by Ian Harvey
Stock chart patterns are patterns that are formed within charts when prices are graphed. They are graphical representations of historical stock prices which help to determine current supply and demand forces in a stock.
In stock and commodity markets trading, studying chart patterns plays a large role during technical analysis. Analysis of stock chart patterns allows a trader to determine with more accuracy just what the current supply and demand is in a stock.
Chart patterns form repeating patterns or shapes, and are commonly used in the stock market.
When data is plotted there is usually a pattern which naturally occurs and repeats over a period of time. Chart patterns are used as either reversal or continuation signals.
History of Charts
Before the advent of computers and data feeds, the use of charts to formulate trading strategies was outside the mainstream of trading techniques. The reason, creating charts was difficult. Each chart had to be created by hand, with chartists adding another data point at the close of trading for each security they were following. Also, chart users were often misrepresented as a bizarre group of individuals huddled in the recesses of the brokerage house as they added the latest data point to their closely coveted charts.
Much of our understanding of stock chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, ”Technical Analysis and Stock Market Profits”, laid the foundations for modern pattern analysis. In ”Technical Analysis of Stock Trends” (1948), Edwards and Magee credit Schabacker for most of the concepts put forth in the first part of their book.
Pattern analysis may seem straightforward, but it is by no means an easy task. Schabacker states:
"The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula."
But with the advancement of technology and the increased popularity of technical analysis, the use of charts has greatly increased, making them one of, if not the most important tools used by technical traders.
A single chart has the ability to display a significant amount of information. More conceptually, charts are an illustration of the struggle between buyers and sellers. While this point is debatable between the schools of investment like technical, fundamental and efficient market analysis, technical analysis assumes that:
a) prices discount everything,
b) prices moves in trends and
c) history repeats itself.
Assuming the above tenets are true, charts can be used to formulate trading signals and can even be the only tool a trader utilizes.
Even though Schabacker refers to "the science of chart reading", technical analysis can at times be less science and more art. In addition, pattern recognition can be open to interpretation, which can be subject to personal biases. To defend against biases and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions drawn. While many patterns may seem similar in nature, no two patterns are exactly alike. False breakouts, bogus reads and exceptions to the rule are all part of the ongoing education.
Why Use Charts?
Traders often study chart patterns to:-
• gauge supply and demand forces in the stock market. Such forces are the basis for price fluctuations, which enables a trader to profit.
• help gauge momentum, support and resistance, and other indications of strength or weakness in a stock.
• help traders to determine market direction as well as time entries and exits. A trader must be able to identify chart patterns properly. Only then can a trader benefit from chart patterns.
Some traders claim that by recognizing stock chart patterns they are able to predict future stock prices and profit by this prediction; other traders respond by quoting "past performance is no guarantee of future results" and argue that chart patterns are merely illusions created by people's subconscious.
Certain theories of economics hold that if there were a way to predict future stock prices and profit by it, then, when enough people used these techniques they would become ineffective and cease to be profitable. On the other hand, if you can predict what other people will predict the market to do, then that would be valuable information.
The difficulty in identifying stock chart patterns and their subsequent signals is that chart use is not an exact science. In fact, it's often viewed as more of an art than a science. While there is a general idea and components to every chart pattern, the price movement does not necessarily correspond to the pattern suggested by the chart. This should not discourage potential users of charts - once the basics of charting are understood, the quality of stock chart patterns can be enhanced by looking at volume and secondary indicators.
Concepts to Understand
There are several concepts that need to be understood before reading about specific stock chart patterns.
One of the most important is a trendline, which is a line drawn on a chart to signal a level of support or resistance for the price of the security. Support trendlines are the levels at which prices have difficulty falling below.
Conversely, a resistance trendline illustrates the level at which prices have a hard time going above. These trendlines can be constant price levels, a specific price, such as $45, or rise or fall in the direction of the trend as time goes on.
This understanding of the concepts behind the use of charts as a trading technique, is a definite move forward in understanding and exploration of the many different patterns used by chartists.
Patterns on a Chart
Stock chart patterns signal to traders that the price of a security is likely to move in one direction or another when the pattern is complete.
There are two types of patterns in this area of technical analysis:
1./ Continuation - A continuation pattern indicates that the prior trend will continue onward upon the pattern's completion.
In other words, continuation patterns are chart patterns which set up the stock for a follow through move in the direction of the prior trend. Continuation chart patterns include all of the patterns listed below.
2./ Reversal - Conversely, a reversal pattern signals that a prior trend will reverse on completion of the pattern.
Another way of putting it is that reversal patterns are chart patterns which reverse the trend of a stock once the pattern is confirmed. Reversal patterns include all of the patterns listed below.
Stock chart patterns put all buying and selling into perspective by consolidating the forces of supply and demand into a concise picture. As a complete pictorial record of all trading, stock chart patterns provide a framework to analyze the battle raging between bulls and bears. More importantly, stock chart patterns and technical analysis can help determine who is winning the battle, allowing traders and investors to position themselves accordingly.
Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly or monthly and the patterns can be as short as one day or as long as many years. Gaps and outside reversals may form in one trading session, while broadening tops and dormant bottoms may require many months to form.