Confirmation: the backbone of technical analysis

Many losses suffered by forex traders occur due to poorly timed market entries, e.g., entering a trade set-up too early or too late. Late entries can be largely prevented by adopting as a trading rule the tenet to never enter a trade more than 24 hours after a trade signal is generated. However, guarding against early entries is more problematical and requires more discretion on the part of the trader.

The problem with early entries is the tempting nature of a chart pattern in progress. As an example, note the potential head and shoulders forming below, on the hourly chart of the Euro versus the U.S. dollar (currency pair EUR/USD) from late July and early August of this year:

The left shoulder and head are in place; it’s merely a matter of sketching in the right shoulder, dropping beneath the neckline, and the decline is on. Although everyone agrees that’s the point where the short market entry would be most appropriate, in the meantime the price action can be expected to fall toward the neckline established earlier, before rising again to form the right shoulder. So why not enter a short-term trade on the expected decline?

According to statistical research performed by analyst Tom Bulkowski, the head and shoulders is the most reliable chart pattern in technical analysis. Fully 93% of confirmed head and shoulders patterns deliver the expected reversal, and 55% of them meet the forecasted price target.

And within that sentence lies the rub: the pattern must be confirmed before it influences the price action. Entering a trade based upon an unconfirmed or incomplete pattern is an early entry at best, wishful thinking at worst.

At this point in any pattern’s formation, prior to completion and confirmation, it’s merely squiggles on the chart. Any trades placed at this point should be based, not upon the potential chart pattern, but upon the usual tools of technical analysis, such as indicators, trendlines, and support-resistance levels.

The pattern above did not complete, and when a decline occurred a few trading days later, it had nothing to do with the potential head and shoulders. Short-term trades would have earned minor profits, at best, but would more likely have been exited at break-even or a slight loss.

Confirmation for a trade set-up, whether based upon a chart pattern or any other trading signal, is something the forex trader who desires success must learn to await. While some short-term profits may be obtained through a gambling approach or early entries, the more scientific approach of awaiting confirmation reduces the risk of loss and enhances the odds of a winning trade.