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The key to understanding why the markets move the way they do is being able to identify and understand chart patterns. Once you can do this, you can trade any instrument in any market.
It’s that simple, at least from a technical standpoint.
Why then do the majority of Forex traders fail to generate consistent profits?
It isn’t their experience level, currency pairs traded or even their strategy (although it does play a role).
Most traders fail because we’re all human. And as humans, we tend to make things more complicated than they have to be. Also, patience and discipline are not exactly common traits – they certainly weren’t for me.
Of course, other factors also contribute to consistent profits. But the technical game is as simple as spotting obvious price patterns and then using those patterns to form trade ideas. That’s it!
But if you’ve been struggling to keep things simple, you’re in luck. I’ve compiled a list of five of the most common mistakes made when trading technical patterns. They range from ignoring critical levels to using the “wrong” time frame.
By the time you finish reading this lesson, you will have a firm understanding of what you might be doing wrong and exactly how to correct it.
Let’s get started!
This one is a biggie. Cutting off the wicks of candles is perhaps the most common mistake I see Forex traders make when it comes to identifying key levels.
The image below is an example of what I see quite often.
Notice how the levels in the chart above have cut off several of the highs and lows of the candles that formed the structure. When you cut off the wicks in this manner, you’re hindering your ability to trade this pattern successfully.
Not only will it be difficult to identify a breakout, but it will also be tough to determine a proper entry.
Don’t get me wrong, the channel above is entirely valid and is the type of structure you should be looking to trade. However, the placement of the levels could be more precise.
Here is an example of how we should have drawn the channel.
Notice how both support and resistance line up perfectly with the highs and lows.
The difference between the two charts above may seem like a minor detail. But when it comes to technical trading, the devil is in the details.
The example above is relatively mild regarding the highs and lows that were cut off. So let’s take a look at a more extreme example.
The NZDUSD chart below shows a swing low that has been cut off by trend line support.
And now for the proper position of this trend line.
Now, besides the fact that this trend line isn’t cutting off part of a candle, there was something else at play here that tipped me off to the correct placement of the level.
By drawing a channel instead of a trend line, we can see that the two swing highs of this pattern help identify the precise position of support.
The occurrence in the chart above is so prevalent that I wrote a lesson on using channels to identify “hidden” levels. While the technique is a bit different, the concept is the same.
While false breaks can and do occur, the truth is that 90% of the so-called false breaks I see traders report are not false at all. The problem usually isn’t that the market failed to follow through on a break, it’s that the individual failed to identify correctly the levels involved.
Always draw your support and resistance levels in line with candlestick highs and lows. By doing this, you ensure that any close above resistance or below support is indeed a valid break and is thus less likely to move against your position.
That said, a level that lines up flawlessly with extreme highs or lows is a rare find. It’s okay if every wick doesn’t conform perfectly to the level you have drawn. What’s important is that it captures the essence of that area of value without cutting off too much of any one candlestick.
Note: By the time you finish the next topic, you will see why these minor details are so important.
Finding price action patterns is great, but they don’t become profitable until you can trade them effectively. And you can’t do that by using price structures that are unconfirmed.
One mistake I see quite often is attempting to trade a formation before it has fully materialized and thus presented a favorable opportunity.
Neither structure is confirmed until the market breaks the neckline. Without a close above or below this level, the price structure is insignificant. In fact, we can’t technically call it a head and shoulders until this happens.
Take the formation below as an example.
Note that at the point in the chart above, EURCAD had not yet closed the day below support. So not only is the reversal unconfirmed, we cannot yet call it a head and shoulders.
A few sessions later we have our break of the neckline and a confirmed reversal.
If you have made this mistake in the past, you aren’t alone. Heck, I even see Forex-related websites (I won’t mention names) calling particular formations a head and shoulders before it qualifies as one.
But this isn’t limited to reversal patterns. The same rule applies to something as simple as a channel or a wedge. While you can trade within the upper and lower boundaries, it typically isn’t advisable nor as profitable as waiting for a confirmed breakout.
Take the chart below. At this point, there isn’t much to do besides setting your levels.
Once you’re comfortable with the placement of support and resistance, it becomes a waiting game. After that, the only thing that should catch your attention is a close above or below resistance or support respectively.
