Chart Patterns: An Overview

Picture of nested Russian dollsIntroduction:

Consider any field of study, and it soon becomes apparent that topics can be categorized in a nested fashion, much like a set of wooden Russian dolls. In the field of technical analysis, chart patterns are one of the bigger dolls inside of the big doll.

Having a detailed understanding of chart patterns will dramatically improve your technical analysis skill regardless of your trading time frame. The interpretation of shorter term price movement will become clearer when taken in light of the larger chart pattern.

The focus of this article is on important chart patterns that occur in major indices. Important chart patterns include but are not limited to:

  • Reversal Patterns: Head & Shoulders, Double Top, Triple Top, Saucer, and Island Reversal.
  • Continuation Patterns: Flag, Pennant, Wedge, Rectangle, and Triangle.

Up, Down, and Sideways:

Markets trend, either in an uptrend or a downtrend. Within these trends, the market can consolidate, or move sideways because major trends tend not to change abruptly. These sideways transitional periods signal by their very shape either a continuation of the previous trend albeit at a different rate, or a reversal of the previous trend.

Therefore, chart patterns are divided into two main groups: reversal patterns which occur at the end of a trend, or continuation patterns which reside within the trend. Most patterns occur in both uptrends and downtrends as almost mirror images. It logically follows then that a prerequisite to any chart pattern is the existence of a prior trend, and that the prior trend line is broken by the consolidation pattern.

The larger the consolidation pattern in terms of its price action, volume, and time in development, the larger its importance in relation to what is to follow.

Chart Patterns and Sheet Music:

Price and volume chart overlayed on sheet musicFor me, recognizing chart patterns is much like learning sheet music. Both sheet music and chart patterns mark time. The treble-clef is like the price action and bass-clef is like the volume action. Chart patterns are as important to investing as the sound track is to a movie. The music during the final victory scene in the movie Invictus is quite distinguishable from say when someone is about to get wacked in a scene from Jason.


The Rationale: During a consolidation, the forces of supply and demand are relatively in balance. The rationale behind chart formations is tied to actions of institutional-size investors. As they reallocate their portfolios in light of their latest analysis, the size and scope of the resulting distribution and accumulation are such that the prior trend is interrupted, maybe even reversed.


Conclusion:

It is important to understand that these formations occur over a period of many weeks to months. Therefore, chart patterns should be plotted on daily and weekly charts using a logarithmic price scale.

Though many technical analysis practitioners will point out one of these chart patterns on an intraday chart, I question whether the rationale behind some of these patterns supports this practice.

Important chart formations help put shorter term movements into context. The knowledge derived from understanding one formation can be readily applied to others. It behooves us therefore to learn as much detail as possible about each chart pattern, its price and volume action over time.

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2 Comments

  • By Allen Taylor, July 26, 2010 @ 10:30 pm

    Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

Other Links to this Post

  1. Chart Patterns: Double-Top | Sargon Y. Zia, merging fundamental analysis with technical analysis — August 31, 2010 @ 11:35 pm

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