Trading Diverging Chart Patterns

Apr 27

Continuing our discussion on trading chart patterns, this is our next tutorial after Trading Converging Chart Patterns

This tutorial is based on our earlier articles on pattern identification and classification.

• Algorithmic Identification of Chart Patterns
• Flag and Pennant Chart Patterns

In this tutorial, we concentrate on diverging patterns and how to define rules to trade them systematically. The diverging patterns discussed in this tutorial are:

• Rising Wedge (Diverging Type)
  
• Falling Wedge (Diverging Type)
  
• Diverging Triangle
  
• Rising Triangle (Diverging Type)
  
• Falling Triangle (Diverging Type)
  

🎲 Historical Bias and General Perception
Before we look into our method of systematic trading of patterns, let's have a glance at the general bias of trading diverging patterns.

🟡 The Dynamics of Diverging Wedge Patterns
Diverging Wedge patterns are typically indicative of the Elliott Wave Structure's diagonal waves, potentially marking the ending diagonal waves. That means that the patterns may signal the ending of a long term trend.

Hence, the diverging rising wedge is considered as bearish, whereas the diverging falling wedge is considered as bullish when it falls under Wave 5 of an impulse or Wave C of a zigzag or flat.

For an in-depth exploration, refer to our detailed analysis in Decoding Wedge Patterns

Both rising wedge and falling wedge of expanding type offers lower risk reward (High risk and low reward) in short term as the expanding nature of the pattern will lead to wider stop loss.

🎯 Rising Wedge (Expanding Type)
Expanding Rising Wedge pattern is historically viewed with bearish bias.



🎯 Falling Wedge (Expanding Type)
Expanding Falling Wedge pattern is historically viewed with bullish bias.



🟡 The Dynamics of Diverging Triangle Patterns
Diverging pattern in general means increased volatility. Increased volatility during the strong trends also mean reducing confidence that may signal reversal.



🎲 Alternate Approach towards trading diverging patterns

Lack of back testing data combined with subjectivity in Elliott wave interpretation and pattern interpretation makes it difficult to rely on the traditional approach. The alternative method involves treating all expanding patterns equally and define a systematic trading approach. This involves.

1. When the pattern is formed, define a breakout zone. One side of the breakout zone will act as breakout point and the other side will act as reversal point.
   
2. Depending on the breakout or reversal, trade direction is identified. Define the rules for entry, stop, target and invalidation range for both directions. This can be based on specific fib ratio based on pattern size.
   
3. Backtest and Forward test the strategy and collect data with respect to win ratio, risk reward and profit factor to understand the profitability of patterns and the methodology.
   

Breaking it down further.

🟡 Defining The Pattern Trade Conditions

Base can be calculated in the following ways.

• Distance between max and min points of the pattern. (Vertical size of the pattern)
  
• Last zigzag swing of the pattern (This is generally the largest zigzag swing of the pattern due to its expanding nature)
  

This Base is used for calculation of other criteria.

🎯 Breakout Zone - Entry Points
Breakout zone can be calculated based on the following.

Pine Script®

If the direction of the last zigzag swing is downwards, then top will form the reversal confirmation and bottom will form the breakout confirmation. Similarly, if the direction of the last zigzag swing is upwards, then top will become the breakout confirmation point and bottom will act as reversal confirmation point.

🎯 Stops

Long entry can act as stop for short and vice versa. However, we can also apply different rule for calculation of stop - this includes using different fib ratio for stop calculation in the reverse direction.

Example.

Pine Script®

🎯 Invalidation

Invalidation price is a level where the trade direction for a particular pattern needs to be ignored or invalidated. Invalidation price can be calculated based on specific fib ratios. It is recommended to use wider invalidation range. This is to protect ignoring the potential trades due to volatility.

Pine Script®

🎯 Targets
Targets can either be set based on fib ratios, as explained for other parameters. However, the better way to set targets is based on expected risk reward.

Pine Script®

🟡 Back Test and Forward Test and Measure the Profit Factor
It is important to perform sufficient testing to understand the profitability of the strategy before using them on the live trades. Use multiple timeframes and symbols to perform a series of back tests and forward tests, and collect as much data as possible on the historical outcomes of the strategy.

Profit Factor of the strategy can be calculated by using a simple formula

Pine Script®

🟡 Use Filters and Different Combinations
Filters will help us in filtering out noise and trade only the selective patterns. The filters can include a simple logic such as trade long only if price is above 200 SMA and trade short only if price is below 200 SMA. Or it can be as complex as looking into the divergence signals or other complex variables.