Note that I said “close” and not “move.” It’s important to wait for a close beyond the upper or lower boundary of the pattern that you’re trading.
The chart above shows a 4-hour close below channel support, which confirms the pattern and sets up a potential short opportunity.
It doesn’t matter if you’re trading channels, wedges, head and shoulders, double tops or bottoms or some other variation of continuation or reversal patterns. The same rule always applies – technical formations are confirmed when the market closes beyond one of the two critical levels involved.
Always wait for the candle to close above or below resistance or support respectively before considering an entry. Not only will this provide a greater degree of conviction to any pending trade setup, but it will also help you develop the patience and discipline necessary to succeed.
Most Forex traders want to be active in the market every day. They believe that a trader is someone who is always trading.
The truth is, the greatest traders in the world understand the importance and value of sitting on their hands. They know that the power of doing nothing is greater than the power of doing something.
In other words, they are extremely selective about how and where they risk their capital.
What attracts most individuals to the lower time frames, at least in the beginning, is the ability to trade frequently. They believe that the more setups they take, the more money they will ultimately make.
As humans, we’ve been seasoned to think that more equals more, so why should Forex trading be any different, right?
Well, I’m here to tell you that it is different. In fact, it’s vastly different from any other endeavor you will ever pursue in your lifetime. As such, the conventional more-is-better approach doesn’t work, at least not in the way we’d like it to work.
For more on this, see the lesson I wrote on trading the higher time frames.
When it comes to technical patterns, the higher time frames will always produce better signals. I don’t say that as an opinion or an idea, but as a fact. As someone who has traded several markets and every standard time frame available since 2002, I think I’m in a place to make such a bold statement.
Why do the higher time frames produce better signals, you ask?
Unlike a 5 minute or 15-minute chart, the higher time frames, especially the daily, can filter out much of the “noise” during a session. Said another way, they help to normalize price action during periods of increased volatility.
As always, the best way to illustrate my point is by showing an example.
As you can see from the daily chart above, CADJPY had carved out a long-standing descending channel. Take particular note of the retest with the arrow above it.
The 4-hour time frame you see below is nothing more than a close-up of that same retest.
Notice the false break on the 4-hour chart. It just so happens that the markets were somewhat volatile on this day, so even the 4-hour time frame was susceptible to head fakes such as this.
However, those who remained on the CADJPY daily chart not only preserved their trading capital, they picked up a favorable entry on the bearish rejection candle that formed. I know for a fact that a few of my members were able to catch this trade which was good for several hundred pips.
Stick to the daily time frame and higher. I do 90% of my analysis on the daily and weekly time frames and occasionally move down to the 4-hour to secure a more precise entry or fine-tune a key level.
That said, if you are just starting out with price action, my suggestion is to remain on the daily chart until you are consistently profitable. Only once you can turn a consistent profit should you begin to venture into an intraday time frame.
At first, this one may sound a bit counter-intuitive. How can you trade the levels that make up a certain technical pattern and at the same time ignore key levels?
Let me start to answer that question by saying that it is indeed possible.
But the “key levels” I’m referring to are the ones formed by swing highs and lows outside of the pattern you’re trading. In other words, the profit targets created by the market.
The thing that makes measured objectives great is the same thing that makes them dangerous. Too many traders learn about the technique and begin blindly setting profit targets without first identifying other critical levels in the surrounding price action.
Let’s look at an example.
The chart above shows a head and shoulders pattern that had formed on the NZDJPY weekly chart. The measured objective for this particular formation was a healthy 1,000 pips.
As is the case with any move of this size, it didn’t occur without bumps along the way.
Shortly after closing below neckline support, NZDJPY caught a bid at an area of value. Now, if I hadn’t made myself aware of this level before taking a short entry, I might have panicked.
But I was prepared. I knew the level existed and was likely to influence price. I also knew that the recent break of the neckline was more influential than this horizontal support level, and thus decided to continue holding the position.
Sure enough, the pair only paused to consolidate before plummeting another 600 pips toward the measured objective.
If we move down to the daily time frame, we can see that this consolidation formed a wedge. As you may well know, a wedge is most often a continuation pattern, which was certainly the case here.
Now, because I made myself aware of this support level before entering short, I gave myself two options.
