1-2-3 Pattern and Pattern Recognition
The great thing about trading the HPS methodology is that you have a great guide to keep you focused on what patterns you should watch for and how to trade them in a low risk- high reward environment. Most traders both experienced and novice have no doubt heard of some of these patterns.
Head and Shoulders and Inverted head and Shoulders
Flags and Pennants
These are just a handful of patterns you might be used to hearing and seeing in the markets. Though you might know what they look like the internal price action in the formation of each pattern has the most influence on how the patterns play out.
Note: Patterns might show up a lot in the markets but for a pattern to work out you must have other things occur along with it. Meaning in a very bullish trending market you will see a Head and Shoulders Pattern break to the upside more then what is expected as it is considered a topping pattern.
Lets go through some of the most common patterns and break down how to recognize them and trade them. Also along with patterns we can add in the term Measured Move. A measured move is a technical project target of a recognizable pattern.
1-2-3 Pattern VIDEO
The Basics of all my chart building comes form a technique I coined years ago as the 1-2-3 Pattern. This technique take in consideration a standard mathematical concept of a line and how it represents a set of points that when connected justify a linear equation. This line is bounded by two distinct end points and contains every point on the line between its end points. Once this is defined, any of the points along the line may have characteristics of being parallel, intersecting, or skew ( lines that are neither parallel nor intersecting ).
That first paragraph represents the 1-2 in the 1-2-3 pattern. The 3 is the the key to the pattern. When trading and scanning for HPS’s The first observation I want to make is market trend. This will be on multiple time frames starting in some cases all the way out on the weekly but most cases I start with the daily and move to the 60 min then the 15 min and 5 min. The 1-2-3 Pattern will show up in all time frames and it can be effectively identified when you see the current trend break down (or up) preferably from a channel . What does that mean? Well a uptrend consists of a series of higher highs and higher lows and placing a trend line through the pivot lows you should see a rising trend line. When a channel or trend breaks down we will see the price break through the lower rising trend line and make a lower low and its subsequent bounce you will be looking for a lower high. Each turning point in price is called a pivot. At these pivots in the market we start to look for the signs of a new trend starting.
Technique: Once you can see a clear trend change in chart, pay attention to the last low and last high before the trend change these will usually be part of the 1-2-3 pattern. You now got 2 main pivots and your waiting for the 3rd to show up this will combine with one of the first 2 to make your first parallel line. In some cases you will have the 1st Pivot still in above the trend line but in most cases you will see the first break down bounce to be a key pivot area.
In some cases you will see a gap in the chart this is usually a starting point for new patterns. 1-2-3 Patterns work well with gaps.
The true purpose of the 1-2-3 Pattern is to identify developing channels before they are fully developed giving you an edge to plan out your trade before it happens. The 1-2-3 Pattern is one of the key building blocks of HPS and you will see this pattern develop more and more over time. Experience will help you see the idiosyncrasy of this pattern.
Head and Shoulders Pattern: A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows (Pivots) of each peak can be connected to form support, or a neckline. The Neckline does not have to be a perfect parallel line and in most cases I see that a slight rising neckline adds to the momentum on the breakdown.
Understanding channels and wedges will really help out in identifying valid H&S reversals and with that said my key criteria to trading this as a top it to see the channel/price divergence show up in a “recognizable channel” remember a channel/price divergence is when the stochastics and price maintain a harmonious trend. The stock price makes and new high and the stochastics make corresponding high. When this relationship starts to fall a part or “diverge” You will be looking for a the Stochastics to get overbought but the price to be under the previous high. Lets look at an example:
Wedge Patterns: You can have 3 different wedges. First is my favorite to trade the Falling Wedge which has a bullish bias to it. The rising Wedge is just the opposite and with a negative bias and finally the symmetrical triangle which has no directional slope and no bullish or bearish bias on its own merit.
