How to Use Chart Patterns Like the

Pros to Find Winners in the Stock

Market
As long as humans walk on Earth, there will be a forever
battle between the camps of fundamental and technical
analysis.

Fundamental investors would argue that it’s those metrics,

like profits, that will determine a stock’s price over the
long term.

And they love to point to Warren Buffett as an example.

On the other hand, technical traders would argue that

charts will tell a trader whether a company’s stock price
could rise or fall. It doesn’t matter what the reason is.

For example, let’s imagine that a company’s profits are

rising.

The stock’s price naturally will rise, as well. And it will be

reflected in the chart for technical traders to see, and they
can simply follow the trend to profit like a fundamental
investor.

Would it matter if a technical trader knows the reason

behind that stock price move? Was it because of the news?
Geopolitical conflicts? Rising profits? A new megatrend?

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They argue that it doesn’t matter. Charts will simply tell
them what to do.

Would it matter if a technical trader knows the reason

behind that stock price move? Was it because of the news?
Geopolitical conflicts? Rising profits? A new megatrend?

They argue that it doesn’t matter. Charts will simply tell

them what to do.

Sure enough, Paul Tudor Jones (a billionaire trader) felt

that the younger generation try to “rationalize” price moves
too much and end up missing out on stock price moves.

"I see the younger generation hampered by the need to

understand and rationalize why something should go
up or down. Usually, by the time that becomes self-
evident, the move is already over.”

He made the same argument with technical traders, saying

that traders should just let the markets tell them what to
do.

“When I got into the business, there was so little

information on fundamentals, and what little
information one could get was largely imperfect. We
learned just to go with the chart. Why work when Mr.
Market can do it for you?”

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 Paul Tudor Jones

Three Principles That Guide

Technical Analysis

Before we go into the weeds about different chart types,

let’s look at the big picture that guides the thinking behind
the technical analysis.

First, price action discounts everything.

This is the core behind the technical analysis. A technical

trader believes that any possible catalyst that could
influence a stock is reflected in the price. Why? Wall Street
is always forward-looking.

Let’s say that a company issue guidance that its profits will
be higher than expected.

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What happens to the stock?

Of course, the price is likely to be higher to reflect the

fundamentals of higher profits on a company’s balance
sheet.

The same thing can be true for catalysts related to

fundamentals, politics, or psychology.

In the early stage of the pandemic, the stock market

plunged on the fears of how it would affect the economy.
A technical trader can recognize a shift in supply and
demand through charts. There was less demand for shares,
so prices fell to reflect the imbalance in supply/demand.

(Source: TradeAlgo)

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So, charts did NOT cause prices to move up or down.

Rather, it simply reflects the current sentiment in the

market.

And this leads to the next critical point…

Often, the beginning of new trends (or critical turning

points) began when almost nobody knows why it is
behaving that way.

Until the reason becomes obvious, it is too late.

Hence the quote by Paul Tudor Jones which I shared with

you recently:

"I see the younger generation hampered by the need

to understand and rationalize why something should
go up or down. Usually, by the time that becomes self-
evident, the move is already over.”

So, technical traders can have the advantage of spotting

new trends by trading what charts are telling them –
rather than waiting until the reason behind price moves
becomes clear.

Onwards to the second principle…

Second, prices move in trends.

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The whole purpose of using technical analysis is to identify
trends in the early stages of their development…

…and trade in the direction of those trends.

This is like Newton’s first law of motion.

A trend in motion is likely to continue in the same

direction until it reverses.

This is where many amateur traders go wrong. They often

try to guess the direction of a stock price within the next
two days – rather than focusing on finding trends and
riding them.

Why? Trends are your best friends.

It is the secret behind many business successes in America.

Once again, we will refer back to Paul Tudor Jones. He
pointed out that Bill Gates wouldn’t be as wealthy as he is
now if he didn’t ride on the megatrend of personal
computers and hold into his Microsoft shares.

In other words, what if Bill Gates was in another industry?

Maybe he would build substantial wealth, but it is almost

certain that he wouldn’t be as wealthy as he was now.
Why? Personal computers simply have a more powerful
trend.

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John D. Rockefeller rode the oil megatrend to build his
fortune.

Cornelius Vanderbilt pounced on two exploding

megatrends of steamboats and railroads.

Andrew Carnegie stuck gold with a steel megatrend.

(Source: Tri County Community College)

So, Paul Tudor Jones insisted that a trader follows the

“predominant trend”:

The first is, you always want to be with whatever the

predominant trend is. You don’t ever want to be a
contrarian investor. The two wealthiest guys in the
United States—Warren Buffett and Bill Gates—how
did they get their money? Bill Gates got his money
because he owned a stock, Microsoft, and it went up
eight hundred times, and he stayed with the trend.”

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All in all, a trader’s job is to find trends early and ride
them until it shows signs of reversing.

Now for the last principle…

Third, history repeats itself.

Patterns repeat themselves over the years.

We will cover common patterns to spot as a trader in the

next following pages. They prove to be very effective 100
years ago and now. The reason is simple – human
psychology doesn’t change.

What Is A Trend?

We are going to talk about trends a little bit more.

