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The Truth About Trading Patterns: Technical Primer - views
BALTIMORE (Stockpickr) -- Triangles, and flags, and wedges, oh my!
For many people who are new to technical analysis, trading is all about price patterns. But making trading decisions using technicals should come down to more than just the lines you draw on a chart. In today’s technical primer, we’ll take a look at the truth about trading patterns: what causes them, whether they work, and when to ignore them.
Patterns have become popular among new traders because they have a fairly low barrier to entry. While mastering fundamental analysis requires a full understanding of complex rules (such as how money flows from a firm’s income statement to its balance sheet), pretty much anyone is capable of spotting a price formation on a chart once they know what they’re looking for. While that’s helped to grow the popularity of technical analysis in recent years, it’s also turned price patterns into a crutch that’s used by too many armchair traders.
That certainly doesn’t mean that patterns are bad. In fact, there are some major benefits to using price patterns. One of the biggest is the fact that the human brain is more or less designed to spot complex patterns in data. Even though computers have become an indispensible technical analysis tool in the past few decades, software still isn’t capable of spotting setups the way that an experienced technician can.
But at the same time, the experienced technician isn’t looking at the same things on a chart that new traders are looking at.
Understanding How Patterns Are Made
In his book, The Definitive Guide to Point and Figure, author Jeremy DuPlessis says that, “The need to learn patterns indicates a lack of true understanding of how a pattern is created. … There is no point in trying to learn dozens of patterns; it is better to understand what causes them.”
That’s an important idea to keep in mind when you’re scouring any sort of price chart.
At their most simple, price patterns are made up of support lines, resistance lines and trend lines. When those factors come together, they can form just about any major pattern that’s traded on the markets today. An ascending triangle, for example, is a formation that’s created by combining a horizontal resistance level with uptrending support. A flag is made up of two parallel downtrend lines. Even the head and shoulders pattern can be broken down into two simple resistance levels.
And because we can break price patterns down to their constituents, we can get a better picture of what’s really going on in the market that’s causing price patterns based on supply and demand. (For a more detailed explanation of how supply and demand forces cause support and resistance levels in the market, take a look at Stockpickr’s Primer on Support and Resistance.)
Contrary to popular belief, price patterns don’t predict anything. Instead, they’re breakout trades, or setups that are contingent on share prices breaking above or below important gluts of supply and demand in the market. Keeping that reactionary trading mentality when approaching any price pattern will help you to increase your profitability dramatically.
Why Patterns Work
Up until this point, we’ve taken for granted that price patterns work. While that’s a topic that’s too complex to fully explore here, the short answer is “yes.” A number of recent academic studies have shown that select price patterns can be statistically and economically significant -- and the anecdotal experiences of professional analysts and traders (including yours truly) bear that out. While computers’ abilities to identify complex patterns are still the limiting factor in academic support for pattern recognition, that’s slowly coming around.
One big question is why technical patterns work.
Some investors believe that patterns can be a self-fulfilling prophecy; that is, when a trader sees a popular pattern (like a head and shoulders) in a large stock, other traders are likely to see that pattern as well and pile into the direction of the trade. Frankly, there’s probably some truth to that belief -- but the fact that patterns have been observed to work in very low volume stocks as well as other supply and demand driven markets suggest that it’s not the whole story.
Instead, it pays to think back to what those patterns actually represent. In an ascending triangle, for instance, a breakout happens when buyers absorb the glut of supply that’s previously restricted share prices from moving higher. From a market mechanics standpoint, it follows closely that prices should continue to rise.
Obviously, because patterns are made up of individual support and resistance levels, the stronger the level the better the trading implications of a breakout.
Patterns themselves aren’t the only thing to consider as a breakout trader. It’s also important to keep confirmation in mind when you’re looking at potential trades. Confirmation is a blanket term that’s used to describe other indicators that add assurance over the validity of a pattern breakout. Uptrending RSI could add confirmation to a trade -- so could strong volume or a second consecutive open above a stock’s resistance level.
Confirmation is important to breakout traders because there are so many factors that can impact a stock’s price on any given day. For a pattern with only moderately defined breakout levels, it pays to have technical confirmation -- literally.
Finally, it’s important to remember that price patterns aren’t the end-all be-all. Other factors, such as sound risk management, and trading strategy can have a material impact on a trader’s ultimate profitability.
Price patterns are an inseparable part of technical analysis. They can provide experienced traders with actionable setups at a glance, and they can clue investors into hiccups in the broad market. But to make the most of any price pattern, it’s essential to understand how and why they work. Hopefully, you’re able to do just that now.
Next week, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.