How to Trade Chart Patterns with Target and SL - Forex GDP
Trading chart patterns is a popular strategy in Forex markets because these patterns provide reliable signals for potential price movements. However, simply recognizing a chart pattern is not enough for successful trading. Traders must also know how to set appropriate targets and stop-loss (SL) levels to manage risk and maximize profit. In this article, we’ll explore how to trade Forex chart patterns effectively with specific guidelines for setting targets and stop losses.
Understanding Chart Patterns
Chart patterns are visual representations of price movements on a chart, reflecting market psychology. They help traders identify potential reversals or continuations in a trend. There are three primary categories of chart patterns:
Reversal Patterns: These signal a potential change in trend direction.
Continuation Patterns: These indicate that the current trend is likely to continue after a brief consolidation.
Bilateral Patterns: These suggest that the price could break out in either direction, depending on market sentiment.
Common Forex Chart Patterns
Head and Shoulders (Reversal)
Double Top/Double Bottom (Reversal)
Flags and Pennants (Continuation)
Triangles (Bilateral)
Cup and Handle (Continuation)
How to Set Targets for Chart Patterns
Setting a target level is essential because it helps traders determine their exit point and secure profits. Targets are typically based on the height or width of the chart pattern. Let's examine how targets are set for common chart patterns.
1. Head and Shoulders
For the Head and Shoulders pattern, the target is calculated by measuring the distance between the head and the neckline. After a breakout from the neckline, traders can project this distance downwards (for a bearish reversal) or upwards (in the case of an inverse head and shoulders).
Example:
In a head and shoulders pattern on EUR/USD, the head forms at 1.1800, and the neckline is at 1.1700. The difference is 100 pips. After the price breaks below the neckline at 1.1700, the target can be set at 1.1600 (100 pips below).
2. Double Top and Double Bottom
In a Double Top or Double Bottom, the target is determined by measuring the height of the pattern from the highest peak to the neckline (for a double top) or from the lowest trough to the neckline (for a double bottom). The distance is then projected from the breakout point.
Example:
On the GBP/USD pair, a double bottom pattern forms with the troughs at 1.3800 and the neckline at 1.3900. The 100-pip height suggests a target of 1.4000 if the price breaks above the neckline.
3. Flags and Pennants
For Flags and Pennants, the target is based on the size of the preceding price movement (called the flagpole). After the breakout, traders measure the flagpole and apply the same distance in the direction of the breakout.
Example:
If a bullish flag forms on USD/JPY with a preceding flagpole of 150 pips, after the breakout, the target would be set 150 pips above the breakout level.
4. Triangles
For Triangle Patterns, the target is determined by measuring the widest part of the triangle (from the support to the resistance line) and projecting this distance from the breakout point.
Example:
In a symmetrical triangle on AUD/USD, the height of the triangle is 50 pips. After the breakout, the target is set 50 pips from the breakout level, whether it breaks upward or downward.
How to Set Stop-Loss Levels (SL) for Chart Patterns
Stop-loss levels are crucial for managing risk. A well-placed SL ensures that traders minimize losses in case the market moves against their position. Stop losses are usually set at key support or resistance levels beyond the breakout point.
1. Head and Shoulders
In a Head and Shoulders pattern, the stop-loss is placed above the right shoulder (in the case of a bearish pattern) or below the right shoulder (in the case of a bullish pattern).
Example:
In a bearish head and shoulders on USD/CAD, if the right shoulder peaks at 1.2800, and the breakout occurs at 1.2700, the stop-loss should be placed slightly above 1.2800, such as 1.2820, to give the trade some breathing room.
2. Double Top and Double Bottom
For Double Top and Double Bottom patterns, the stop-loss is set just above (in a double top) or just below (in a double bottom) the second peak or trough. This ensures that the trade is exited if the price reverses unexpectedly.
Example:
On AUD/NZD, if a double top forms with the peaks at 1.0800 and a breakout below 1.0700, a stop-loss can be set just above 1.0800 at 1.0820 to manage risk.
3. Flags and Pennants
In Flags and Pennants, the stop-loss is placed just beyond the consolidation pattern. For a bullish flag, the stop-loss would be below the flag pattern, while for a bearish flag, it would be placed above the flag.
Example:
In a bearish flag on EUR/CHF, with the breakout at 1.0800 and the top of the flag at 1.0850, the stop-loss would be set slightly above 1.0850, at around 1.0865.
4. Triangles
For Triangle Patterns, the stop-loss is placed just outside the opposite side of the breakout direction. For example, in an ascending triangle, the stop-loss is placed below the triangle's support line to avoid a premature exit.
Example:
In a descending triangle on the EUR/GBP pair, if the breakout occurs at 0.8600, with support at 0.8700, the stop-loss would be placed just above 0.8700, at 0.8720.
Case Study: Trading the Double Bottom on USD/JPY
In August 2020, USD/JPY formed a double bottom at the 104.00 level with a neckline at 105.00. After the price broke above the neckline, the target was set by measuring the 100-pip height, resulting in a target of 106.00. A stop-loss was placed below the second bottom at 103.80.
Result:
After the breakout, USD/JPY surged to 106.00, reaching the target within a week. The stop-loss remained untouched, providing a risk-reward ratio of nearly 2:1.
Conclusion
Trading chart patterns with clearly defined targets and stop-loss levels is an essential skill for Forex traders. By calculating potential profit targets based on the size of the pattern and setting appropriate stop-loss levels beyond key price points, traders can effectively manage risk while maximizing their chances of success. Whether using head and shoulders, triangles, or flags, understanding how to set targets and stops ensures a more disciplined approach to trading.
