Why “Busted Chart Patterns” are EVERYWHERE and How to Identify These Obscure Traps to Grow Your Account
I want to start this week’s report by delving into a detailed discussion on busted chart patterns.
When I first started trading, I absorbed material from all kinds of sources to learn about technical chart patterns. Whenever I spotted one, I typically got really excited and thought that once I saw something, it affirmed where the market was going to go.
Things aren’t always that simple, however. It took me a while to evolve my thinking about how I look at the market and specific patterns. That includes the times when they work and when they don’t.
I’ll illustrate this with a current weekly chart of AUDCAD (the Australian dollar versus the Canadian dollar):
Typically the way I view this chart is to note the governing price pattern: the double top all the way back at the 1.06 price area. That market top suggested AUDCAD would likely to go lower and that's exactly what happened. There was a series of descending movements. For a while, these were checked by a new neckline.
Then that support failed during the coronavirus panic and AUDCAD broke lower. It seems that the final breakdown fulfilled the expectation of the double top.
Because now you can see AUDCAD’s price action is starting to go the other way. Is this just a bounce within a bear market? Or is this now what I call a busted pattern?
A busted pattern is when price breaks out against the trend suggested by the governing pattern. AUDCAD has broken the long neckline that acted as support for several years. It now looks ready to start busting ALL the bearish price patterns that built up in earlier years, including the multiple tops that came after the original double top.
For now AUDCAD is around 0.94 after busting that long-term neckline at 0.92.
How does a pattern bust like this? The market likes to confound most people by changing when they least expect it. Once everyone “knows” the price will drop, it eventually reverses and the market takes on a life of its own against expectations.
That phenomenon traps a lot of traders who expected the earlier trend to continue forever. And the reversal can have explosive effects when those traders finally throw in the towel and exit their positions.
So will AUDCAD keep moving up?
To support the busted pattern idea in the pair (and a new uptrend), there looks to be an intermediate inverted head and shoulders with a sloping neckline forming now. The neckline is sloping because the right shoulder is higher than the left. Because of the pronounced upward tilt, my expectation is that not only will AUDCAD continue rising but it will rise swiftly.
There was also a bullish key reversal in the last week. AUDCAD made a new low and then closed on the high. Since key reversals often point in the direction the market wants to go, I’d say AUDCAD has busted that earlier double top governing pattern, established a (tentative) new one with the inverted head and shoulders, and is set to keep moving up.
Perhaps even a better example of a busted chart pattern is NZDCAD (the New Zealand dollar versus the Canadian dollar):
Again we see a classic double top at the 0.98 level, plus a series of peaks on either side which makes this a complex head and shoulders pattern.
A double top combined with a head and shoulders should set the price action on a perfect trajectory lower. This did happen, but once NZDCAD traded below the long-term neckline of that pattern, the response was not in line with expectations.
When price action doesn’t agree with my price analysis (and therefore expectations), it’s time to examine what the market is telling me. You can see that rather than a decisive breakdown below the neckline, NZDCAD instead bounced quickly. That created a bear trap for every trader who bet on a breakdown and went short below that neckline.
And now NZDCAD is trading considerably higher.
However, the new upward trajectory is facing a few obstacles. There’s a downtrend line NZDCAD still has to break, plus a resistance level (defined by a key reversal at that price) that must be cleared.
If NZDCAD can take out those levels (right now they’re just above its current price), that will be the catalyst for a new bull market in NZDCAD as the old bear pattern that was controlling it will be successfully busted.
Now let’s look at the opposite of a busted pattern …
In this chart, I'm looking at GBPJPY (the British pound versus the Japanese yen):
Here the market is confirming the governing structure that’s in place, which is a bearish double top and head and shoulders pattern.
You can see once GBPJPY went through the neckline for that pattern, it’s dropped significantly and hasn’t managed more than a lower double top within a complex head and shoulders. All of this bearish price action has been contained with a larger rounding top formation for the last few years.
And then GBPJPY recently tested the resistance line at 140 but failed to rally.
Therefore all price action remains bearish and my expectations are that GBPJPY will keep falling and eventually take out its last line of support. This is why I remain short GBPJPY.
Now of course we could see continued volatility and a narrow range of trading before the descent continues. But over time I expect that GBPJPY will NOT bust the existing patterns and will instead set new lows.
Here’s GBPCHF (the British pound versus the Swiss franc) at the monthly level for another example of similar behavior:
Again, there’s no ambiguity in this chart. There are no busted patterns here and GBPCHF has behaved according to the existing patterns and trend for 14-15 years and counting.
GBPCHF remains in a huge downtrend and the best the bulls could do is an intermediate double top at the 1.50 area. After that, the next leg lower began and GBPCHF is currently poised to take out the next support level.
I believe GBPCHF will soon be challenging multi-year lows at around the 1.10 level based on the trajectory of this chart. I see nothing to stop it.
In fact, the British pound is the weakest currency on the board and the Swiss franc is one of the strongest. The Japanese yen is another of the strongest, and so my expectation is that the pound will continue going lower against both.
