Trading Classic Chart Patterns
Trading Classic Chart Patterns is the foundation for technical traders but what can the charts actually tell you? Quite a bit as it turns out.
Bullish Trading Patterns with the best performance was found to be the descending triangle pattern with an average rise nearly 50%. Second in line: an intermediate-term rectangle pattern with over 40% rise.
If that sounds interesting then the novice trader could do worse than learning some of the most common classic chart patterns or finding a copy of the book "Trading Classic Chart Patterns" by Thomas Bulkowski. Then take time to test out your skill by playing Wall Street Survivor online to see how you stack up.
Trading classic chart patterns is as much of an art form as science but with time and patience it is possible and profitable.
Bull or Bear? Can You Identify?
You heavily invested in a new stock last week and have watched as the price increases daily. Obviously you are brilliant with nothing to fear but fear itself while riding this bull. Whoa cowboy. Better slow down and put a hold on the celebration until you know for sure you aren't actually chasing a bear.
Bearish rising wedges are a powerful yet often ignored indicator you should be familiar with. This pattern is easily confused with a bull market since the stock continues to rise; the critical differentiating factor is volume. Increasing prices with decreasing volume leads to a situation where the daily trading range becomes narrow and likely to result in a sharp, sudden decline. By the time you know what is happening it is too late.
Don't get ambushed - keep an eye on price and volume.
Bullish Descending Wedges
Repeat after me:
- A falling wedge is bullish.
- A Falling wedge is bullish.
- A Falling wedge is bullish
The novice investor will naturally be leery of investing in something which they perceive to be falling or declining especially if unable to identify the resistance signals indicating a breakout. Instead, this is precisely the time to buy - reversals are followed by increased demand and specify the exact opportunity most investors are searching for. However, property identifying bullish descending wedges takes a bit of practice. Spend some time practicing before putting your hard earned money to work and use these indicators:
- Volume: Look for increased volume despite falling prices.
- Track the Trend. All reversals - by their very nature - indicate the turning around or "reversal" of a prior trend. It can take several months to establish the downtrend which is why it takes practice to identify bullish descending wedges.
Cup With Handle Pattern
No, this isn't the stance taken by day traders when visiting family over the holidays although some impulsive "investors" seem to fit this description more than they would like to admit. Cup with handle patterns begin with an upward trend that is followed by a decline, upward move, small decline and upward trend again. It literally looks like a cup with a small handle when looking at it on the chart itself.
What you are looking for is a nicely rounded curvature to the drop and resulting rebound. Unlike other charts, this is not a spiked appearance with dramatic upward or downward movement but a more consistent approach. Essentially you are looking for a "U" shape not a "V" shape.
Also pay attention to the handle - a general rule of thumb is a downward movement of 1/3 to the right of the cup at which point it should resume the upward movement once again.
Great. So, when is the time to buy? I'm glad you asked because this is a chart pattern that differentiates the men from the boys since 9 out of 10 will be afraid to buy a stock at what seems like a high point but this strategy is based upon volume as much as price. Obviously, the very definition of the cup precludes the ability to distinguish this pattern until the later stages as the cup or even handle becomes discernible. The investor isn't trying to time the market and buy at the exact low or sell at the high - instead, the objective it to wait until the stock reaches a pivotal point. According to Jesse Livermore, that volume should increase at least 50% above normal.
Going Nowhere Fast - Stock Market Trends
There is a now infamous story where someone asked legendary J.P. Morgan his opinion about the market. His reply: "It will fluctuate". An experienced investor will recognize the pure genius of this statement. Of course, most people expect the market to move up or down depending upon where their money is invested. However, savvy investors understand that stock market trends sometimes indicate stagnation over movement.
Any serious investor needs to understand when stock market trends or other indicators point to a market that is going nowhere fast. Here are a couple measures to keep your eye on:
- Unchanged Issues Index. This index is calculated by dividing the number of issues that are unchanged in price by the total number of stock traded.
- Absolute Breadth Index. This is the difference between the numbers of advancing versus declining stocks.
Pattern Trading Questions
Bullish descending wedges, Channel patterns, Cup with handle patterns, Double Tops and Bottoms...whatever charts or pattern trading systems you are using it is a wise idea to ask yourself some basic questions before investing your hard earned dollars.
- Is the volume strong or weak?
- Are support and resistance levels clearly defined?
- What pattern is indicated? Are you sure? Is it clear or sloppy?
- Uptrend or downtrend?
- Beginning, middle or end of a trend?
Once you answer each to your satisfaction, ask a trusted friend or trading partner to take a look at the same information and interpret the same data. It is a great checks and balance to assure you remain objective.
Pattern Trading Stages
Investors that enter the world of pattern trading typically go through several developmental stages before becoming a mature investor. Save yourself time and trouble by discovering your personal pattern trading stage and useful tips for how to correct the most common pitfalls associated with each stage.
- Ignorance is Bliss. This novice investor is enthralled by claims of investment guru's hawking software or systems designed around various pattern trading systems each claiming to be easier than the next. Forget the fact that over 90% of all traders lose money - THIS system is different and so are you. Yeah, right. The fix to this stage is to lose enough money that you decide to learn the fundamentals without putting your life's savings or the kids’ college fund at risk.
- Overwhelmed Co-Dependent. This investor has lost enough money to make it hurt and is now frightened to go it alone. They rush to spend hundreds or even thousands of dollars on analyst reports, consultants and seminars in an effort to find the secret to success. The fix to this stage is to realize there isn't a secret: One size doesn't fit every situation when it comes to investing. There is risk and that is why there is a reward. Get back on the horse and stop searching for the impossible. Instead, spend all that hard earned money building a solid portfolio.