Do you think we’ve been on the topic of trends a little bit

too long? It is worth understanding the principle of trends
because of one reason…

ALL charts, patterns, and lines have one purpose: To help a

trader identify and analyze trends with a motivation to
participate in that trend.

Now, what is a trend?

First of all, markets typically don’t move in a straight line

in any direction.

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You see it in all stock charts. There are ups and down
along the trend. Sometimes a stock would climb quickly.
Then it will pull back to “breathe” a little bit before
climbing again.

(Source: [Link])

And there are three main directions in the market: (1)

uptrend, (2) downtrend, and (3) sideways.

(Source: [Link])

It is critical for a technical trader to identify the markets

going sideways.

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The reason is simple – most technical tools are designed
to be trend-following. Meaning? They don’t work as well
if the markets are trading sideways. Trading in a sideway
market is almost like gambling because you don’t have a
definite trend to back your analysis on.

So, don’t use trending tools to trade in a market going

sideways.

Therefore, traders have three options on a given day:

1. Buy when the market is uptrending

2. Sell (go short) when it is downtrending
3. Do nothing if it’s moving sideways

Three Main Categories Of A Trend

The next step is to know three main categories of a trend.

It is important to be aware of where a stock stands in

these three categories – long-term, intermediate and
short-term.

However, there are virtually unlimited numbers of trends

within these categories. Take the short-term as an
example. You can find trends in a chart covering minutes
of a stock’s movement. Or hours. Or days.

As for the long-term, you can look at 5 years or go as far

back as 100 years to find a trend.

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So, each trader can assign different time periods for each
three categories. Generally, we look at trends in these
periods:

Short-term: Less than 2-3 weeks

Intermediate: 3 weeks to several months
Long-term: 6 months to 2 years

Keep in mind that trends can conflict with each other.

A short-term trend could show a stock taking a breather

from a major (long-term) uptrend.

You can see it in the example below:

(Source: [Link])

What if someone asks you which trend a given stock is on

right now?

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You cannot answer without clarifying which category of
trends that he/she is referring to. After all, a stock could
be in the middle of multiple trends. You just need to know
which time frame to answer with a proper trend.

Which category should you pay attention to when trading?

Generally, our traders like to follow the intermediate

trend but use short-term trends for timing.

For example, a short-term pullback could be used to

initiate long positions to ride on an intermediate uptrend.

Support and Resistance

Stocks move ups and downs along a trend, right?

What makes a stock “bounce” from a short-term trend?

Or to reverse from its uptrend?

Often, there are support and resistance lines.

Support is the line where a stock reaches the level where

there is enough buying interest to overcome selling
pressure. So, buyers would scoop up shares once it hits a
price level, reversing the trend upwards.

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See below for an example:

(Source: Investopedia)

On the other hand, resistance represents a price level

where there are more sellers than buyers, causing the
price to pull back.

Usually, you can identify a resistance line by looking at

the previous peak.

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 (Source: Investopedia)

Here’s the important thing: In a downtrend, a support line

eventually won’t be enough to push prices up. That’s why
some options traders will buy put options once a stock falls
below the support line.

Vice versa with the resistance line.

If a stock penetrates a resistance line in an uptrend, it could

be a good time to buy call options.

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 Using Resistance and Support Levels to
Diagnose The Health of a Trend

In a healthy uptrend, you want the support level to be

higher than the one prior to it… and… for each resistance
level to be higher than the one before it.

It would look like this:

(Source: [Link])

However, if the corrective dip in an uptrend falls all the

way down to its previous support level, it should flash a
warning sign.

It could mean that the trend could be reversed soon, or the

stock may start trading sideways.

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This is an example of a trend reversal:

(Source: [Link])

It is the same thing with a downtrend, as you can see

below:

(Source: [Link])

17
 Why Do Resistance and Support Lines
Get Formed? (It’s All Psychology)

Generally, there are three groups of traders – the bulls,

the bears, and the uncommitted.

The bulls are those who already bought calls in the stock.

The bears bought puts.

And the uncommitted are undecided on which side to

enter.

Now, imagine that the stock begins to climb up from its

support line. The bulls are happy that their trades are
turning profitable. But they wish that they bought more
call options, so they hope the stock would dip back near
the support line. That way, they can buy more shares.

On the other hand, the bears are nervous that they make
the mistake of buying puts. They pray for the stock to
fall back to the support line, so they can sell at break
even.

This falls to the next group…

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The uncommitted can be divided into two groups:

Those who realized they sold their calls too soon at

the support line, so they wanted to get back in at
that level again

Those who never had a position yet but wished that

they bought calls at the support line

Now, do you see how all four groups want the stock
price to fall back to the support line?

As soon as the stock falls back to the support line, the

bulls and the undecided swoop in to buy shares while the
bears sell their shares to get out.

Meaning? The stock bounces from the support line.

Here’s the key: The more trading occurring near the

support line, the more powerful it becomes.

If there’s a huge volume coming in at the support line, it

could indicate that there is a lot of demand for the stock.

What’s more, the longer the stock price trades around

the support line (or the resistance line), the more
powerful the movement can be. Often, it’s called the
accumulation cycle where buyers keep scooping up
shares once the stock hits the support line over the few
weeks.

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 (Source: Investopedia)

The same thing happens in the opposite direction with the

downtrend.