Therefore GBPJPY and GBPCHF should keep dropping.
Now it’s time for a look at the USDI (the US Dollar Index) which measures the dollar against half a dozen of the most liquid currency pairs:
At the height of the pandemic panic, USDI made what I feel is an exhaustion top that will establish a long-term trend for a lower dollar over time.
But having said that, USDI hit a level of support a couple weeks ago and carved out a key reversal. This support will likely keep the dollar in a tight support range for the next little while, perhaps even as long as the entire summer season.
While I’m a long-term dollar bull, it could still rise against the weaker currencies such as the British pound in the near term:
GBPUSD has already been in a 10-year downtrend. There have been two double tops along the way, each of which set in motion another leg of the downtrend.
Right now there’s some interim support right around 1.20 area in GBPUSD, so this pair might remain range-bound, but it does look like this pair is setting up to challenge its all time lows at some point this year.
For comparison, here’s USDJPY (the US dollar versus the Japanese yen):
For the last few years, I've been pretty bearish on USDJPY based on the governing double top and head and shoulders pattern. Since then, USDJPY has established a long-term descending triangle which is also bearish.
On that basis, it's my expectation that over time USDJPY will continue to drop.
However, I always try and envision the other side of my analysis. This is why I started this discussion with some examples of busted patterns.
So here’s an alternative view to my long-term USDJPY bear stance:
From a neutral perspective, you can make the case that USDJPY has been forming a long-term symmetrical triangle going back six or seven years. That suggests the pair could be ready to rise sharply instead of dropping.
But what would constitute a busted pattern here is a breakout above that upper trendline of the triangle and so far, I don’t see that happening.
There’s just too much bearish action in place, including the H top (a narrow double top) that strongly suggests USDJPY is headed lower. And that’s why I'm sticking to my guns by remaining a USDJPY bear.
It’s entirely possible that the price action will kick around inside the triangle (either the bearish descending one or the neutral symmetrical one) for many more weeks. But I think ultimately USDJPY will bust lower.
If it doesn't (and USDJPY can make it over 112 and hold) then that would create a situation where I would re-evaluate my analysis and consider the bearish patterns are busted.
Until then, I’m looking for USDJPY to drop through 104, then 102, and then much lower over time.
Let’s move on to the precious metals, starting with XAGUSD (spot silver):
There’s growing potential for a busted price pattern in silver just like we’ve seen in NZDCAD and AUDCAD.
Silver broke below the long-term descending triangle during the pandemic crisis and created what looks to be a bear trap below the neckline of the triangle.
However, silver has to exit the triangle on the upside (and hold) to create a busted pattern and a valid bull case for the metal.
In other words, I need to see silver making new highs and surging past $21.15 to break the pattern of lower highs over time. Only then can I see silver prices soaring as the metal takes on a life of its own.
Until this happens, silver could remain trapped in the triangle and turn back down to the neckline … again.
So we’re right at an inflection point in silver and I'm going to be monitoring prices very closely. The potential for a busted pattern and a soaring silver price are tempting, but its too early to call yet.
Meanwhile, XAUUSD (spot gold) has been in an uptrend:
Back in 2015, gold established a bullish double bottom pattern flanked on either side by a series of shoulders. That makes the overall pattern an inverted complex head and shoulders.
Once gold smashed through the neckline at $1,380, that set the stage for an impressive climb to current levels.
Gold has been trading within a reverse triangle and has been consolidating and rising right at the upper trendline of the triangle. Any momentum here is likely to carry gold much higher.
On the other hand, gold could be vulnerable to dropping back into its recent consolidation range.
So as with silver, I'm going to be monitoring the price action of gold very closely as both metals are at key inflection points right now.
Now here’s the NASDAQ stock index:
Recently the NASDAQ broke above its highs but also carved out a bearish key reversal. The index made a new high and then closed on the low. This suggests that all good things must come to an end.
I think the recent run was a bit of a short squeeze where the market got ahead of the fundamentals. I believe the NASDAQ is likely to return to a trading range somewhere within the ascending broadening price pattern I’ve drawn here.
While I don’t think we’re about to see a drop that would break through the lower line of that pattern, I can see a 10%, 15%, maybe even 20% pullback from recent highs.
More immediately, I expect prices will fall over the next couple of weeks with the bearish key reversal in place.
One more chart for you, this time the S&P500 stock index:
While the NASDAQ went to a new high, the S&P fell well short of that metric. It just turned over and is likely to stay within the range it’s in at the moment.
The key point is that there’s a bearish divergence with the NASDAQ going to a new high even as the S&P500 and also the Dow didn’t. When you see this kind of divergence, it supports the case that the outlying index (the NASDAQ in this case) is likely to fall until it conforms with the others.
In the meantime, I’m bearish on GBP and bullish on CHF and JPY. I’m long-term bearish on USD but neutral in the short term.
I’m also waiting for the precious metals to “prove it” and break out to new highs … or not.
I wish you a very healthy and prosperous trading week.
Regards, Mark "BustedPatterns" Shawzin