Module 12 Innerworth — Mind over markets

Chapter 185

Classic Chart Patterns: Know How to Use Them

Technical analysis and short-term trading go hand in hand. The revelation that one can make huge profits by looking for reliable chart patterns that repeat with unfailing regularity has raised many traders’ outlook from bleak desperation to euphoric optimism. Too many novice traders, chart patterns are the elusive Holy Grail. But the excitement soon fades as one discovers that identifying chart patterns is subjective and quite difficult and that history rarely repeats itself with infallible accuracy.

Besides a desperate search for winning strategies, it’s easy to see why so many are drawn to the study of classic chart patterns. The numerous hardbound weighty texts lend credence to the entire enterprise. “If everybody is writing about them and talking about them, they must work” is a reasonable supposition held by many traders. Perhaps they do work to some extent, but it’s vital to avoid trading chart patterns in a shallow and mechanical manner. It’s important to fully understand how they work and how to trade them. For example, some novice traders place too much faith in the chart pattern: They believe that if A occurs, and B occurs, then C must occur. Consider the classic head-and-shoulders pattern, for example.

The typical head-and-shoulders pattern (which occurs in an advancing trend in this example) consists of a final rally of a stock (the head) separated by two smaller rallies (the right and left shoulders) that occur before and after the final rally. The line joining the lows of the two rallies is called the neckline. Most trading books suggest entering a short trade at the break of the neckline since it’s at this point where the trend should start declining. If this trading pattern recurred with unfailing regularity, trading would be easy.

If A occurs (left shoulder), and B occurs (head), then C should occur (right shoulder). Right? If only it were that simple. Some traders make the mistake of entering prematurely. They enter after B on the assumption that C will indeed occur. That is, they forecast a bearish trend based on an incomplete head-and-shoulders pattern. They impose their expectations on the market before seeing what actually happens. The right shoulder, or C, may not happen, however. A better trading strategy is to wait for C to actually occur and possibly signal a declining trend. But it’s still not that easy.

Martin Pring in “Technical Analysis Explained” warns, “the prevailing trend is assumed to be in force until the weight of the evidence proves otherwise. An incomplete head-and-shoulders is not evidence, just a possible scenario.” It’s important to remember that a chart pattern may not always work in the way you expect. You must fully understand all the forces that contribute to its formation. For example, it is useful to also consider volume. Volume is critical for the verification of this chart pattern. Activity is usually heaviest during the formation of the left shoulder and also tends to be heavy as prices form the head. But the strongest confirmation comes if the formation of the left shoulder is accompanied by lower volume. So always remember to fully understand the dynamics of the market forces that underlie the pattern.

Developing trading strategies based on chart patterns is useful, but it’s crucial to think critically and not oversimplify. Technical analysis still requires a mastery of one’s personal psychology. John Murphy, in “Technical Analysis of Financial Markets,” reminds us that chart patterns merely describe past market behaviour. They summarize in a descriptive statistical sense only. There is no scientific or statistical reason to believe they forecast the markets with precision.

It’s important to remember that it’s more art than science (not science at all actually), and that, in turn, means you must develop an intuitive feel for the markets and learn to trust it. The development of intuition only comes with experience. You’ve got to build up your trading skills, experience a variety of market conditions, and learn the “conventional wisdom.” But at the same time, cultivate healthy scepticism. Remember to question “conventional wisdom.” The astute trader asks, “How is the chart pattern supposed to work,” yet also asks, “Is it working under the market conditions I’m seeing right now?” In the end, it’s still about developing the proper mental edge, even when studying a seemingly objective method of trading, such as classic chart patterns.

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