How to Read Chart Patterns: Analyzing Stock Charts
Charts are popular among traders. According to legend, they have been used for hundreds of years with early traders in Japanese rice futures markets developing candlestick charts to help them forecast price trends.
In many ways, charts are based on legends and as is so often the case with legends, there are some truths and embellishments in the story.
Let’s address the embellishments first. Charts are not the key to trading. Now, the truth. When patters are clearly visible, there is a better than random chance a trader can profit.
Why Charts Are Popular
Two reasons could account for the appeal of chart patterns.
First is the fact that they are easy to use. At a glance, traders can claim to complete an analysis. Some insist they don’t even need to know the name of the stock since the chart contains all the information they need.
Second is the fact that they sound useful. Chart patterns were given esoteric names like a head and shoulders top of a rounding bottom. Precise-sounding rules accompany the names and give traders the illusion of a sound strategy.
Both of these factors are the reason charts exist.
The first exhaustive reference to charts dates back to 1930 when Forbes magazine editor Richard Schabacker published the Stock Market Theory and Practice. This was a catalog of pattern traders talked about at the time.
At that time, before the Securities Act of 1933 and the Securities Exchange Act of 1934, companies were not required to provide investors any information and exchanges were not required to treat investors fairly. Charts were a tool that provided at least the appearance of a strategy.
The reason pattern sounds useful is because their proponents use well-selected examples.
The Well-Selected Example
To understand how charts are commonly used, consider the head and shoulders patterns that consists of three peaks in price occurring at the end of the uptrend, with the center peak being higher than the other two.
Traders expect the first and third peak in the pattern to top out at about the same price. These form the shoulders of the pattern and the head is the higher peak that stands above the shoulders. Traders draw a line at the bottom of the peaks to obtain the neckline.
When prices fall under the neckline, traders act because that signals the uptrend is over. Below is an example, a chart of the top that preceded the 2008 bear market.
Source: Trade Navigator [1]
After the break of the neckline, buyers push the price to just above the neckline, a pattern that traders call a “throwback” and then the downtrend follows.
In hindsight, this was a perfect sell signal. I keep this chart as part of a course I teach on technical analysis because perfect patterns like this are rare. I haven’t found a more recent example to use in my course. [2]
A More Useful Way to Trade Charts
The most important part of any pattern is the expectation that there will be some amount of symmetry in the price action. This is shown in the next chart.
Source: Optuma [3]
Because chart patterns are subjective, the name of the pattern will not be important. We could call the highlighted area a rounding bottom or a double bottom counting the June 2019 spike as the first bottom.
What is important is that the pattern is shows a buy level. It’s not a precise level and aggressive investors would already be buying on a break above line 1 while conservative traders would wait for a break above line 2.
The depth of the pattern provides a price target. The depth is highlighted by the rectangle, which is about 30 points. Risk can be defined within the rectangle. If prices fall by one-third or one-half the depth of the pattern, the buy signal is negated. That’s $10 or $15 in this example.
This symmetry is consistent in all patterns and is the most important point of any pattern you spot. The depth of the pattern provides a tool to find price targets.
This demonstrates that charts can offer a complete trading plan. Instead of looking for a pattern name, just look for an area that contains a price consolidation and then trade a breakout. You can identify a price target and a risk level so that you know when you’ll sell even before you buy.
The name of the chart pattern isn’t important because all price targets and risk levels use that same idea. Charts are valuable because they provide a quick way to assess the price action and manage risks while pursuing rewards.
Regards,
Editor, Peak Velocity Trader
Sources:
[1]: Trade Navigator — https://www.tradenavigator.com/products/platinum [2]: New York Institute of Finance — https://www.nyif.com/fundamentals-technical-analysis.html [3]: Optuma — https://www.optuma.com/research/
After spending nearly 20 years developing pattern recognition software for the United States Air Force, I retired from my military career in 2005. My plan was to utilize the same pattern recognition principals I used in the military and apply them to the largest and most lucrative market in the world: the stock market.
