Archive of Trading Education Articles

Classical Chart Patterns and the ADX

By Daniel Chesler of Chesler Analytics*
Posted: May 22, 2009

Although the universe of trading strategies is as wide and varied as the number of traders,
orthodox technical analysis can be summarized simply as the forecasting of markets
through the study and analysis of data generated exclusively from the buying and selling
of financial instruments. The most obvious piece of data under this definition is price.
Yet, there are many other types of data besides price that are also generated exclusively
from the buying and selling process and that are no less important to the astute
technician.

Besides price, some other examples of such data include volume, open interest, realized
and implied option volatility, the relative performance between markets and asset classes,
large trader position data, seasonal patterns and quantitative measures of price strength,
intensity and momentum.

A brief bit of technical analysis history is useful for context. Technical analysis is
perhaps the oldest form of financial market analysis, with origins spanning back at least
to the mid-1700s. One of the most popular modern texts on the subject is Technical
Analysis of Stock Trends, first published in 1948 and written by Robert Edwards and John
Magee.

Edwards' and Magee's work, which is often referred to as "classical charting", was
inspired by even earlier writings on the subject of charting, namely Stock Market Theory
and Practice, published in 1930 and written by Richard Schabacker.

Going back to the late 1800s, before the advent of "open-high-low-close" bar charts,
traders and analysts used point-and-figure charts to forecast the price direction of stocks
and commodities. Classical charting has survived the test of time and continues to hold a
prominent place in the arsenal of even the most seasoned traders.

Today, of course, traders have access to the speed and convenience of advanced, feature-
rich software platforms to help them organize and study technical data. Perhaps the most
valuable feature of such platforms is the availability of accurate market data. It is
essential, for example, for technicians to work with reliable price data, reflective of the
precise prices transmitted by the exchanges.

Let's take a look at some charts and see how the application of Wilder's Average
Directional Index (ADX) can help improve the timing of classical chart pattern breakouts
and breakdowns.

It is helpful to understand that classical chart patterns are not just a means of forecasting
price direction. Classical chart patterns are more properly viewed as a method for
identifying and cordoning off specific market conditions that precede price trends. The
interpretation of classical chart patterns can be enhanced, however, by using the ADX
indicator in an unconventional manner.

ADX was originally designed to evaluate trend strength. For example, rising or falling
prices, accompanied by rising ADX values, are normally viewed as supportive of further
directional price movement. However, for the classical chartist interested in getting an
early lead on a price breakout or breakdown, we can flip this traditional ADX approach
on its head.

Instead of looking for rising ADX values to confirm a price trend already underway,
chartists can look for low and declining ADX values in tandem with developing chart
patterns as a means of identifying markets that are ready to move outside the bounds of
their respective chart pattern.

Some chart examples (using eSignal's FutureSource Workstation) follow.

Note the low and declining ADX values just prior to chart pattern breakouts (and
breakdowns from topping patterns). This is a technique that combines the time-honored
tradition of classical charting and modern technical indicators with reliable price data (as
previously mentioned). It can be applied to all freely traded exchange markets and is just
as valid on intraday and weekly time frames as it is on daily charts.

Reading Patterns
By Alan Farley, founder and publisher of Hard Right Edge*
Posted: Apr 10, 2009

Everyone is a chart reader these days, but this venerable practice isn't as easy as it looks.
That's because there are just a few ways to make money and a thousand ways to be
wrong. This is especially true currently when all sorts of Fundamentals types are staring
at price patterns now that their nine-to-five discipline no longer works.

The devil is in the details with pattern analysis because no two charts are exactly alike.
And, above all else, chasing the same patterns that everyone else sees in the books, or on
the web, is a straight shot to the poorhouse. But, that doesn't stop legions of amateur
technicians from throwing cash at the same losers over and over again.

In reality, observant technicians can find good trading opportunities with relatively little
effort, because they know exactly what to avoid when looking at similar sets of patterns.
This is an advanced skill set that's missing with the majority of folks who believe they
possess magical powers because of their chart divinations.
With this admonition in mind, let's talk about stock scanning and your evening research.
Chart database programs offer advanced tools that search quickly for your needle in the
market haystack. Many traders think the purpose of these nightly scans is to find perfect
positions that can be mindlessly executed, but nothing is further from the truth.

The most accurate scans just take you to the next step, where you're forced to discover
the trading opportunity for yourself. This "last yard" of effort is where armchair
technicians fail miserably because, in truth, their unskilled eyes try to fit all sorts of
random chaos into predictive patterns that, in reality, aren't so predictive.

The most effective way to overcome this form-fitting bias is to embrace subtlety when
you're flipping through the price charts. You can start by internalizing these four
cautionary patterns that are lying in wait to steal your money.

Bunny Slopes

There's little profit when price rises or falls in an overly gentle pattern. Conversely, real
opportunity comes when strong tension between bull and bear energy gets released
suddenly, trapping one side and triggering sharp directional movement. Of course, this is
nothing more than opportunity-cost translated onto pattern analysis.

The good news is that it takes only a second or two to identify a weak angle of attack on a
price chart. Ironically, trading bunny patterns during periods of high volatility is a
bonafide defensive strategy because it limits risk. Perhaps that's the reason you'll find so
few of them after last year's market crash.

Border Disputes

Stand aside when price action gets caught up at, or in between, big moving averages.
These conflict zones eventually yield trades, but they require patience because the battle
can go on for weeks. For example, notice how Broadcom (BRCM) has chopped along the
50-day moving average for almost three months now, while everyone waits for it to break
out or break down.

In particular, focus on interplay among price and the 50-day and 200-day moving
averages as you flip through the charts. You'll often see ping-pong action as price
bounces back and forth between the two major barriers. Not surprisingly, these pivots
will provide interesting swing trades as long as you don't overstay your welcome.
Davy and Goliath

Conflicting patterns in different time frames trap many traders in very bad positions.
These trend relativity errors occur when you see a great pattern but miss the larger
support or resistance that's going to screw up the trade. Avoiding this error is simple.
Look above and below the entry price for the setup that's catching your eye.

Then, do the math. Realistically, how far can price travel before it runs into a major brick
wall? If that number is less than three times the distance to your logical stop loss, avoid
the trade entirely. This sounds easy, but marginal traders have a really tough time staying
out of trouble with this pattern because it looks too good to pass up.
Trend Mirrors

What happened in the past has a major impact on what happens in the future, so look to
your left before taking the trade. Trend mirrors point out all the past debris that will affect
price movement right now and into the future. In particular, current action responds with
startling reliability to pivots created by old highs, lows and gaps.

In truth, price reacts a lot more than it acts. In other words, prior reversals and gaps
generate major swings during current price discovery. With this in mind, smart
technicians gauge the adverse impact of all prior highs / lows, gaps, volume spikes and
candle shadows when they're examining an interesting pattern right here in the present.