Do you know what traders trade? What exactly they look for in the charts?
The answer is Pattern. A technical analyst who is willing to trade will always search for a pattern in the chart.
Basically, trading pattern is one of the easiest ways to trade because they will always have certain entry and exit points. What we have to do is just identify the pattern perfectly.
In this topic, we are going to discuss a pattern which is about 85 years old and first mentioned by Richard Schabacker’s 1932 book: “Technical Analysis and Stock Market Profits,”. The pattern which looks like a megaphone is seen in a trending market.
There are various nicknames for this pattern like Broadening wedge and Inverted Symmetric triangle. But in this topic, we will name it as Megaphone pattern.
What is it?
Megaphone pattern is a pattern which consists of minimum two higher highs and two lower lows. The pattern is generally formed when the market is highly volatile in nature and traders are not confident about the market direction. Normally this pattern is visible when the market is at its top or bottom. The greater the time frame is better the pattern will work. However, traders love this pattern when it is formed in a daily or weekly time frame.
To get a better idea of different aspects of technical analysis you may do: NSE Academy Certified Technical Analysis
Have a look at this picture. These are the idle Megaphone Pattern.
How to identify this pattern?
Generally, Megaphone Pattern consists 5 different swings. But the swing has to have minimum two higher highs and two lower lows. A trend line is drawn by connecting point 1 and point 3 while point 2 and 4 are also joined together to draw a line. These two lines create a shape which looks like a megaphone or inverted symmetric triangle. This swings high and lows have to close above or below its pivot line and therefore they will create swing high as pivot high (R1, R2 and R3) and swing lows as pivot lows (S1, S2 and S3). A breakout occurs when the line does not respect its support or resistance line and close outside the shape after making the 5th swing.
Theoretical ways to trade the pattern:
Megaphone pattern is known to give multiple trading opportunities to the trader.
A trader can trade Megaphone pattern as
- Breakout Trades
- Swings trades (while making higher highs and lower lows)
- When the Price fails to give a breakout.
When the price breaks the trend line after making the 5th swings and closes outside the pattern, a breakout is confirmed. Breakout may happen in positive or in a negative direction. Depending upon the market condition and the position of the pattern in the chart, bullish and bearish breakout happens.
This is the chart of July 2016 Sensex. As we can see the market was in a strong uptrend. From the beginning of June, the pattern started taking shape and finishes in one month. The trend remains in an upward direction after price breaks the upper line of the pattern (Point number 5).
After a prolonged bull run, when this pattern is formed at the top and the price closes below its lower trend line, then it acts as a trend reversal pattern.
But, if the price closes above the higher trend line and makes new higher highs in the chart then it will be termed as a Continuation Pattern.Traders can take a trade when price closes outside the pattern (in whichever direction) to get the best possible confirmation of the breakout.
Though this is a Geometrical pattern, it has a tendency to respect Fibonacci levels. Respecting and maintaining Fibonacci levels without respecting Pivot lines is not possible. So it is obvious that this pattern will have a certain line which will be its pivot line and accordingly resistance and support lines will also be there in that pattern.
Also, read Fibonacci and Stock Market Analysis
For long trades, RI and R2 may act as a probable resistance while S1 and S2 may act as a probable support for a short position.
In case of breakouts finding the target is a bit tricky. Because it is nearly impossible to find out the perfect exit. But there is a way to make an exit. Generally, traders calculate the distance between two trend lines from the point it breaks and books partial or full profit when the price reaches 60% of that Redline (upside or downside) as shown in the figure.
This is the Daily chart of Jet Airways. After a downtrend Megaphone pattern forms. The green line (1) indicates the length of the gap of Resistance and support line. Line number 2 is the nearly 60% of that gap line (1), where we can book our profit.
This pattern also can be traded when it fails but is necessary to identify the failure perfectly. Now how to spot the failure?
A failure can be spotted when it fails to break the trend line (upper or lower as the case may be) after completing the 5th swing.
Suppose in a bull market condition, this pattern is formed and if it fails to break the upper trend line, traders go short when the price goes below 3rd swing high (R2).
Similar is the scenario, when the market is in a bear phase and it fails to break lower trend line (S2), trader take a long position when price closes above 3rd swing high.
Here is the chart of TCS we can see that every time price is respecting its supports zone and beautifully following the trend line. When price unable to break its resistance line (Upper line connected by point 1, 3 and 5) after the 5th swing, a short position can be added below the black line as shown in the figure.
Patterns are easy to trade. But finding the pattern from the chart and identifying it properly is the main art of trading. Sometimes only pattern is not enough to take best trading decisions you may need multiple indicators to identify better entry and exit points.