Momentum Trading with the Wave and Chart Patterns. 

(If I were told I had to teach you just one set up...this would be it!  If I did nothing but momentum trades for the rest of my trading career I would still have no problem finding and capitalizing on trades.  I did three momentum trades today -- just over the course of about 35 minutes this morning and made 98 pips.  I mention this not to impress, I'm sure there are more aggressive traders that me who made much more, but I want you to see this this entry style is very powerful!)

It was only after I embraced market cycles that I truly began to understand what to do with all the “lines and levels” I had learned to draw on my charts.  Early on as I began teaching myself to trade in the late 1980’s to early 1990’s there were not many books available to read about the subject of technical analysis.  I found myself gravitating towards price (instead of news) because my mother was a bit of a market timer (although not trained nor conscious that she was indeed market timing). 

Price and price action made sense to me and I ventured into charting armed with my father’s old engineering graph paper, drawing my own charts based upon the closing price I would get from my commodity futures broker.  It was also during this time I went to college and discovered the books that would forever shape my view of the markets.  Books by Richard Schabacker and Richard Wyckoff were like the light I was searching for in my quest to become a trader.  What is interesting about the books I read early on was that they were written in the early 1900’s and are still as true and applicable today as anything on my bookshelf. 

The other pivotal moment in my trading as I alluded to earlier was the introduction of market cycles to my chart analysis.  My bread and butter trades are momentum trades.  Let’s first define what this is to me because there are so many definitions of this that I want to be sure we are on the same page.  Momentum trading is an entry style that is based upon entering a market as it break out or breaks down from a sideways market.  Sideways markets are cycles of congestion or consolidation.  Congestion is typically a wider ranging sideways market with higher volatility and a little more erratic support and resistance levels as compared to consolidation.  Consolidation is a narrower sideways market with firm support and resistance levels, that is the levels have little variance between the highs that make up resistance and the low that make up support.  It is during these sideways markets that two of my favorite patterns for momentum trading develop:  triangles and rectangles.  Both these sideways market descriptions were born of the fact that they were initially discussing the stock market, where there is a buy-side bias.  So consolidation is that low volume, quiet channel where a stock is typically bought with little notice.  Congestion typically follows an uptrend and is an interesting mix of selling muddled with late-comers to the uptrend who are buying.  However since there is not enough interest and money chasing the market higher, the market levels off into a wider range, as compared to the accumulation cycle.  Now when talking about markets such as commodity futures and forex, this is not as apparent, especially in the forex market where the buy-side bias is not as prevalent. 

Chart patterns are powerful tools as they are the visual embodiment of price action on a chart.  That being said I think that there is one distinction that took my analysis of chart patterns to the next level.  Early on I would memorize the criteria as well as nuances of chart patterns such as my aforementioned triangles, rectangles, wedges, flags, head and shoulders, and rounded tops/bottoms.  I would scan charts for hours a day looking for these gems on the charts.  Back then, that meant flipping through large, printed, daily charts that were mailed to my home once a week.  With pen and ruler in hand I would draw the lines of the patterns I knew.  Those were great days - long days.  Starting something new is always exciting and discovering charting patterns only to see that my analysis was (mostly) right on was a thrill.  But still, I wanted to know what “went wrong” on those patterns that would whipsaw me. 

Before entering any market, it is vital that a trader (or investor) know what market cycle a chart is in.  Markets travel in one of four market cycles at any given time:  accumulation (consolidation), distribution (congestion), mark up, or mark down.  Mark up is simply an uptrend and mark down is a downtrend.  Here’s the next challenge every chartist faces:  How to consistently determine which market cycle a chart is in. 

