Use Patterns and Indicators to Guide Your Trading

Traders spend years seeking the right balance between patterns and indicators. The difficulty arises from a common misconception. We want a logical way to make decisions, and indicators look more scientific than patterns. After all, they're math-based and not dependent on fuzzy thinking. But in reality, price and volume rule the roost, and nothing divines the market more accurately than pure pattern analysis.

Patterns and indicators are not equal. A skilled technician can find good trades interpreting price bars alone. But the best indicator has little value when viewed without price. Not sure you believe this? Just try this little exercise. Pick a stock, but don't look at the chart. Then buy it when your indicator says "oversold" and sell it when it reaches "overbought." Not a good way to make money.

Patterns expose crowd behavior. To the trained eye, they uncover low-risk trading opportunities. But the mind can play cruel tricks on what the eye thinks it sees. The brain does a great job constructing false order from visual chaos. For example, a Rorschach inkblot shows how random shapes turn into well-defined patterns when fed to the waiting mind. Traders face the same problem trying to pick out market inefficiencies on a price chart.

Newer traders should never rely on patterns alone. Indicators fill in missing pieces for inexperienced eyes and filter out meaningless price action. A little math also avoids laziness and desire for the easy buck. No one but the Mint is printing money, and profits require an empirical approach that examines trades from all angles.

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Energy sources leave telltale signatures in the form of exhaust or radiation. Similarly, true predictive patterns emit evidence that indicators can detect and measure. When trading signals converge through both patterns and indicators, odds increase that price direction will unfold exactly as anticipated.

Indicators have two common quirks you need to consider. First, endless variations of the same studies have been published over the years. Stick with the classics until they stop working. Second, all indicators have the same limitation. They only work in certain markets and not others. Know your market stage before relying on a specific indicator.

Objective numbers and subjective emotions spin off market trends. Although software can create effective buy or sell signals, most indicators overlook key elements of crowd behavior. Perform this essential task through visual examination of the price action. The most powerful trading strategies meld both types of analysis into focused execution systems.

Pattern analysis evaluates crowd behavior by locating signals within the random noise of price charts. Many patterns emit a bias that predicts how they should evolve over time. A seasoned chart reader can safely ignore indicators when price bars paint a very clear picture. But the safest path for most of us is to seek confirmation in the cold, hard numbers before executing a trade.

Each indicator carries a distinctive look and feel. Experienced traders use this "fingerprint" to interpret price direction, but only when viewed in context with the pattern. The trick is to learn when to listen to its message, and when to ignore it. This can take years to master, for obvious reasons. In the meantime, just remember that indicators support the price pattern, and not the other way around.

Patterns look at the future only, but indicators look at the future or into the past. For example, stochastics is a "forward oscillator" used to anticipate overbought-oversold markets. Alternatively, MACD is a "backward indicator" that looks back to measure shifts in momentum.

Let the interplay between patterns and indicators guide your trading hand. You'll discover the best setups appear when many elements converge and point to a singular event. Then all you have to do is jump on the train before it leaves the station.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. At the time of publication, Farley had no positions in any of the stocks mentioned in this article, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to [e-mail].. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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