Most of the mainstream trading literature is chock full of references to patterns with funny names, like the megaphone pattern. To novices looking to learn the ropes, this can come off as a practice in reading tea leaves or moon cycles.
And while the trading world admittedly has its fair share of quacks, the purpose of learning stock market patterns is not to memorize enough patterns that you know exactly where the market is going at a given time. Instead, patterns are heuristics.
They’re rough guides that allow you to quickly categorize and understand price action.
So, while the “megaphone” pattern might sound a little ridiculous, bear with us here because there’s real meat on the bone.
What is the Megaphone Pattern?
The megaphone pattern is a chart pattern. It’s a rough illustration of a price pattern that occurs with regularity in the stock market. Like any chart pattern, there are certain market conditions that tend to follow the formation of the megaphone pattern.
The megaphone pattern is characterized by a series of higher highs and lower lows, which is a marked expansion in volatility:
When you draw lines around the pattern, it should be clear why we call it the megaphone pattern.
Note how while the highs continue to get higher, indicating a potential uptrend, the lows continue to get lower, meaning this is not a typical stock market trend.
A directional trend in the stock market requires a series of higher highs and higher lows (or vice versa for a downtrend). Contrast the megaphone pattern against the classic “ABCD” trend pattern which consists of a series of higher highs and higher lows forming a stair step pattern like so:
This pattern could more accurately be called a volatility trend, as volatility is trending up, even when the price isn’t trending in either direction.
This pattern isn’t super common on daily or weekly charts in the stock market, at least over the last decade, because of the stock market’s relentless uptrend and most stocks follow the broad market.
Market Conditions Following a Megaphone Pattern
Going back to the introduction to this article, the reason why we as traders learn, study, and identify chart patterns is because they give us clues to the type of market we’re dealing with, which will help us identify advantageous entries and exits.
For this reason, you can’t really have a productive conversation about a chart pattern without talking about the market conditions leading to and following the formation of the pattern. This crucial context is the entire reason for studying the pattern. It’s not kindergarten, you won’t get rewarded by identifying the right picture on a chart, the visual patterns are simply a heuristic to indicate the market conditions and dynamics.
The megaphone pattern is a volatility trend pattern. That could be confusing because, after all, we just explained why the megaphone is not a price trend in the previous section, but bear with us for just a few more sentences.
It’s true that the megaphone pattern is not a price trending pattern. There is no discernable direction that the market is headed. It goes up a lot, but then it goes down a lot. It’s essentially going sideways.
However, volatility, the range between the high and low, is trending up. But what is the significance of an uptrend in volatility?
Well…
Increasing volatility without the presence of a directional price trend indicates significant indecision and uncertainty on the part of the market. When the highs continually get higher and the lows continually get lower, it indicates nobody really knows what the correct price should be.
And when nobody knows what the right price is, the price has a tendency to go crazy, often reaching skyscraper highs and basement lows because people are panic buying and selling.
This means that a patient trader can take advantage of the emotional trading decisions going on in such a market and bargain hunt.
You see, while the megaphone pattern creates a market full of confusion with no anchor point for pricing, that doesn’t mean you have to follow the herd. Sometimes a price is simply too low and creates an excellent buying opportunity. And vice versa, sometimes the price has risen too high too quickly and needs to come down.
It’s these unsustainable, short-lived extreme prices that megaphone pattern traders live to take advantage of.
A Simple Framework to Trade Megaphone Patterns
The problem with chart patterns is that they’re rough templates. Those neat ideal patterns you see in books and articles like this one aren’t the reality. Real price action is far noisier and doesn’t conform to the orderly geometry of a Microsoft Paint drawing.
And that’s to be expected. The stock market is the most competitive way to make money in the world–it’s chock full of the smartest and richest people on earth putting their huge wallets to work to try to make more. So of course, trading won’t resemble a “click on all the boats” captcha.
It’s for this reason that we have to come up with a framework for deciding when to trade a chart pattern. It’s easy to identify the pattern, but the real question marks arise when you have to choose where to enter the trade, when to close a successful trade, and decide when a pattern setup has failed.
Below we’ll present a simple framework doing so, however, it’s just a rough template. Your own trading experience, style, and products of choice should dictate this at the end of the day.
Buying at the lows:
- Wait for the stock to make a new low
- Set a buy stop above the high of the following bar, continue trailing your buy stop down to the high of each bar until you’re triggered into the trade
- Set your stop loss to either:
- 1-2 ATRs away from the low of the bar you bought on
- The low of the bar
- Set your profit target to either:
- The 20-period moving average
- Sell half at the 20MA, sell another piece at the previous high, and scale out of the rest.
Of course, you’d simply invert everything for selling stocks short on a megaphone pattern.
Again, these are some basic ideas for you to create your own framework from, rather than a prescription. Each of the choices provided will result in dramatically different P&Ls, as trade management is as crucial as choosing good trade setups.
Bottom Line
The megaphone pattern is an interesting stock market pattern to trade because it enables you to take advantage of the mean reversion effect (which is essentially ‘buy things that have gone down too much too quickly’) without buying into a merciless downtrend, which is typically what you’re dealing with in mean reversion trading.
Good trading requires creativity and some thinking outside of the box. Mean reversion isn’t the only way to trade these patterns. Many traders report success trading breakouts from these expanding ranges or using options to trade the volatility.
The post Megaphone Pattern appeared first on Warrior Trading.
Original source: https://www.warriortrading.com/megaphone-pattern/