Looking back on price, it’s always easy to see what the chart has already done.  The key to charting analysis is being able to determine this as a market is trending or as the market is heading sideways.  I do this quickly and easily with a simple visual tool I call the Wave.  The Wave is made up of three individual 34 period exponential moving averages - one on the high, one on the close, and one on the low.  These three exponential moving averages create a “wave” that travels across the chart and by looking at the direction the lines are traveling I can determine if there is a trend and how strong it is.  More importantly, the Wave tells me when there is no trend at all.  And this is precisely when I look to set up a momentum trade, when there is no trend. The 60 minute chart of the British Pound has a flat, sideways Wave.  This gets my attention because now I will look to draw trendlines, support and resistance and see if there is a chart pattern on this chart.  I will only use congestion and consolidation patterns like triangles (symmetrical and asymmetrical) and rectangles in the sideways market cycles that I have identified with the sideways Wave.  This is a key component to using chart patterns.  Congestion and consolidation patterns should only be used in sideways markets. 

It is important to go about identifying chart patterns by finding the building blocks of the pattern.  One thing I realized early on is that I don’t want to enter trades by looking for the specific patterns, like triangles or head and shoulders.  After all, what is a symmetrical triangle but the convergence of an uptrend and downtrend.  No matter the head and shoulder’s location, inverse or otherwise, what is a neckline but support or resistance?  Once all the trendlines, support and resistance levels are drawn on a chart, only then can I look for any patterns those lines and levels may have formed.  This is a very different approach as opposed to looking for a specific pattern.  Look hard enough at the clouds and your eyes will find a bunny.  Look hard enough at the charts with a specific pattern in mind and it will appear. 

 It’s only after drawing the lines and levels on the chart do I see that a triangle pattern has formed and this is exactly the kind of pattern I like to see when setting up momentum trades.  Without this triangle pattern there would be no way to mark and measure the potential breakout or breakdown on the chart.   This pattern – along with the sideways Wave – offers me a momentum set up on this 60 minute chart of the Pound.  In a momentum set up I do not carry a bias as to which side prices may break.  The point is that there is no trend and that as a momentum trader I am waiting for the momentum to show itself to me.  I do however use a confirmation indicator, the MACD Histogram.  This allows me to confirm a move after the prices breaks through either the support or resistance level.  So when prices finally broke through the support of multiple uptrend lines as well has support levels all I have to do is acknowledge the price trigger of the short and then glance down at the MACD Histogram reading.  I use the MACD Histogram in an “on/off” fashion so in this scenario, the MACD Histogram simply has to be negative or below the zero line.

While the MACD Histogram is not much below the zero line, in the “on/off” way I use it, it is negative so the trade is confirmed.  As prices break through the bottom of the triangle chart pattern, think about what is really happening:  support is giving way.  In this case that support is an uptrend line and that uptrend line is half of what makes up this triangle pattern.   

One of the challenges of trading support and resistance levels and chart patterns is how to determine that the pattern has confirmed an entry.  In my opinion, it is not the job of the pattern to confirm, rather only to trigger.  Because I have the MACD Histogram to confirm the pierce through the pattern, I do not have to wait for the candle to close; I can enter at the pierce of the pattern thus optimizing the chart pattern based momentum entry. 

The follow through from a triangle pattern with a sideways Wave is usually swift as momentum trading is like getting on the base of a trend.  Consider that as a market cycles from trending to sideway to trending again, a sideways market typically precedes a trend and therefore if the momentum persists in an organized way, the Wave will also shift from the sideway direction and angle upward or downward signaling a shift away from the balance of a accumulation or distribution cycle to a trend.  Momentum traders can be effectively traded by

1. Identifying a chart with a flat, three o'clock Wave

2.  Drawing all the uptrends, downtrend, support, and resistance lines that are on the chart and see if a congestion or consolidation pattern has formed.  (The only time you really need to spend time drawing the lines and levels on a chart is when you see a sideways Wave)

3.  Wait for the price trigger.  This means that you will wait for prices to pierce the support or resistance levels of the chart pattern, then and only then go to step four.

4.  Check the MACD Histogram for confirmation of the price break direction.