It is important for a trader to understand why patterns

work. They are not just lines. There’s a whole lot of
psychology behind these patterns, and it will help you
understand their reactions to market events.

When Resistance and Support Levels

Reverse

Did you know that a resistance line can reverse into a

support line almost immediately?

I am sure that you witnessed this before.

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When a stock penetrated a resistance line to continue its
uptrend, what happens to that resistance line?

Of course, it becomes your new support line.

In other words, a resistance line used to be when traders

sold. But once it was penetrated, that line becomes a
support line where buying starts once the price falls back
to that level.

(Source: Investopedia)

In a downtrend, a support line will become a new

resistance line:

21
 (Source: Investopedia)

The Penetration of Resistance and

Support Lines

Sometimes a stock would penetrate a resistance line only

slightly before continuing its downtrend.

After all, a resistance line is almost never a perfect one.

So what would be considered a true penetration of a

resistance or support line? Each trader has their own rules.
For major resistance and support lines, a benchmark of
3% is often used.

But for those with shorter-term lines, a 1% can be used.

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Just remember that support/resistance lines only reverse
their roles when the stock moves far enough away to
convince traders that they’ve made a mistake. So, the
farther the stock moves away, the more convinced
traders become that they’ve made a mistake.

Round Numbers = Support and

Resistance

This is a quirk of the stock market where round numbers

often stop advances or declines. It’s just trading
psychology. Traders often place special emphasis on
rounded numbers – such as 10, 20, 25, 50, 75 and 100.

These numbers often act as “psychological” support or

resistance levels.

So, how should you apply this principle?

Don’t place an order right at these round numbers. If

you believe a stock is due for a downtrend, you can place
limit orders just above an important round number (or
the resistance line).

Vice versa for those traders who are looking to buy call
options on a bounce at the round number. They can
place limit orders just below the round number (or the
support line).

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 Trendlines

The next foundation of trends is a classic trendline.

Yes, it is perhaps the simplest tool in the chartist’s

toolbox. But it is also one of the most useful.

A picture will describe everything you need to know

about trendlines, starting with an up trendline:

(Source: Investopedia)

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And a down trendline:

(Source: Investopedia)

Now, let’s analyze further on trendlines.

A chartist will face the question of what makes a true

trendline. Generally, there should be at least two lows
(with the second low being higher than the first low).
After all, you need two points to draw a line, anyway.

What’s more, some chartists consider a trendline to be

confirmed once the price moves above the second low:

25
 However, some would prefer to wait until the stock
moves above the second high before confirming a
trendline.

But this is just a “tentative” trend at this point.

The valid trendline is when the price bounces off a third

low (and higher than the second low).

26
Once a trendline gets validated, how should you trade it? In
an uptrend, a trader will want to use the corrective dip that
bounces from the trendline as a buying opportunity.

As long as the trendline maintains, a trader can keep using

it to determine buying and selling areas. Once the line gets
violated, it indicates a reverse in a trend, and selling should
be done.

Remember this – a break in the trendline is one of the

earliest warning signs that the trend has concluded.

27
 (Source: Investopedia)

Determining the strength of a trendline: A general rule is

that the longer the trendline is and the number it gets
tested, the stronger it is.

For example, a trendline that has been going for eight

months and got tested nine times is much more powerful
than one that was tested just three times.

And once that strong trend gets penetrated, it is much

more significant than a weak one.

What if it gets penetrated during the day? Sometimes, you

will see a trend getting violated during the day… but
close the day above the trendline.

28
Should you ignore that penetration, or draw a new line?

This is the question that many traders have. The best

solution is to draw another line while keeping the
original line. This way, you can compare these lines to
see which one is truer.

(Source: Financial Analysis of the Financial Markets)

In general, a close below the trendline is much more

important than an intraday violation.

Some traders use different rules. One would use a 1-3%

rule where the price must finish 1-3% below the trendline
in order for it to consider as a penetration. The same
thing is true for a downtrend.

Some would consider time range. Meaning? The price

must finish below the trendline for two days in a row.

There are several ways to determine if a trend is violated,

so experiment and find what works for you.

29
 Using Multi-Trend Lines

Ready to take things even further?

Let’s look at multi-trend lines.

A popular one is the channel line. Sometimes, a stock

will trade within two parallel lines, calling the basic
trendline and the channel line. The way to make profits
from the channel line is clear.

Here’s an example of a channel:

(Source: Investopedia)

It is simple to draw a channel line. In an uptrend, draw a

basic trendline along the lows. The next step is to draw a
dotted line from the first peak to the second higher peak.
If the next rally backs off after hitting the second peak, it
is possible that there’s a channel at play.
30
If the price bounces from the third higher low, then it is
likely to be confirmed.

Here’s how a trader would play this – the basic trendline

can be used to buy long positions, while the channel line
can be used for short-term profit taking.

Now, many amateur traders will try to be aggressive by

taking short positions (such as put options) once the price
hits the channel line.

This is extremely dangerous.

It is always best to trade with the trend – not against it.

Using the channel line to spot a sign of a weakening trend: If

the price fails to reach the top of the channel line and
begins pulling back, it could be a sign that the trend is due
for a reversal.

And it is likely that the basic trendline will be violated.

