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Understanding Trading Strategies
A trading strategy includes a well-considered investing and trading plan that specifies investing objectives, risk tolerance, time horizon, and tax implications. Ideas and best practices need to be researched and adopted then adhered to. Planning for trading includes developing methods that include buying or selling stocks, bonds, ETFs, or other investments and may extend to more complex trades such as options or futures.
Placing trades means working with a broker or broker-dealer and identifying and managing trading costs including spreads, commissions, and fees. Once executed, trading positions are monitored and managed, including adjusting or closing them as needed. Risk and return are measured as well as portfolio impacts of trades and tax implications.
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The longer-term tax results of trading are a major factor and may encompass capital gains or tax-loss harvesting strategies to offset gains with losses.
Developing a Trading Strategy
There are many types of trading strategies, but they are based largely on either technicals or fundamentals. The common thread is that both rely on quantifiable information that can be backtested for accuracy. Technical trading strategies rely on technical indicators to generate trading signals. Technical traders believe all information about a given security is contained in its price and that it moves in trends.
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For example, a simple trading strategy may be a moving average crossover whereby a short-term moving average crosses above or below a long-term moving average.
Fundamental trading strategies take fundamental factors into account. For instance, an investor may have a set of screening criteria to generate a list of opportunities. These criteria are developed by analyzing factors such as revenue growth and profitability.
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There is a third type of trading strategy that has gained prominence in recent times. A quantitative trading strategy is similar to technical trading in that it uses information relating to the stock to arrive at a purchase or sale decision. However, the matrix of factors that it takes into account to arrive at a purchase or sale decision is considerably larger compared to technical analysis. A quantitative trader uses several data points—regression analysis of trading ratios, technical data, price—to exploit inefficiencies in the market and conduct quick trades using technology.
Special Considerations
Trading strategies are employed to avoid behavioral finance biases and ensure consistent results. For example, traders following rules governing when to exit a trade would be less likely to succumb to the disposition effect, which causes investors to hold on to stocks that have lost value and sell those that rise in value. Trading strategies can be stress-tested under varying market conditions to measure consistency.
Profitable trading strategies are difficult to develop, however, and there is a risk of becoming over-reliant on a strategy. For instance, a trader may curve fit a trading strategy to specific backtesting data, which may engender false confidence. The strategy may have worked well in theory based on past market data, but past performance does not guarantee future success in real-time market conditions, which may vary significantly from the test period.
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What Is a Retracement?
A retracement is a technical term used to identify a minor pullback or change in the direction of a financial instrument, such as a stock or index. Retracements are temporary in nature and do not indicate a shift in the larger trend.
KEY TAKEAWAYS
A retracement is a minor pullback or change in the direction of a financial instrument, such as a stock or index.
The term, used by technical analysts to analyze the price of securities, refers to a short-term change in a stock's price relative to an overarching trend.
Once a retracement is over, there should be a continuation of the previous trend.
Retracements are not the same as reversals—with the latter, the price of the security must breach support or resistance levels.
Understanding a Retracement
A retracement refers to the temporary reversal of an overarching trend in a stock's price. Distinct from a reversal, retracements are short-term periods of movement against a trend, followed by a return to the previous trend.
The chart below illustrates the share price of General Electric Co. It is showing that the stock is in a downtrend. However, there are points on the chart that indicate that the price is rising, which would be considered a retracement.
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A retracement by itself does not say much. However, when combined with other technical indicators it can help a trader identify if the current trend is likely to continue or if a significant reversal is taking hold.
A retracement should be used with other technical indicators and never alone. If not used correctly, it could cause the analysis to be misguided.
Retracement vs. Reversal
It is essential to determine the difference between a reversal and a short-term retracement. A retracement is not easy to identify because it can easily be mistaken for a reversal. Even worse is if a reversal is mistaken for a retracement.
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The chart below shows the S&P 500 during 2018 when a significant uptrend took place between April and October. There are three retracements identified on the chart, although there were a series of smaller ones as well, as the S&P 500 was rising to record highs.
What is most important is that the retracements never breached the uptrend. However, in October what appeared to be a retracement became a reversal after the index did finally fall below the uptrend, leading to a sharp decline.
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Again, it is important to remember that a retracement is a minor or short-term pullback in the price of a stock or index. What is key is that the stock does not breach a critical level of support or resistance nor breach the uptrend or downtrend. Should the price fall below or rise above support or resistance, or violate an uptrend or downtrend, then it is no longer considered a retracement but a reversal.
