By Alan Farley, founder and publisher of Hard Right Edge*
Posted: Apr 10, 2009

Everyone is a chart reader these days, but this venerable practice isn't as easy as it looks. That's because there are just a few ways to make money and a thousand ways to be wrong. This is especially true currently when all sorts of Fundamentals types are staring at price patterns now that their nine-to-five discipline no longer works.

The devil is in the details with pattern analysis because no two charts are exactly alike. And, above all else, chasing the same patterns that everyone else sees in the books, or on the web, is a straight shot to the poorhouse. But, that doesn't stop legions of amateur technicians from throwing cash at the same losers over and over again.

In reality, observant technicians can find good trading opportunities with relatively little effort, because they know exactly what to avoid when looking at similar sets of patterns. This is an advanced skill set that's missing with the majority of folks who believe they possess magical powers because of their chart divinations.

With this admonition in mind, let's talk about stock scanning and your evening research. Chart database programs offer advanced tools that search quickly for your needle in the market haystack. Many traders think the purpose of these nightly scans is to find perfect positions that can be mindlessly executed, but nothing is further from the truth.

The most accurate scans just take you to the next step, where you're forced to discover the trading opportunity for yourself. This "last yard" of effort is where armchair technicians fail miserably because, in truth, their unskilled eyes try to fit all sorts of random chaos into predictive patterns that, in reality, aren't so predictive.

The most effective way to overcome this form-fitting bias is to embrace subtlety when you're flipping through the price charts. You can start by internalizing these four cautionary patterns that are lying in wait to steal your money.

Bunny Slopes

There's little profit when price rises or falls in an overly gentle pattern. Conversely, real opportunity comes when strong tension between bull and bear energy gets released suddenly, trapping one side and triggering sharp directional movement. Of course, this is nothing more than opportunity-cost translated onto pattern analysis.

The good news is that it takes only a second or two to identify a weak angle of attack on a price chart. Ironically, trading bunny patterns during periods of high volatility is a bonafide defensive strategy because it limits risk. Perhaps that's the reason you'll find so few of them after last year's market crash.

Border Disputes

Stand aside when price action gets caught up at, or in between, big moving averages. These conflict zones eventually yield trades, but they require patience because the battle can go on for weeks. For example, notice how Broadcom (BRCM) has chopped along the 50-day moving average for almost three months now, while everyone waits for it to break out or break down.

In particular, focus on interplay among price and the 50-day and 200-day moving averages as you flip through the charts. You'll often see ping-pong action as price bounces back and forth between the two major barriers. Not surprisingly, these pivots will provide interesting swing trades as long as you don't overstay your welcome.

Davy and Goliath

Conflicting patterns in different time frames trap many traders in very bad positions. These trend relativity errors occur when you see a great pattern but miss the larger support or resistance that's going to screw up the trade. Avoiding this error is simple. Look above and below the entry price for the setup that's catching your eye.

Then, do the math. Realistically, how far can price travel before it runs into a major brick wall? If that number is less than three times the distance to your logical stop loss, avoid the trade entirely. This sounds easy, but marginal traders have a really tough time staying out of trouble with this pattern because it looks too good to pass up.

Trend Mirrors

What happened in the past has a major impact on what happens in the future, so look to your left before taking the trade. Trend mirrors point out all the past debris that will affect price movement right now and into the future. In particular, current action responds with startling reliability to pivots created by old highs, lows and gaps.

In truth, price reacts a lot more than it acts. In other words, prior reversals and gaps generate major swings during current price discovery. With this in mind, smart technicians gauge the adverse impact of all prior highs / lows, gaps, volume spikes and candle shadows when they're examining an interesting pattern right here in the present.

*Reprinted (and modified) with permission from Alan Farley, founder and publisher of Hard Right Edge