What’s more, some chartists believe that once there’s a

breakout from a channel line, prices often travel a distance
equal to the width of the channel.

So, you can measure the width (not the length) of the
channel and estimate the length of a breakout from the
point when the trendline was broken.

Once again, the same strategy is true for a downtrend.

31
 Using Fibonacci Retracements

When a stock is breaking out for a new trend, it often pulls

back.

You and I know that.

This “countertrend” moves tend to behave in predictable

ways if we measure them using percentage retracements.

Let me give you an example.

A stock is trending up from $20 to $40. Very often, it will

pull back by about half of the previous move – which is $30
– before it begins climbing again.

This is a popular tool and happens very frequently.

Moreover, traders use minimum and maximum percentage

parameters that are 38% (minimum) and 62% (maximum).

What does this mean?

If a stock pulls back from a strong trend, it typically pulls

back to about 38% of its previous move.

So, a trader will use this information to estimate buying

opportunities once the stock resumes its rally.

32
 (Source: Investopedia)

As for the maximum (62%), it is the critical line where the

correction must stop at the 62% line to maintain the
current trend.

This often makes a low-risk buying opportunity in an

uptrend.

What if the price moves below the 62% line? It likely

means that the trend is broken and may retrace the entire
100% of its recent trend.

Yo can see how the stock reached 100% in the chart

above.

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 Reversal Patterns

Now, we will finally talk about popular patterns that

you may recognize.

Listen, inexperienced traders make the mistake of

thinking that most changes in trend will be a quick one.

But it is not true.

It often takes a period of time for a trend to transition

from the previous one to the next one.

In fact, it is common for stocks to trade sideways just to

pause or consolidate before resuming the current
trend… or reversing to an opposite trend.

Therefore, price patterns are useful to study this

transition period.

There are two categories of price patterns – reversal and

continuation. A reversal means that the trend is in the
process of reversing, while a continuation indicates that a
rally is just taking a breather before resuming again.

So, a trader wants to identify either pattern early in the

formation of the pattern.

34
Before we dive into the reversal pattern, a trader must
remember that a stock must have an existing major trend
in order for a pattern to work.

If a pattern shows without a prior trend, a trader should

be skeptical about it.

Secondly, the larger the pattern is, the bigger the

potential is. If a pattern shows a big height and width, it
indicates a powerful move ahead.

The reason is simple – a big height shows that the

volatility is extremely high. And the longer it takes to
build the pattern, the more important the pattern
becomes.

Okay now…

We will cover some of the most popular major reversal

patterns in the following pages, starting with the head
and shoulders reversal pattern.

Head and Shoulders

Reversal Patterns

This is perhaps the best-known (and the most reliable)

pattern.

Before we go deep into the pattern, let’s see it with a

visual example:

35
 (Source: Investopedia)

The original trendline is on the left side of the chart.

The stock bounces off the trendline, and it’s only when
you see the Head that the price broke the trendline.

However, the stock rallied to reach close to the peak at the

Left Shoulder (often on a light volume). Since it failed to
surpass the peak at the Head, it offers a clue of a new
downtrend.

And we will see the Neckline (the straight line) which has a
slight upward slope at tops.

36
This is a vital line because as soon as the stock moves
below the Neckline indicates that it broke the support
line and begins a new downtrend.

Then, a stock would bounce back to the top of the

Neckline (the new resistance line) before resuming its
downward trend.

Now, it is important for traders to pay attention to

volumes when analyzing the head and shoulders pattern.

The Head should see a lighter volume than the Left

Shoulder.

The biggest key is the volume signal for the Right

Shoulder.

Volume should be lighter than the previous two

peaks (the Head and the Left Shoulder).

Volume should grow on breaking below the

Neckline, become light on a rally to the Neckline,
and grow again on its way downward.

37
 Inverse Head and Shoulders

This pattern is almost exactly the same as the Head and

Shoulders. The only difference, of course, is that you flip
the pattern upside.

(Source: Investopedia)

Triple Tops and Bottoms

This pattern is almost similar to the Head and the

Shoulders. It is so important to pay attention to how
volume behaves in this pattern.

First, let’s look at the pattern itself:

38
 (Source: Investopedia)

Now, the volume typically grows on a rally on the left

side of the chart. The volume becomes lighter when the
stock falls in the first two peaks. However, after the
third peak, the volume expands when the stock begins
falling.

The stock would bounce on a lighter volume before

increasing the volume on its downward move.

In other words, the left side will have a bigger volume

when the stock is moving up.

The trend is reversed when the volume expands when the

stock falls on the right side of the chart.

39
 Double Tops and Bottoms

This is more common than the triple tops and bottoms.

In fact, the pattern for double tops or bottoms is perhaps
the second most popular after the head and shoulders.

Double Tops Pattern:

(Source: Option Alpha)

(Source: [Link])

40
These two photos are pretty much self-explanatory.

The volume plays a big role here, as well. You can notice
that for double bottoms, the volume expands when the
stock is falling. When it bounces, the volume is lighter.

However, the volume behavior changes once the second

bottom is reached.

The volume rises when the stock climbs up, becomes lighter
when it pulls back, and rises again when it rallies.

