading with chart patterns we are able to do this, as our wins will generally be larger than our losses. The only pattern which is generally a one to one risk/reward is a range trade, also known as a rectangle chart formation.
The rectangle can be made a potentially profitable chart pattern by placing our stop somewhere within the formation, instead of on the outer reaches. If prices break out, only to fall back below a support level within the range, we can call that a false breakout and look for a new entry or trading opportunity. Our profit target will remain the height of the range, added to the break out price.
A topping head and shoulders pattern can also be made profitable by placing a stop just above the right shoulder when we enter a trade. The profit target for a head and shoulders pattern is the top of the “head” to the low point between the shoulders and the head. This is then subtracted from the breakout point, which is the low point of the shoulders (or “armpits”). The breakout point can also be the “neckline,” which is a trend line which connects the lows of the armpits. If this trend line is broken, the pattern is completed and and entry can be made.
The profit target for a bottoming pattern is calculated the same way, based on a break upwards above the high of the armpit. The alternate method of using a trend line which connects the highs of the highs of the armpits can also be used.
In this way, our profit target is based on the full formation, while our risk is limited to a portion of the formation. Thus our risk is less than our potential reward. So why trade with chart patterns? Quite often a chart pattern provides us with everything we need to trade with. They provide us with an entry point (the breakout), a stop level, profit target, and generally the risk can be kept to less than our potential reward.
There are also several other patterns to watch for, which can be traded profitably if we manage our risk and allow the market to reach our profit targets.