The option I chose is irrelevant. What’s important is to understand that by making myself aware of all critical levels before committing to a position, I gave myself options. And by preparing for every possible outcome, I was able to react logically rather than emotionally.
Always mark your support and resistance levels before you enter a position. By doing this, you give yourself options which in turn allows you to prepare for every possible outcome.
Also, never use a measured objective by itself. While they can offer an excellent way to identify a potential target while trading Forex chart patterns, they are most effective when used in combination with other critical levels.
Last but not least, always have a plan. You should always know what the plan is before risking capital. This way you can strategize with a neutral mindset rather than waiting until there is money on the line, which can influence your thought process.
What do I mean by “obscure or unfavorable” patterns? Simply put, I’m referring to the price structures that don’t jump out at you. If it takes you more than a couple of minutes to spot a technical pattern, it probably isn’t worth trading.
Now, I realize there are some who are just getting started in the Forex market and are thus not as quick to spot favorable opportunities. But even if you have only been trading for a month and understand nothing but the basics, you should be able to identify such formations within a matter of minutes.
Let’s test this theory, shall we? Take a look at the chart below and see if you can identify the most distinct pattern.
If you saw the head and shoulders that I’ve outlined below, congrats!
Pretty basic stuff, right?
And just to eliminate the chance that the example above is an anomaly, let’s take a look at another chart.
Take a couple of minutes to analyze the chart below and see if you can spot the same pattern I did at the time.
(Hint: It consumes the entire image.)
If you saw the massive rising wedge that I’ve pointed out below, you would have had a position that was eventually worth 1,000 pips in profit.
The EURUSD wedge you see above was not only obvious, but it was also extremely favorable. In fact, the subsequent breakdown turned out to be more profitable than any trader could have possibly imagined at the time.
The weekly chart above shows the aftermath. A simple wedge pattern triggered a selloff that would eventually span more than ten months and exceed 3,000 pips worth of damage. But even for those who stayed conservative and targeted the pattern’s low, it was still a 1,000-pip move.
The key takeaway here is that neither technical structure above was hard to find. By sticking to the higher time frames and taking a “big picture view”, we were able to identify the price action relatively quickly.
Learning to recognize the most prominent and favorable structures is half the battle. Once you master this step, the rest of your technical game will begin to fall into place.
Stick to the higher time frames and clear your mind of everything you want to see happen. Instead, stay neutral and focus on what is taking place in the market.
As human beings, we have a talent for only seeing the outcome that would benefit us and ignoring the risks involved. Doing this can get you in a heap of trouble as a Forex trader. So the next time you sit down at your trading computer, take a few minutes to absorb what the market is telling you.
Forget about previous annotations you’ve made or whether you have a bullish or bearish bias. Forget all of that. Then move out to the daily, weekly or even monthly chart, clear your mind and ask yourself, what is the market telling me? You may be surprised at what you see.
Take the two charts below. They both show the same chart pattern, but the second one allows your eyes to view the structure in the context of the surrounding price action, making it much easier to spot.
The price action above is somewhat obscure. However, once we zoom out, we can see that the AUDNZD weekly time frame isn’t so hard to read after all.
The potential inverse head and shoulders pattern (remember, it isn’t confirmed just yet), gives us a clue about the pair’s likely path forward.
Notice how the second chart is much easier to “read”. The reversal pattern becomes much more apparent once we expand the viewable area.
Regardless of how long you’ve been trading technical patterns in the Forex market, making any one of the mistakes outlined above is a surefire way to kill your profit potential.
Becoming consistently profitable boils down to trading the higher time frames, staying conservative and utilizing the most distinct price structures to form trade ideas.
If you’ve been making these mistakes, it’s okay. What’s important is that you’ve recognized the problem, and you’re willing to fix it, which I will assume to be the case if you have read this far.
Always remember that becoming a successful Forex trader is a process, not a project. You cannot attain success overnight, but the end game is certainly worth the time and effort required.
I hope that you now see why these are five of the most common and costly mistakes you can make as a Forex trader.
If you enjoyed this lesson, I recommend that you download the free summary PDF below.
The summary will show you how to avoid these five mistakes easily. I condensed this entire lesson into bullet points and charts just for you.
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Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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