You can see an example below:

(Source: [Link])

41
I want to give you another example of why it is so
important to watch the volume.

Sometimes there would be a false breakout where the

stock penetrates the resistance line from the previous high.

A trader may get fooled and buy call options, but the
stock begins a new downward trend.

How can you spot something like this?

Try to pay attention to the volume. If the stock climbs

above the previous peak (forming a second top) on a light
volume, it is a huge red flag.

And it will confirm the red flag if the stock increases its
volume on a pullback.

As you may remember, you want the stock to see its

volume rise if it were to climb toward the second top.

It doesn’t always happen this way, but it is helpful to be

alert to the volume action. It raises your odds of not
getting caught in a “bull trap.”

Continuation Patterns

Now, we will shift our attention to continuation patterns.

42
They indicate that the sideways price action on the chart is
merely a pause of a previous trend and the next move will be
in the same direction as the recent trend.

This is different from reversal patterns which indicates that

the trend is about to be reversed.

What’s more, reversal patterns usually take much longer to

form than it takes for continuation patterns (typically short-
term or intermediate patterns).

(It doesn’t always happen this way, but it often turns out
like that.)

Let’s start with the first one – Triangles.

Triangles

There are three main types of triangles – symmetrical,

ascending, and descending.

The symmetrical triangle demonstrates how the stock would

move shorter and shorter in terms of ups and downs before
resuming its rally upwards.

43
 (Source: [Link])

Generally, there should be four reversal points at

minimum. It is possible for a triangle to have six reversal
points, as well.

As for the volume, it should become lighter as the price

swings narrow within the triangle.

And then, the volume should spike when the stock

penetrates the top line of the triangle.

The ascending triangle will show an upper trendline

being flat, while the lower line is rising. This shows that
buyers are more aggressive than buyers, thus
demonstrating a bullish sentiment.

Once the stock penetrates the upper trendline, it often

resumes the rally beyond the triangle.

44
 (Source: Investopedia)

Now for the descending triangle, it is an upside version of

the ascending. Naturally, it is considered a bearish
pattern.

In this case, sellers are more aggressive than buyers,

leading the stock to slide downward once it breaks the
bottom trendline.

45
 (Source: Investopedia)

It can be used to spot market tops.

For example, when a stock pulls back from its all-time

high, a trader may be unsure if it is just a normal pullback
or a beginning of a downtrend.

Spotting a descending triangle could be a red flag that the

trend has been reversed.

46
 (Source: [Link])

Flags and Pennants

The flag and pennant patterns are also common.

Both is very similar in appearance and have similar

requirements. The first and foremost requirement is for
the stock to see a recent major price move upward. In
fact, it should be almost a straight-line move.

Let’s start with the flag.

In the chart below, you can see that the stock shot
straight up on a heavy volume. Then it begins a channel-
like trend slightly downward on a light volume. Finally, it
breaks the trendline for a big rally on a heavy volume.

47
 (Source: [Link])

The pennant is very similar to the flag, but with a slight

difference in appearance:

(Source: Investopedia)

Both patterns should be completed in the short-term –

around one to three weeks.

Now for the next pattern…

48
 The Wedge

The concept of a wedge is similar to a symmetrical

triangle. Notably, the wedge typically takes about one to
three months for the pattern to form. One thing that
separates the wedge is its slant.

Let’s say that a stock is in an uptrend.

The wedge will slant in the opposite direction of a trend,

which means it would be downward. Traders call it a
“falling wedge.” It is actually a bullish pattern.

(Source: [Link])

On the other hand, a rising wedge is bearish.

49
 (Source: [Link])

This is often a continuation pattern, so if you spot this

pattern, it could be wise to buy either calls or puts once it
breaks the trendline.

The Rectangle

You can spot this pattern very easily.

Sometimes a stock would pause from its trend and begin

trading sideways for a while before resuming its trend.

Wall Street calls this a “trading range.”

50
See the chart below for a bullish rectangle:

(Source: [Link])

And for a bearish rectangle:

(Source: DreamStime)

51
The volume plays a big role in this pattern.

If a stock is in an uptrend, a heavier volume on the rally and

a lighter volume on a pullback within the rectangle is a
good indicator of a continuation in the uptrend.

But if you see a heavier volume on a pullback, it is a major

red flag for a possible trend reversal.

Vice versa for a bearish rectangle.

Japanese Candlesticks

Candlesticks are a Japanese tool that become popular in

recent years.

Here’s the important thing: Candlestick uses the exact same

data as standard bar charts, which are open, high, low and
close prices.

However, the design makes it easy to analyze and interpret.

The name “candlesticks” got its name because a single bar

looks like a candle with a wick. You can see it in the
example photo below:

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 (Source: TradingSim)

The rectangle represents the difference between the open

and close price for the day. It’s called the “body.”

Now, if the stock closed the day in positive territory, it will

be shown in green color. That means close will be the top
of the rectangle, while open will be the bottom. Moreover,
the wick will show the day’s high and low.

As for a negative day, it will be the opposite. Open will be

the top of the rectangle, while close will be at the bottom.

Here’s the visual aid to summarize the concept:

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Note that some traders will call wicks “shadows.” They
mean the same thing.

Now, let’s dig deeper into the Japanese candlesticks.