Lets start off with some great examples of what a proper wedge looks like. 2 Lines form this pattern and there is a few key points to look for. Not all falling wedges are equal and just like 1-2-3 Patterns over time you will get a feel for the angles of the 2 lines. In a falling wedge the upper downtrend line (resistance) and the lower (support) line are in a process to converge at a point in the distant future. This convergence should not happen and you want to see the lower support line at less of an angle to the top trend line The chart will play out with the stock making new lower lows but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line.
Trading Patterns for close to 20 years has made me aware of some very profitable scenarios that play out in the market. One of these involves trading the falling wedge pattern. Once you think you identified a valid wedge pattern rising or falling (not symmetrical). Take the 2 trend lines that are slowly converging and extend those trend lines out till they meet. They break down the chart by placing a line at the beginning of the pattern and where the trend lines will eventually converge and then go back and but a vertical line right in the middle of the pattern representing the 50% mark. Now put a line between the middle and the end and that will represent the 75% zone. This is a excellent gauge on when and where the wedge will break out. The area is between 65%-75% in the wedge.
Try to take the trade closest to the lower trend line in a falling wedge and closest to the top trend line in a rising wedge.
Important to watch the stochastics here to as you want to see a divergence happen or at least get a good rotation back up and momentum to start gaining to the upside.
These are some active alerts that represent both the pattern and the setup alert:
This pattern is the least reliable for predicting a directional breakout, In many cases the first break of triangle is a a false move and should be considered a a higher risk trade. The reason is the “Wedge” is a pattern inside a channel and when a wedge breaks down or up it usually moves down to test the “Channel Line under it or over it depending on the break”
Flags and Pennants: Whats great about flags? Well for one thing they are everywhere and on every time frame. I actually have a technique on the 1 minute chart that is up close to 85% success rate when it appears. This you will find on the futures HPS section. Flags also usually consist of multiple indicators that I use in the HPS. It is a great pattern but just like everything else you need to have converging indicators line up at the same time.
Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.
My # 1 Setup when trading a flag is that I want the stochastics to be oversold and at that time the price to be above the 20 ema or 50 ema. This is a guide for me and not a hard set rule. and I mostly look for this set up on the daily time frame. In some cases the price will chop around the 20-50 ema and you don’t want to be so exact that you miss some great opportunities. Lots of times you will see the price drop below the 20-50 ema just to see it close back above it by the end of the day.
The keys are:
1. Trend is intact, we are pulling back but holding above the previous pivot low.
2. Stochastics making a fast rotation back to oversold levels <20 as the price makes a very organized pullback but hold above the 20-50ema
3. Flags like any pattern have a unique look to them. Basically they are mini channels that should be traded like any other channel (Channel Lesson) “Make sure it looks like a flag”
This combination has had high probability of success. In My experience it works over 70% of the time. That would increase depending on other convergences at that time. (Trend Lines, Reversal candles,ect)
Flags are continuation patterns and usually show up multiple times in a row, but it is important to identify them early in the trend so you can profit form them.
Here are some examples of my Trade-able Flag Setup
Lets start with the Daily Time frame:
Now lets break down how to trade the flag
Breaking down the daily time frame into a 60 min time frame shows you a great entry technique called the “Daily 60 Stochastic Combo” which is a multiple time frame trigger when both the 60min stochastics oscillator get oversold at the same time the daily stochastics are oversold.
Because the daily is a slow moving time frame the combo doesn’t happen every day but when it does it should be considered.
The Next chart is the same flags that we had on the daily now broken down to the 60 min time frame. You can see the channel much more in detail and the much quicker rotation of the stochastics.
This above technique as with any setup is dependent on market conditions. Flags are great in a trending market but trends can be defined and spotted in any time frame. You can have a trend develop on the 5 min time frame or a 1 min time frame. So understand your time frame and what to expect from it. The 60min daily combination is great for swing trades but also because the 60min is a trigger could be a great scalp also.
You can trade the 60 min flag by itself you don’t have to always wait for the combo to setup. (Go over the 60-15-5 combo)