In recent years, we have seen some major developments in the way CFD trading is conducted: new software programs, indicator tools, methods of chart analysis. Most of these developments, however, remove the human element from trade assessments and miss the highly subjective nature of market analysis. As much as we might like to believe that CFD trading can be totally automated by software programs and trading ‘robots’, the reality is that none of these methods can replace hard work and research into the identification of chart patterns.
The fact remains that chart pattern analysis is one of the most commonly used techniques for forecasting future CFD price activity and identifying potential position entries. Since this field of study is so intricate and complex, we will only attempt here to cover some of the basic assumptions involved when looking at chart pattern structures and the implications involved when CFD trading signals are generated.
Overall, chart patterns can be separated into two categories: reversal patterns and continuation patterns. Reversal patterns give signals to CFD traders that a current trend is over-extended and will soon be changing direction. Continuation patterns send signals that the underlying momentum within a larger trend is still strong and that the trend has yet to complete its overall impulsive wave.
Most successful traders will use these patterns in conjunction with other key elements (such as technical indicators, macroeconomic data releases, or stock trading volume) to determine the validity of the underlying chart formation. When all of these factors are in agreement, the trade signal is seen as being more valid (or as having a higher probability of predictive accuracy).
For example, one of the most famous chart patterns is the ‘head and shoulders’ formation. This pattern is comprised of three price peaks, with the middle peak (the ‘head’) being the highest and the two outside peaks (the ‘shoulders’) both slightly lower. The main assumption here is that prices are in an uptrend but that this trend is reversing, as prices are unable to retest the highest peak at the end of the pattern.
This lack of market conviction is considered a bearish signal (within an uptrend), so when this chart pattern appears many traders will start to consider short selling as a CFD trading strategy. It is also possible to have a ‘reverse head and shoulders’ pattern. In this case, the peaks are inverted (creating troughs) and this is viewed as a bullish signal, indicating that the previous downtrend is running out of steam.
One of the most important factors when looking for chart patterns is the element of volume, as this is seen as a measure of market sentiment that will either confirm or invalidate the chart formation. Another common phenomenon is that continuation patterns generally tend to become visible on shorter-term timeframes (with reversals often visible in longer-term charts). This should not be surprising given that, in continuation patterns, a good portion of the underlying move has already taken place. This would not be the case for reversal patterns.
Some other commonly referenced chart patterns include double tops and triple tops (and double and triple bottoms). A double top, for example, is a bearish reversal signal, with two price peaks seen in the same area: the assumption here is that prices have rallied twice to the same resistance level and then failed, strengthening that level and leading many to predict that prices will be unable to breach that area in the future.
This would be viewed as an even stronger resistance level if a triple top had occurred there, as prices would have then failed three times in that area. You should remember that the same logic holds for double bottoms, where prices have twice found support at a lower level and bullish momentum is then likely to start building.
In contrast, triangle patterns are generally viewed as continuation patterns. In a triangle formation, prices form a straight lower base while the hypotenuse constricts price activity for a definite length of time. A break of the resistance line will confirm that the original uptrend is in place and that the underlying momentum is set to continue.
There are several variations of the triangle chart pattern for uptrends and downtrends, and a small amount of research will show that there are many other chart patterns commonly used by CFD traders. For example, flags and patterns are short-term continuation patterns, while rising and falling wedges are typically viewed as reversal patterns, if the wedge matches the prevailing trend.
A firm understanding of these patterns is essential for any trader wishing to employ trend-based CFD trading strategies. Trading CFDs requires the ability to spot entry points in the most favourable areas (helping to eliminate drawdown and decreasing the possibility of margin calls). To accomplish this, new CFD traders should research the many chart patterns that have been identified and begin looking for them on charts in different CFD asset markets.
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