When there is a big difference between the open and close

prices, it is called Long Days. Meaning? There is a big
gain/loss on that day. However, those days with a small
difference is called Short Days.

But keep in mind that this is measured by the length of the

body – not the wicks. Meaning? It doesn’t matter if the
stock soared but fell to finish the day close to its open price.
It will be still called a short day.

The next key term is spinning tops. They indicate the days
where candlesticks have small bodies with upper and lower
wicks showing greater length than the body.

Everything is shown in the graphic below:

(Source: Financial Analysis of the Financial Markets)

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What if the open price and the close price finish the day
with the same price? It is called Doji lines.

The key is paying attention to the wicks.

If there’s a long-legged Doji, it will show long upper and

lower wicks. Traders generally consider it to mean an
indecisive market.

Gravestone Doji has a long upper wick and no lower wick –

a bearish signal.

Dragonfly Doji is the opposite with the lower wick being

long and no upper wick – a bullish signal.

(Source: Financial Analysis of the Financial Markets)

These are just examples of how candlesticks can measure

the psychological makeup of traders at that time. A single
candlestick can demonstrate traders’ activities, and a
technical analyst can identify patterns to anticipate future
price movements.

Most candle patterns are used to find potential reversal

points in the market.

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 Reversal Candle Patterns

Here’s the ultimate principle every trader must keep in

mind when using candlesticks to analyze patterns:

You cannot have a bullish reversal pattern in an uptrend.

Vice versa with a bearish reversal pattern in a downtrend.

In other words…

If you spot several candlesticks indicating bullish signals,

they are useless if the trend is up.

Therefore, you must identify the overall trend in order to

analyze Japanese candlesticks.

Ideally, the minimum is to identify the short-term trend

(about ten trading days) before candlesticks can be useful.

Now, let’s cover several popular candlestick patterns.

Dark cloud cover is a two-day reversal pattern that is

bearish. The characteristic is simple. The first day will
have a long green candlestick. It would continue the
uptrend, and traders would think all is good.

But the next day, the stock will open above the high price
of the previous day. Once again, it looks good. But the
stock fell later in the day and closed at least below the
mid-point of the body of the first day.

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 This may force traders to exit the position, marking a
potential reversal in the trend.

(Source: Financial Analysis of the Financial Markets)

Piercing line is the opposite of dark cloud cover. The first

day would continue the downtrend with a long red day.
The next day, the stock opens at a new low, but trades
higher and closes above the midpoint of the prior day’s
body.

This could cause traders to exit the position and end the
trend.

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 (Source: Financial Analysis of the Financial Markets)

Let’s go to the next two popular patterns…

Evening star is a strong reversal pattern, and traders must

be aware of it. It is a 3-day pattern where the first day of
this pattern will be a long green candlestick. This, of course,
would continue an uptrend.

Now for the second day, trading is tight and the close price
is near the open price. The body is small. This is often called
a Star pattern. It is when a small body day that gaps away
from a long body day.

However, the third (and last day) of this pattern will open
with a gap below the body of the star and closes at the price
below the midpoint of the first day.

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This is a powerful pattern that can reverse a trend.

You can see it in the chart below:

(Source: Financial Analysis of the Financial Markets)

Morning star is exactly the same as evening star but just in

the opposite direction, as you can see in the chart below:

(Source: Financial Analysis of the Financial Markets)

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 Continuation Candle Patterns

Understanding how to spot continuation patterns is

critical. Why? Each trader needs to make three possible
decisions – enter, exit, or remain in a trade.

So, spotting a candle pattern indicating that a trend

could continue can help traders decide whether to stay in
a trade.

There are lots of continuation candle patterns, but we

will discuss a few here.

Rising Three Method is a bullish pattern that only can

happen in an uptrend. The first day of its pattern will see
a long green day. So far, so good. But the next three
trading days will see small body days finishing lower on
each day.

That would end up in a brief downtrend.

But the key is that all three trading days will remain
within the range of the first day’s long green body…
and… at least two of them will have red bodies.

But then, a long green body will close with a new high
and continue the uptrend.

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 (Source: Financial Analysis of the Financial Markets)

Now, listen: It doesn’t have to be exactly the same as I

listed above. Maybe there will be one green day within the
three-day period of short bodies. Or these three days could
stay within the first day’s high-low range – rather than the
body’s range.

Just be flexible with it.

Falling Three Method is the same as rising three method,

but it is a bearish pattern.

Greg Morris’s Candle Pattern Filtering

Greg Morris developed a valuable concept where it

improves the reliability of candle patterns. How it works is
simple. Traders should use overbought and oversold
indicators to validate a candle pattern.

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For example, Stochastics %D is a popular indicator that
oscillates between 0 and 100. If it is under 20, it is
oversold. 80 is overbought. Meaning? If it rises above 80
and then falls below 80, it triggers a sell signal.

When it rises above 80 (or falls below 20) for the first time,
it is called the presignal area.

The filtered candle pattern uses only when a stock enters

the presignal area. In other words, let’s pretend that a
candle pattern develops when stochastics %D is at 60. A
trader should ignore this pattern.

This concept works only for reversal candle patterns.

(Source: Financial Analysis of the Financial Markets)

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 Price Gaps

Mastering price gaps can be a powerful skill for traders

because it can precede a monster run in a stock.

