Autochartist In-Depth: Non-Trending Patterns

Non-trending patterns are a powerful way to take advantage of indecision or confusion in the market.

There are two types of sideways markets: accumulation and distribution. Accumulation cycles are quiet, narrow ranges, while distribution cycles are wider and more volatile while moving within a range. To distinguish between the two, the simplest way is to consider a pattern's initial trend reading.

If the initial trend reading is medium to low, the market can be considered sideways. The lower the reading is, the more likely that the market is in accumulation; if the reading is closer to medium it suggests either a distribution market or a weak trend.

While this process of establishing a trend is not completely objective, you can also look at the pattern's shape and angle to help clarify the market's direction. Knowing what type of cycle you're looking at will help you understand whether you should use a breakout/breakdown or fading strategy to trade on the pattern's resistance and support.

Trading strategies

Trading with breakout/breakdown strategies is also known as 'momentum' trading. This involves waiting for price action to pierce the support or resistance of patterns such as triangles, rectangles, and pennants. These patterns are best traded when the market cycle is in accumulation and the initial trend reading is low.

To trade a distribution cycle 'fade' – which basically means shorting resistance or buying support – the pattern needs a horizontal support (a 'floor') or resistance (a 'ceiling') level. As such, those patterns with horizontal lines of support/resistance – i.e. rectangles, ascending triangles, and descending triangles – are best suited to 'fade' trading.

Notice the three bars on the initial trend on this pattern reading – on the dividing line between a low and medium initial trend. This opens the door to a fade from the horizontal 'floor' of the descending triangle pattern.

Not all support lines will be strong enough to hold prices within the pattern. For further confirmation of this you can look at key price levels and the Autochartist breakout (B) reading. Since the example shows a very low reading, the lower momentum at the time of the breakdown suggests negligible follow-through, but there is always the chance that the pattern defies expectations – so it would be sensible to limit risk by keeping a tight Stop-loss (10 to 12 pips) on any fade off a floor or ceiling.

In the above pattern the initial trend reading is relatively weak – just two bars. However, the breakout through the triangle pattern's resistance shows strong momentum along the line of the trend, illustrating that there is no way to be 100% sure that a pattern will reverse or follow through. In the end every trading approach needs a solid risk management strategy. Understanding pip movement and volatility at the entry point (as well as throughout the position) is the first step, best taken by considering the pattern's timing in terms of forthcoming economic data releases.

Setups and entry strategies

If a trending market is indicative of an imbalance between buyers and sellers, a sideways market reveals that supply and demand are approximately matched and as such prices are likely to remain relatively stable. You have to wait for a shift in this balance for an entry point to open up, as prices pierce the support or resistance of patterns such as triangles and rectangles. Keep in mind that there are two potential entry scenarios for non-trending patterns, depending on whether the market is in distribution or accumulation.

To determine whether you're seeing an opportunity for a momentum entry or for a distribution fade entry, look first at the pattern itself. Distribution fade entries rely on a horizontal ceiling or floor, allowing you to sell from resistance and buy from the floor. As such, rectangles and ascending/descending triangles are the patterns you should be looking for as potential fade setups.

The initial trend reading for this setup should ideally be medium. A low reading indicates an accumulation setup, while a high one suggests the underlying market cycle is most likely trending. Try to confirm this with a view of the live chart.

In this example, the resistance is angled slightly upwards but effectively horizontal, giving us an ascending triangle pattern. Note the three-bar initial trend (T) reading, barely high enough to signal a potential distribution cycle. One or two bars more would have been better. Also note the very low breakout (B) reading, suggesting minimal potential for upside momentum.

One option here is to short the resistance level. All fades are aggressive setups and the short's validity extends only 10 to 12 pips beyond the ceiling's high point. In this way if there is momentum beyond the ceiling, the aggressive fade can be reversed and the momentum bought.

The more cautious entry is to anticipate momentum and react as prices break through a sideways pattern's support or resistance. This is an accumulation cycle setup and is ideal for markets where the volatility is low and the range narrower.

Think of the accumulations setup as a 'coiled spring' ready to release. As the spring coils it stores energy, which will unload as the price pierces support/resistance. The more it is compressed, the more potential energy on release.

Momentum setups must be traded in an unbiased way, meaning that the trader should anticipate the possiblity of a break in either direction, given the lack of an initial trend. Visually it is ideal to see a narrowing range in the price action.

Building momentum

Triangles and pennants by their very nature are self-limiting patterns. If prices do nothing else but move sideways within the pattern, they will eventually run out of room. When the pattern narrows, that's where the breakout can be expected - a simple indicator like a MACD Histogram could be used as a directional filter for the break.

Remember the coiled spring. If prices break too early there is a chance that the market may be in distribution after all. However, the coiled spring works for rectangle patterns too. Even though rectangles (and double/triple tops or bottoms) are parallel and/or horizontal line patterns, the range of the pattern can show how much potential energy the spring is storing.

Narrow ranges work very well for momentum trades, while wider ranges are less likely to show strong breakouts and are therefore more suitable for distribution fades. Again, be sure to check not only the initial trend but also the actual range of the pattern to see if there is a spring being coiled.