The Psychology Of Chart Patterns
More than once, finance profs have told me that chart patterns don't work. After all, why should the market obey a chart pattern?
This misses the point about patterns. Patterns don't dictate to the markets. Human collective behavior dictates to the markets. And as a species, human beings act today just we did thousands of years ago when we first came together to trade in markets. We chase the prospect of profits. When returns become overabundant, the crowd turns greedy. When price turns against us, the herd becomes anxious, anxiety gives way to fear, fear gives way to panic. Then in come the bargain hunters, and the whole process starts again.
Variations on this theme have recurred throughout history. Valid chart patterns are simply the graphic record of these recurring turns in the crowd, expressed through price and volume.
The trading literature does a pretty good job describing patterns and how to recognize them. I am going to go a step further. I want you to grasp the forces at work behind patterns. In my own experience, I found this understanding improved my ability to interpret charts as well as my skill at pattern recognition. I will take you step by step through a chart pattern. As the pattern unfolds, I will explain the underlying shifts in the balance between bullishness and bearishness, demand and supply.
For our behind-the-scenes technical analysis, I've chosen the cup-with-handle pattern because it's easily the best-known chart formation to the intermediate-term trader. The pattern is also known as the saucer-and-platform. Gilead Sciences (GILD | Quote | Chart | News | PowerRating), a Foster City, Calif.-based biopharmaceutical company, traced an example of one in 1999 prior to making an explosive advance.
The following chart employs a logarithmic price scale and 50-day moving average lines for price (in red) and daily volume (in blue). As you can see, Gilead shares peaked at 57 1/2 on March 19, 1999. In the next session, March 22, the stock gapped down and fell further on 2.6 million shares, five times its average daily volume.
Fear Ascendant This is a decisive break. Trust your eyes. Let the stock talk to you. All the signs point to more downside ahead. A sharp price decline (15% from close to close), a U-turn to the south, a close in the bottom half of the daily range. Lending clear authority to these signs are the dramatic expansions in both volume and daily price range. What are all these signs telling you? Fear is taking hold of shareholders. And no one is coming their rescue. People are heading for the exits, and whoever remains in the stock must be reaching for the Rolaids. That may sound obvious, but you'd be surprised how many people try to trade against such powerful directional movement. Panic & Capitulation For a few days, the stock tries to make a stand just above 45 7/8, the intraday low of the selloff session. Note the progressive decline in volume. Fewer and fewer buyers are willing to step up to the plate and take shares off the hands of anguished shareholders. Sellers next resort to dropping their ask price in an effort to entice more buyers to market, and the price crumbles further. Meanwhile, those holding on in desperate hopes that the stock will recover come under increasing strain.
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If you have at least a few months that Forex came into your life you have surely heard of Fibonacci levels in Forex charts. But what is Fibonacci?
Fibonacci sequence is a series of numbers. Every number is being produced by adding the last Fibonacci number to the previous. The first numbers of Fibonacci sequence are 1,2,3,5,8,13,21,34,55,….etc But what has Fibonacci sequence to do with Forex Trading? IF you divide two sequential numbers you get the result 1,618. The square of 1,618 is 1,27. The inverse number of 1,618 is 0,618. The inverse of 1,27 is 0,786. These numbers are called Fibonacci numbers because they result from Fibonacci sequence number’s analogies. The 1,618 number was called ‘Golden Mean’ by ancient Greeks and other ancient cultures. They called it so because they observed that this number is found everywhere in nature.
The result of creations, living organisms to space galaxies, that have this number embedded is symmetry. But enough with maths and science! Let’s see the use of Fibonacci numbers in trading. Since the beginning of investment industry, traders have noticed that prices tend to change direction in levels that are very close to these numbers I mentioned above. For example in an uptrend prices will go up and then swing down to a level that is a Fibonacci number before continuing the uptrend. These levels are called Fibonacci Retracement levels.
The most common Fibonacci levels in Forex market are 0.382, 0.5, 0.618 and 0.786. Nobody knows why prices tend swing in these Fibonacci levels. And nobody knows at which exact Fibonacci level will the price change direction in advance. How could you use this knowledge to improve your trading? Well, you should know that prices tend to reverse at Fibonacci retracement levels. A lot of novice traders use the exact point of a fibonacci retracement level e.g. 0.618 as a trade entry. Experienced traders know this fact and wait for other traders to get their stop loss hit and then enter the market. Fibonacci retracement levels should be used as an indication of entry and not as the exact point of entry. Moreover the bulk of traders use 0,618 and 0.386 retracement levels. Experienced traders know this tendency and wait for other retracement levels not widely used like 0.786 or 0.707 in order to enter a trade. Use these Fibonacci retracements as well. Make the difference! But how would you know at which Fibonacci retracement level will the price change direction? Fibonacci retracements, like other technical indicators are more valid when they are calculated for a greater time value.
Do not pick minor swings to calculate Fibonacci retracements. Pick greater price swings instead. Moreover, a Fibonacci level becomes more valid when it coincides with another technical indicators such as trendline resistance or support, MACD or RSI divergence and so on. The most valid retracement level should be choosen keeping in mind that further confirmation from other technical indicators should be taken into account. You wouldn’t like to put your money on risk with only one reason, would you? So choose the Fibonacci retracement level that coincides with other reverse signals. Last of all let’s see the use of Fibonacci numbers in trading time analysis. It is a method that only few traders know. Pick a significant hi or a low in a daily chart. Then calculate trading days (excluding weekends) from that point and on using Fibonacci sequence.
You would have the first, the second, the third, the fifth the eighth trading day and so on. Watch that in trading days that are Fibonacci numbers, prices tend to reverse direction! Isn’t it amazing? Add this tool to your chart analysis and you wont lose! After all these years of trading experience and research I have found that Forex charts iclude some special patterns created by price swings. These patterns are formed under certain Fibonacci relations between their swings. Fibonacci Patterns can give low risk and hi reward trading entries.
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