It is simply the area where the stock price skipped from the
previous day. For example, in an uptrend, a stock will
open above the highest price of the previous day, leaving a
gap on the chart that’s not filled during the day.

Same thing with a downtrend.

Upside gaps indicate strength, while downside gaps show

weakness.

What’s more, gaps can exist on long term weekly and

monthly charts. But they are more common on daily
charts.

Now, let’s look at three common types of gaps…

The Breakaway Gap often happens at the end of a pattern.

It can be interpreted as a breakout from the pattern and
hint big moves ahead. This tends to happen from topping
or basing areas. And more importantly, a breakaway gap
often happens with heavy volume.

Traders often use a breakaway gap as a support line for

future price corrections.

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 Lastly, the stock price shouldn’t fall below gaps during an uptrend
(or a downtrend). What if it closes below an upward gap? It
indicates a weakness in the trend.

(Source: Financial Analysis of the Financial Markets)

The Runaway Gap is the second phase where it will create

another gap after a few days of the move from the original
gap. It confirms that the stock is breaking out on
moderate volume. It is a sign that the uptrend is likely to
continue (or a sign that a downtrend can continue if it
gaps on the downside).

Often, it happens at about the halfway point in a trend.

This is key. A trader can measure how much the uptrend
can keep going by finding out the length between the
original gap and the runaway gap… and… add that
length to find a potential top in the trend.

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Lastly, the runaway gap also serves as a support line for
future correction.

The Exhuastion Gap is the final type of gap that marks

the end of a major price move. Once a trader identifies a
breakaway and a runway gap, he/she should start
keeping an eye for the exhuastion gap.

Namely, it will jump in a final push of the recent uptrend.

Then that jump quickly cools down and the stock would
trade lower within a couple of days to a week.

As soon as the price closes below the exhaustion gap, it

often signals a bearish move ahead.

(Source: Financial Analysis of the Financial Markets)

The Island Reversal is what it is called when the market

moves in a narrow range after the exhaustion gap before
gapping downside.

This often signals a trend reversal.

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 Multi Time-Frame Analysis

Multi time-frame analysis is where the trader combines

different timeframes to raise the odds of being correct in its
analysis.

For example, a trader may choose to trade long-term signals

in a short-term timeframe. In other words, he/she will trade
in the same direction of the long-term trend while using a
short-term timeframe (like daily charts).

There are two important terms – higher timeframe and lower

timeframe.

Higher timeframes analyze the longer-term chart to uncover

the general market direction and sentiment. Then the trader
uses this insight to look at potential trading opportunities
following the long-term trend with lower timeframes.

So, traders use lower timeframes to find entry/exit points and

manage positions.

We suggest traders to start the analysis with higher

timeframes. Then they should start looking for opportunities
in lower timeframes.

For example, a trader could look at weekly charts (higher

timeframes) to establish a trend before looking at 1-hour
charts (lower timeframes) to find opportunities.

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Here are some ways that traders use for higher timeframes
and lower timeframes:

(Source: TradeAlgo)

Now for the next step…

A trader could find multiple patterns to support his/her

trade thesis.

I can give you one example, and it will be clear for you to
apply it in many different situations.

In the example below, a trader (using a higher timeframe

of 4-hour) spots British Pound bouncing its resistance
level.

That would be a bearish signal.

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 (Source: Tradeciety)

Now for the lower 15-minute timeframe, the trader spots

the Head and Shoulders chart pattern. Knowing that the
higher timeframe just displayed a bearish signal, this
pattern confirms the potential downside move ahead.

(Source: Tradeciety)

This is just one example of combining patterns to

support a trade thesis by using higher and lower
timeframes.

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We recommend a trader stick to one timeframe
combination for about 30 trades to develop an instinct for
it. Then he/she can consider adding another. It is important
for a trader to master one – rather than trying different
combinations at once.

Top 5 Indicators

This is just one example of combining patterns to support a

trade thesis by using higher and lower timeframes.
There are abundant technical indicators, and amateur
traders often go off-track by following too many indicators
at once.

It is recommended to follow under 10 indicators to

maintain their effectiveness.

There are two general types of technical indicators –

Overlays and oscillators.

Overlays are technical indicators that are plotted over the

top of the prices on a stock chart. You will see them in the
same area as stock price lines.

Oscillators are not laid on a price chart. Rather, they are

plotted below a price chart. These indicators oscillate
between a local minimum and maximum – such as the
stochastic oscillator, MACD, or RSI.

Let’s look into 5 popular indicators…

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On-Balance Volume measures the positive and negative
flow of volume in a stock. This is a powerful indicator. It
measures the supply and demand in a stock. How? It is a
running total of up volume minus down volume.

Up volume = the number of volume on the green day.

Down volume = vice versa for the red day.

Each day volume is added or subtracted from the

indicator (based on if the price goes higher or lower).

Now, how does it work?

If OBV is rising, it indicates that buyers are pouring into

the stock and pushing the price higher. What if it is
falling? The selling volume is higher than buying volume
– a bearish signal.

Traders often use this as a trend confirmation tool.

