200 DAY MOVING AVERAGE & CHART PATTERNS
Chart patterns do not form frequently on price charts. If you find yourself looking for a chart pattern on a specific chart of your interest, pause for a second and remind yourself that the longer you search for a pattern the higher the chances that you will see some sort of a pattern that actually is not a valid pattern.
How do we overcome this “over-analysis”? We set certain criteria before we even start looking for chart patterns.
One criteria for me is to look for bullish chart patterns in an uptrend and to look for bearish chart pattern in a downtrend. But first we need to identify what is an uptrend, downtrend and sideways market.
Below exercise is to identify which areas are Sideways, Uptrend or Downtrend.
Drag and Drop numbers to correct market phases.
Long-term averages are great tools to help us stay on the right side of the market. We can get help from long-term averages by confirming price action relative to the average. In an uptrend price will remain above the long-term average more often than not. In a downtrend, price will remain below the long-term average and in a sideways movement, price will fluctuate around the average. I use the 200-day exponential moving average (learn more about different averages) as a trend filter. I look for bullish chart patterns above the 200-day average and bearish chart patterns below the 200-day average. A breakout should take place in the direction of the overall uptrend. Likewise, a breakdown needs to be confirmed with price action either below the 200-day average or breaking below the 200-day average at the same time of chart pattern completion.
Over the past 8 years the chart above (GERMANY MDAX INDEX) offered 4 major chart pattern breakout/breakdown opportunities. Combined with the trend identification (price action relative to long-term average), one could have taken advantage of those long-term trends with the help of classical chart patterns. Below we will analyze 4 chart patterns that offered directional movement on MDAX Index. By clicking on the chart above you can expand the image for better resolution.
In Area 1 MDAX formed a 16 month-long H&S continuation with a well-defined horizontal boundary. The pattern had a complex head. Though the horizontal boundary had minimum 4 touches and the breakout was on the 5th attempt. The right shoulder settled above the 200-day average and the breakout took place when price was clearly above the long-term average and in an uptrend. As you can see, we first confirmed the price action relative the long-term average and then acted on the breakout signal.
In Area 2 the index formed a 6 month-long symmetrical triangle. Symmetrical triangle is a neutral chart pattern. As the price settled above the long-term average we were prepared for a breakout higher and a continuation of the existing uptrend. But we also realized that incase of a breakdown the symmetrical triangle can act as a top reversal chart pattern. Both the lower boundary of the symmetrical triangle and the 200-day average overlapped at the same level, making it an inflection point. Breakdown not only completed the symmetrical triangle as a top reversal but also breached the 200-day average, confirming the downtrend.
In Area 4 the index has recovered from a correction. The first part of the advance remained below the long-term average. As the rectangle chart pattern started to become visible, the index settled above the 200-day average, offering a high conviction long trade setup. Breakout was followed by a similar advance when compared with the beginning of the uptrend. Rectangle acted as a bullish continuation chart pattern and marked the midway of the uptrend.
In Area 6 MDAX Index after a lengthy uptrend started forming a top reversal chart pattern. First the index sold off to test its long-term average. Then price fell below the 200-day average and broke down the neckline of a double top chart pattern. Breakdown took place below the long-term average and confirmed the downtrend.
So which comes first? Is chart pattern signal more important than trend direction or the other way around? I’m sure many of you have read “trend is your friend” phrase in different books/articles. Yes, trend should be your friend. You need to make sure you are trading in the direction of the overall trend. That is the path of least resistance.
To summarize: When price is above the long-term average, act on bullish signals. When price is below the long-term average, act on bearish signals. Those setups should offer high conviction trade signals.