- Mature Investor. The mature investor has taken time to slowly build a diversified portfolio based upon information. Pattern trading strategies, analyst reports, software and seminars are each a segment in the arsenal of this investor.
Relative Strength Index
The Relative Strength Index or RSI is a common stock market timing signal that is easy enough for even novice investors to use.
Compare the ratio of recent gains against recent loss to calculate a number from 0 to 100. Wilder, the inventor of the RSI, suggests using 14 time periods and levels of 30 to 70. A level above 30 is considered bullish or an RSI that falls below 70 is considered bearish.
Keep in mind, RSI is an indicator - not an absolute. If the indicator seems to point to a stock or index being oversold, don't automatically assume it is time to buy. Even if the indicator is correct it doesn't provide information about how long the stock will remain oversold. Instead, keep your eye out for divergences or other indicators that the price isn't tracking in an appropriate manner.
Finally, understand what you are buying and use indicators as methods to inform you of the possibility of a change or shift not as a means unto themselves.
Don’t confuse RSI with RS. Understand the difference and
learn about Relative Strength
Stock Market Timing Signal
There is a lot of information about how to identify a stock market timing signal but each and every market timing system requires at least three fundamental assumptions that every investor should understand.
- In order to properly identify the current trend, it is necessary to establish a specific set of criteria. To put this into plain language... garbage in, garbage out. The market doesn't move in perfect patterns so the system is only as good as the assumptions forming the foundation.
- Conflicting signals sometimes cancel out one another and sometimes not. For example, let's assume the industrial average indicates a "buy" but the transportation average points to a "sell"...don't simply select which suits your preference at the moment but rather take all information into consideration.
- Remember, it is easier to win when tracking a stock market trend rather than attempting stock market timing. This is one of the most common mistakes made among new investors; using stock market timing signals as a forecast tool. The primary purpose is to identify the present trends of the market - not forecast the future of the market.
Stock Market Timing Tips
It seems everyone is in on the big secret to success. Everywhere you turn there is another proprietary stock market timing system being sold. Let's take a few minutes to review these claims against common sense.
First of all, if these proprietary systems, books, software and other information were as great as claimed then why are they hawking their wares on the Internet and late night infomercials instead of joining the ranks of Bill Gates or Warren Buffet?
Tip #1: Do a search on the guru behind the hype before investing in their system.
Next, stock market timing sounds easy in theory but so does alchemy as in changing lead into gold. The fact is that every winner requires one or more losers in the investment arena; where do you think that money is coming from if not someone else's loss?
Tip #2: If you are going to compete in the stock market then be prepared to take on the challenge. You wouldn't enter a boxing ring without having trained so don't expect to win at the stock market without discipline, dedication and determination.
Trends are your friends...if you understand the basics. Identifying a market trend is something every serious investor should be able to do but that is not always the same as the ability to correctly time the market.
Tip #3: Buy low and sell high based upon your own criteria. Don't get greedy by trying to buy at the lowest point or sell at the top; it disproportionately increases risk.
Support & Resistance aka Supply & Demand
Support and resistance. You have heard these terms but the fear of sounding utterly stupid has prevented you from finding out what they actually mean in real life terms. Don't worry, you aren't alone. The fact is a lot of people assume they understand financial terminology much more than they actually do...and the results show in their portfolio.
In financial markets, having too much supply - aka, to many sellers - will cause stock to drop. This is the Resistance portion. Support is the exact opposite; now there is too much demand as more buyers chase after a limited supply of stock. The increased demand will drive prices up.
Support = Buy
Resistance = Sell
But...and yes, there is always a "but"; don't wait until it is too late. Once price increases beyond what the market will bear then demand will again drop and the trend will reverse. This is why price is instrumental in understanding all technical analysis indicators and market psychology typically concentrates on identifying novice investors who are always a day late and a dollar short. By the time they "think" they have identified a trend, they are buying on resistance and selling on support creating profit for others not themselves.
Understand Price Over Pattern Trading
Novice investors make the mistake of thinking pattern trading is predictive in nature rather than descriptive. Indeed, every late night guru would love for you to believe it is possible to forecast and time every movement of the market if you just had "the right" software package...which is whatever they are selling at the moment. The truth of the situation is that pattern trading is much more descriptive than predictive. Understanding that fundamental truth will set you above most novice investors.
Human behavior has a tendency to follow certain patterns and in trading, those patterns will eventually reach a point where they are recognized as indicators for buying, selling or even consolidation. However, part of the information is always missing so you never have the complete picture all at once.
Instead, focus on price and the psychology of the stock market. What is the price saying? Remember these quick tips:
- Use price to understand the patterns as evidence of prevalent market psychology.
- Pattern trading should be used as a descriptive not predictive practice.
Use Head and Shoulders Chart Patterns to Track Industry Behavior
Head and Shoulders chart patterns are one of the most familiar and widely used charting patterns but before you think there isn't anything new to learn, try this little twist: Use head and shoulders chart patterns to track industry behavior - not just isolated stocks.
A Head and Shoulders chart pattern looks just like what it sounds like...a short rise followed by approximately equal decline with a larger rise and subsequent decline ending with a final rise and decline. One of the more valuable contributions to a Head and Shoulder pattern is the identification of negative moment stocks...a major indicator of note for serious investors. The risk adjusted excess returns are roughly 5-7 percent per annum.
Research indicates stock price is comprised of:
- 20% industry behavior
- 30% economy
- 30% the company
- 20% other
Of course, you are a wise investor and buy what you know so one method of staying abreast of the industry is to follow three or more representative stocks for the industry. When you see each demonstrating characteristic Head and Shoulders formations within a similar time frame then it is time to take note for the industry as a whole.
Simple but powerful. Try it.