Somebody once told me he could draw all kinds of patterns on a stock chart–cars, people, unicorns, you name it. I’m sure he would find these and many more weird and wonderful patterns. Personally, I would not put money on some vision of a unicorn. Then there are the so called “armchair technical analysts” who devote vast amounts of personal energy using all manner of exotic indicators to create impressive looking but completely meaningless charts. Nine times in ten they have no idea what any of the indicators mean or even how they are calculated. The patterns themselves are not important–it is the price action they represent that counts. I stick with simple technical patterns I can justify with reasonable arguments. I make use of simple indicators to maintain a sense of perspective–the topic of another post.
The diagram depicts a typical bullish ascending triangle pattern. This is one of the most reliable trading chart patterns around. The reason is quite simple. The time to trade this pattern is during a strong upward bullish move. The pattern represents a strong pullback after a strong move up. It would be extremely unwise to bet against the trend on the back of such momentum.
How do you go about making sense of chart patterns?
I take a bottom up approach. I don’t actually use a fixed methodology but here are some useful guidelines.
- Fundamental economic principles–supply and demand 101
- Fundamental human behavior
- Contextual human behavior
- Characteristics of the financial instrument
- Contextual characteristics of financial instruments
- Macroeconomic context
- Other crowd: Political context, major events
Supply and demand is the most useful tool to help formulate a general theory of price action. The basic idea behind technical analysis is human behavior, especially crowds, does not change. People are creatures of habit and our responses to fear and greed are to some extent hardwired. People tend to do the same things over and over, and technical analysis gives us the tools to observe that behavior in graphical form.
The red line in the diagram marks a level of significant resistance to further upward price movement–buyers outnumbered sellers by enough margin to push prices sharply higher. As the price reached that resistance level bears stepped in and (temporarily) tipped the scales in favor of sellers. The bears soon exhausted themselves and bulls once again stepped in at the rising blue line to push prices higher. This pattern (of behavior) repeated until the sellers exhausted themselves to the point where on balance buyers outnumber sellers. At this point the last of the sellers gave up and covered their short positions. Some closed out their positions, others reversed and bought in the opposite direction–either way, they are all bids (orders to buy) in the opposite direction that help push prices to the next value area.
Note the pattern of higher lows along the rising blue line. This is a sign of strength that makes this a particularly strong pullback. Prices can’t go up forever. At some point they must take a break–pull back. The pattern of higher lows shows little interest in selling. Traders were waiting for this pullback–either to enter with a new position or add to existing positions.
What makes prices pause at the support and resistance levels?
There are many factors at work behind the scenes. It is often argued that it is not necessary to know anything about the fundamental factors at play. We believe rather than mindlessly drawing lines on their charts people should at least try to understand price action. Some of price action can be attributed to psychology. Prices often bounce off psychologically significant whole numbers–for example gold $1000/ounce. Trader tactics can account for some price action–there are a number of common trade setups professional traders watch for. A big part price action is supply and demand. Part of it is supply and demand for financial securities or derivatives; commodity financial and security futures, options, warrants, bonds–and of course supply and demand of the actual underlying instruments–gold, stocks, credit, currency etc.
Tags: Price Action, Technical Patterns