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What is a pattern?
The "trend" is the essential ingredient in chart analysis.
Edwards and Magee define trend
as "the tendency or proclivity to move in a straight line."
The theory is that once a trend is in motion, it will continue in
that direction. To the technical analyst, this means that prices
will move in trends. A technical analyst is, therefore, always trying
to determine the direction, strength and duration of the trend.
The earlier the trend can be identified, followed and traded upon,
the more profit can be made.6
That trendline, whether it be up (a bullish trend) or down (a bearish
trend), is never a completely straight line. Look at any chart and
you'll see that prices usually zigzag along, waver around, and sometimes
break, that trendline.
That zigzag movement, experts tell us, is the foundation of all
chart patterns, and is the key to their forecasting value.7
The movements that prices make as they zigzag their way along a
chart form "patterns." Studies over many years show that
these patterns tend to repeat themselves. Technical analysts look
to this history of repeating patterns as having a predictive value.
The patterns are given names which roughly describe the shapes
they draw on the charts: head and shoulders top, head and shoulders
bottom, symmetrical triangle, ascending and descending triangles,
double tops, and double bottoms, for example.
Why are patterns important?
A pattern gives the technical analyst clues on how to read the
chart and, in turn, determine the movement of stock prices in the
future. Bulkowski, in fact,
refers to chart patterns as "footprints of the smart money"
of knowledgeable investors.8
By observing and studying these patterns over many years, experts
have developed their own interpretations of how to read them, the
level of reliability they will ascribe to them, and other factors
that need to be taken into consideration when analysing the pattern.
Time, for example, is an important element in understanding patterns
and reading a chart, according to Schabacker.
"In order to be of practical service in studying formations
and technical action a daily stock chart must cover at least several
weeks, and preferably several months. The longer the period of time
covered the more complete the pictorial record and the more satisfactory
and valuable the chart in practical study and analysis." 9
Sklarew warns that "for
a chart formation to have valid forecasting value, it must be composed
of minor and daily trends that could themselves signal the next
direction of the trend." 10
According to Murphy, a technical
analyst has a distinct advantage over a fundamental analyst because
the technician has "the big picture." A technical analyst
has the ability to follow many more markets than a fundamental analyst
who tends to focus on one market at a time. By watching more markets
and stocks, the technical analyst avoids "tunnel vision"
and can see more opportunities as they develop.11
Like many other experts, Murphy
writes extensively of the "art" and "skill"
of technical analysis, telling investors that there's no one way
to interpret charts. Even if technical analysts did agree on a specific
chart, their trading approaches could be extremely different from
one another, based on their trading methods. Day traders, for example,
would trade a pattern far differently from a long-term investor
- they are looking for different things from the market and
are willing to assume different levels of risk.
Like Murphy, Edwards and Magee
point out that technical analysis is superior to fundamental analysis
because the fundamental analyst can never gather and analyse all
the factors which go into the determination of the price of a stock.
"The market price reflects not only the differing value opinions
of may orthodox security appraisers, but also the hope and fears
and guesses and moods, rational and irrational, of hundreds of potential
buyers and sellers. . . "12 These
latter factors cannot be collected and analysed. The technical analyst,
on the other hand, focuses on the going price which, because it
is established by the market itself, comprehends all the fundamental
factors at work in the market.
What are the different
types of patterns?
Technical analysis is founded on the principle that stock prices
move in trends. Prices do not continue in a trend in perpetuity.
When prices change direction, the move seldom comes cleanly and
unequivocally. Prices tend to move back and forth, zigzagging up
and down as investors try to analyse the market and arrive at new
price expectations for the stock.
These price fluctuations often move along in a sideways movement
as investors work away at coming to a conclusion about where they
feel the price of the stock should be heading. These sideways movements
cause price patterns to emerge on the chart.
These formations tend to repeat, offering the investor a prediction
of where prices may be headed next. Edwards and Magee refer to these
formations as "area patterns."
These patterns fall under two basic headings:
Consolidation of
Continuation Patterns
This pattern breaks out in the direction of the previous trend.
In other words, the pattern confirms the existing trend, suggesting
that investors are considering whether the market is overbought
or oversold but ultimately deciding to confirm the existing trend.
Examples of this type of pattern include ascending triangles, descending
triangles, and symmetrical triangles.
Reversal Patterns
These patterns breakout in a direction opposite to the previous
trend. They mark a change in direction of the price of the stock.
After pausing to consider their investment strategies, investors
decide to reverse an existing trend in a stock's price. Examples
of this type of pattern include head and shoulders tops and bottoms,
double bottoms or tops, triple bottoms or tops, ascending triangles,
descending triangles, and symmetrical triangles.
How long does it take
for a pattern to form?
This is a difficult question to answer. It can take days, weeks
or months for a pattern to form. The general consensus is, however,
the longer the pattern takes to form the more significant the resulting
move in the price of the stock will be.
6Kahn,
p. 25
7Sklarew, p. 15
8Bulkowski, p. 3
9Schabacker, p. 21
10Sklarew, p. 19
11Murphy, p. 8
12Edwards and Magee, p. 6
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