Namely, if the stock is climbing in an uptrend, a rising
OBV confirms this,

What’s more, if the OBV is falling even if the stock price

is climbing, it could indicate that buying isn’t strong and
could reverse the trend soon. It is called divergence.

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 (Source: Investopedia)

Onwards to the next indicator…

Accumulation/Distribution Line measures the money

flow in and out of the stock.

It is very similar to the previous indicator (OBV) but it

uses a different calculation that could make it more
or less useful. A trader will need to see both
indicators to see which has been more accurate for
that time period.

Now, the A/D line measures the same as OBV but it

also considers the trading range for that period and
where the stock closes within the range. For example,
if a stock finishes near its high, the A/D line will give
volume more weight than if it closes near the
midpoint of the range.

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Let’s imagine an example.

A stock is in an uptrend. It closes above the halfway point of

the range. The A/D will add volume positively. And for the
next day, the stock finishes green but it closes in the lower
end of its daily range. Meaning? The A/D will subtract
volume from the running total – even if the stock finishes in
green.

What’s more, it is a good tool to spot divergence. If the A/D

line beings falling while the stock price is rising, that should
raise alarms in a trader’s head because it may signal a
reversal coming soon.

(Source: Investopedia)

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Moving Average Convergence Divergence (MACD) is very,
very popular with traders. It is also easy to follow. It helps
traders to see the trend direction – along with trade signals
that could provide entry/exit points.

If the MACD is above zero, it is a bullish signal. Going

below zero is bearish.

Now, you will see two lines – the MACD line and a signal
line. When MACD crosses below the signal line, it could
mean the stock is due to fall. If it crosses above, it signals
that the price could be rising.

Here’s how a trader could use the MACD as an entry point.

Let’s say that the trader sees the MACD line hovering close
to zero. That’s almost the “bottom.” Moreover, the MACD
just crossed above the signal line. These are two bullish
signals, and it could be a good entry point.

(Source: Investopedia)

73
Relative Strength Index is similar to the MACD but with
just one line. The range is between zero and 100. It plots
recent price gains and losses to measure the momentum
and the trend strength in a stock.

Using RSI is simple.

When it moves above 70, it is overbought.

Below 30 is oversold.

This is where paying attention to divergence is

important. If the stock is rising while its RSI is falling, it
could signal an upcoming downtrend.

(Source: Investopedia)

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Relative Strength Index is similar to the MACD but
with just one line. The range is between zero and 100. It
plots recent price gains and losses to measure the
momentum and the trend strength in a stock.

Using RSI is simple.

When it moves above 70, it is overbought.

Below 30 is oversold.

This is where paying attention to divergence is

important. If the stock is rising while its RSI is falling,
it could signal an upcoming downtrend.

(Source: Investopedia)

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Stochastic Oscillator is a play of MACD and RSI. It
measures whether the price is making new highs in an
uptrend… or making new lows in a downtrend. It is
plotted between zero to 100 – like RSI.

Above 80 is overbought.

Below 20 is oversold.

Here’s an important tip to remember – in an uptrend,

the lower range of stochastic oscillator is much more
important. If the stock is in an uptrend and the
indicator just hit 20, that’s a prime buying opportunity.

But don’t pay too much attention if it hits 80 in an

uptrend because it will happen frequently if the stock is
uptrending.

Now, for a downtrend, hitting 80 is much more

important than 20 for the same reason as an uptrend.

(Source: Investopedia)

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 Confluence

Similar to what we discussed in multi time-frames, a trader

want to combine more than one technical analysis to
increase the odds of a winning trade.

You do not want to trade on a single technical signal.

Rather, you want to find multiple technical signals that give

off same signals – bullish or bearish – to create confidence in
a trade.

For example, the chart below shows (1) three touches on the
trend line and (2) hitting 0.68 and 0.50 confluence:

(Source: [Link])

Always be sure to find confluence by identifying several

patterns and signals before entering a trade.

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 Final Chapter:
Risk Management

Have you read Hedge Fund Market Wizards?

It is a brilliant book by Jack D. Schwager who interviewed

hedge fund stars on their strategies to win consistently in
the markets.

These managers get paid hundreds of millions of dollars

to manage clients’ money.

And the most common principle among these managers is

very simple. This principle has been true four decades ago,
and will remain valid three decades from now.

What is the principle? Risk management.

These star managers employed a painstakingly accurate

risk control. Listen, average traders settle for average
risk/reward ratio. In other words, they take more risk to
generate more profits. But of course, it is the thing that
wipes out most traders when things turn against them.

The “gurus” make sure their positions are properly sized.

Avoid as many risks as possible. And exit positions at the
right time.

As a result, fund managers interviewed in the book

consistently had very low losses.

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Now, every trader has their own risk management system.
There is no definite system, but here’s a guideline that we
like to follow:

Never risk more than 2% of your account on a single trade

Only trade 50% of your account – if you have a $100,000

portfolio, you should only risk $50,000 in the market
while leaving the rest untouched in case of a major
drawdown.

Don’t trade more than 10% in the same market group

The last one is important. Let’s imagine that you trade

nearly half of your portfolio in the technology group.
Even if there are 20 separate trades, there’s almost little
diversification because the technology sector tends to
move together.

So, it is best to spread your risk across different market

groups.

Okay, that’s it.

Best of luck to your trading journey!

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