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30 Mar 2007 | 18:03 |
Price Patterns 1
After having gone through the simpler patterns in the last two updates - the straight-line studies (trend lines) and the curved line studies (moving averages), we now move on to the next set of tools in the realm of technical analysis. This is the area of Price patterns.
We have often read or heard technical analysts discuss something arcane such as Head and Shoulders and Triangles and Dark Cloud Covers and what not. Sounds weird doesn't it? But then, so will Swahili. Why? Because, anything which we do not understand, will always seem mystical and inexplicable. And what does one do when met with something, which is not readily explicable? Withdraw, of course! That is why most people have remained shy of knowing what exactly is the arcane sounding stuff that is being discussed by a set of technical analysts.
If one moves closer and examines the topic it will be found that the explanations are fairly simple! As is the case with so many other things in life! Price patterns are repetitive patterns - or shapes - which appear often enough on price charts- that they have come to be recognized as having some value in trend assessment as well as trend forecasting.
What causes these patterns to appear? Do you recall that under the discussion about trendlines we referred to something called the Market Symmetry? It is a state where the push and pull of supply and demand manifest themselves in such an orderly manner that the prices remain within an orderly structure for a long period of time. In the case of the Trend line, this orderliness exhibits itself whenever a certain percentage of climb or fall has occurred from around an invisible mean. There are other ways that the market expresses such symmetry. Many a times, it is found that such expressions of symmetry assume Geometric shapes. These patterns have appeared often enough on different charts of different companies through different times that they have now been validated to their consistency. Hence Price Pattern study as a separate subject within technical analysis was born.
The detailed study of price patterns were done by the early tomes on the subject. Indeed, after the advent of the computers, this area of the subject has been named as "traditional" technical analysis while the computer- based studies are the modern technicals. Somewhat like the classification of "old" and "new" economy stocks, what? Books by authors such as Edwards and Magee, Richard Schabacker, H.M. Gartley etc became the bibles of technical analysts back in the early days - right up to the late seventies.
Let us now proceed to look at these price patterns in more detail. As stated, price patterns have the following characteristics :
| They are expressions of market symmetry and hence would be part of the support-resistance mechanisms |
| They appear to be often in geometric or some easily identifiable form | For the sake of a clearer study, the first item of action is classification. Patterns are classified into two categories :
| Reversal Patterns |
| Continuation Patterns | Since Time is also a classification method in technical analysis, we also have a further delineation into Major and Minor patterns depending upon which time period these patterns are seen. There are some patterns, which are specific to certain time periods, and knowing this can be advantageous in not making errors in reading.
Reversal Patterns
These are often seen as a Major variety of pattern as they are seen at the end of long moves. The following are the most commonly found Reversal patterns :
| Head Shoulder (and its mirror the Inverted Head and Shoulder) |
| Triple Tops (and its mirror the Triple Bottom) |
| Double Tops (and its mirror the Double Bottom) |
| Rounding Bottoms |
| Expanding Triangles | The Head and Shoulder Pattern
This is so named because it appears in the shape of a "head", which is bordered on two sides by two "shoulders". Pictorially, it would look thus :
Since the "head" is joined to the "shoulders" at the Neck (in our body), the line joining the two shoulders and the head is referred to as the Neckline. The pattern is deemed to be completed (or resolved, as the jargon goes) only when prices penetrate the neckline (or achieve a breakout below the neckline).
The inverted Head and Shoulder is nothing but a mirror image of the picture given above. For those of you who cannot still picture it in your minds, perhaps, this picture will help (…. didn’t they say somewhere that a picture is worth a thousand words?)
This can be seen as a man standing on his head!
The Double and Triple Tops and Bottoms--these are different varieties of the head and shoulder pattern. In the pattern above, the two shoulders are minor tops, which are below the final top (which is the head). If the two shoulders were to rise to the level of the head, then we would have a pattern, which has three highs around the same level - the Triple top. If there were to be only two drives to the top and the levels are the same, then the pattern would be a Double top. Pictorially, it would seem thus :
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| Triple Top |
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Double Top | The Triple and Double bottoms are exact mirror images of the two patterns shown above. The price area between two tops is known as the Valley. The pattern is said to have completed when the prices break below the valley.
What can be noticed in these patterns is the following: The Head and shoulder pattern is a higher-top and higher bottom formation succeeded by a lower top and lower bottom (once the neckline breaks) The double (or triple) top is similarly a same top followed by a lower bottom (once the valley level breaks). Hence the rules relating to the support-resistance concept as well as the Dow theory discussed earlier, remains consistent. The following charts are a few examples of a head and shoulder top as well as bottom.
The rounding pattern
This pattern resembles a large U shaped structure and hence the name "rounding" pattern. It is characterized by a long drawn out, slow development where the prices become less and less volatile, dropping down to an almost quiet level. Slowly, they flatten out and start a slow climb upward. This gradual process takes on a rounded shape and gives the pattern the name. The slow nature of the pattern means that this pattern develops over weeks and months and is usually a signal of slow and quiet accumulation. Since this is found at the bottom of bear markets, it is classified as a major reversal pattern. It is suggestive of action by insiders. Our markets are full of this pattern. In fact, this is the pattern, which is most often found in our markets. This is particularly because, ours is yet a young market, which is undergoing accumulation. Mutual Funds, Operators and FIIs are still pumping in money into the market on a steady basis and therefore we will continue to see this pattern in the future too. Every accumulation phase is characterized by the appearance of this pattern. The Rounding top is an exact replica (but reverse) of the same pattern at the top. However, since our markets have not begun witnessing any major distribution as yet, there isn't a single good example of a stock with rounding pattern. The pattern is said to be resolved when the top of the U pattern is exceeded by the prices.
Volume Behaviour in the above patterns
One of the elements, which help to confirm the patterns as they develop, is the role of volumes. In the Dow Theory, we have already seen that volumes must expand in the direction of the main trend. Hence, in a head and shoulder pattern, increased volumes should accompany the break of the neckline, which is what confirms the change in the trend. Similarly, the break of the valley in the double and triple top patterns should also be on high volumes. In the rounding bottom, the rising leg is the change in the trend. So the falling leg of the pattern should be on decreasing volumes and followed by increased volumes on the rising leg of the pattern. The volume should continue to remain high when the prices move past the top of the U or the rounding. |
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