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Beta and Passive Risk Management
Another risk measure oriented to behavioral tendencies is a drawdown, which refers to any period during which an asset's return is negative relative to a previous high mark. In measuring drawdown, we attempt to address three things:
The magnitude of each negative period (how bad)
The duration of each (how long)
The frequency (how often)
For example, in addition to wanting to know whether a mutual fund beat the S&P 500, we also want to know how comparatively risky it was. One measure for this is beta (known as "market risk"), based on the statistical property of covariance. A beta greater than 1 indicates more risk than the market and vice versa.
Beta helps us to understand the concepts of passive and active risk. The graph below shows a time series of returns (each data point labeled "+") for a particular portfolio R(p) versus the market return R(m). The returns are cash-adjusted, so the point at which the x and y-axes intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us to quantify the passive risk (beta) and the active risk (alpha).
The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every unit increase of market return, the portfolio return also increases by one unit. A money manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk (i.e., a beta greater than 1) or alternatively decrease portfolio risk (and return) by reducing the portfolio beta below one.
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Alpha and Active Risk Management
If the level of market or systematic risk were the only influencing factor, then a portfolio's return would always be equal to the beta-adjusted market return. Of course, this is not the case: Returns vary because of a number of factors unrelated to market risk. Investment managers who follow an active strategy take on other risks to achieve excess returns over the market's performance. Active strategies include tactics that leverage stock, sector or country selection, fundamental analysis, position sizing, and technical analysis.
Active managers are on the hunt for an alpha, the measure of excess return. In our diagram example above, alpha is the amount of portfolio return not explained by beta, represented as the distance between the intersection of the x and y-axes and the y-axis intercept, which can be positive or negative. In their quest for excess returns, active managers expose investors to alpha risk, the risk that the result of their bets will prove negative rather than positive. For example, a fund manager may think that the energy sector will outperform the S&P 500 and increase her portfolio's weighting in this sector. If unexpected economic developments cause energy stocks to sharply decline, the manager will likely underperform the benchmark, an example of alpha risk.
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The Cost of Risk
In general, the more an active fund and its managers shows themselves able to generate alpha, the higher the fees they will tend to charge investors for exposure to those higher-alpha strategies. For a purely passive vehicle like an index fund or an exchange-traded fund (ETF), you're likely to pay one to 10 basis points (bps) in annual management fees, while for a high-octane hedge fund employing complex trading strategies involving high capital commitments and transaction costs, an investor would need to pay 200 basis points in annual fees, plus give back 20% of the profits to the manager.
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The difference in pricing between passive and active strategies (or beta risk and alpha risk respectively) encourages many investors to try and separate these risks (e.g. to pay lower fees for the beta risk assumed and concentrate their more expensive exposures to specifically defined alpha opportunities). This is popularly known as portable alpha, the idea that the alpha component of a total return is separate from the beta component.
For example, a fund manager may claim to have an active sector rotation strategy for beating the S&P 500 and show, as evidence, a track record of beating the index by 1.5% on an average annualized basis. To the investor, that 1.5% of excess return is the manager's value, the alpha, and the investor is willing to pay higher fees to obtain it. The rest of the total return, what the S&P 500 itself earned, arguably has nothing to do with the manager's unique ability. Portable alpha strategies use derivatives and other tools to refine how they obtain and pay for the alpha and beta components of their exposure.
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Self-control
Self-control, an aspect of inhibitory control, is the ability to regulate one's emotions, thoughts, and behavior in the face of temptations and impulses.[1][2] As an executive function, it is a cognitive process that is necessary for regulating one's behavior in order to achieve specific goals.[2][3]
A related concept in psychology is emotional self-regulation.[4] Self-control is thought to be like a muscle. According to studies, self-regulation, whether emotional or behavioral, was proven to be a limited resource which functions like energy.[5] In the short term, overuse of self-control will lead to depletion.[6] However, in the long term, the use of self-control can strengthen and improve over time.[2][6]
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Self-control is also a key concept in the general theory of crime, a major theory in criminology. The theory was developed by Michael Gottfredson and Travis Hirschi in their book titled A General Theory of Crime, published in 1990. Gottfredson and Hirschi define self-control as the differential tendency of individuals to avoid criminal acts independent of the situations in which they find themselves.[7] Individuals with low self-control tend to be impulsive, insensitive towards others, risk takers, short-sighted, and nonverbal. About 70% of the variance in questionnaire data operationalizing one construct of self-control had been found to be genetic.
Counteractive
Desire is an affectively charged motivation toward a certain object, person, or activity, but not limited to, that associated with pleasure or relief from displeasure.[9] Desires vary in strength and duration. A desire becomes a temptation when it impacts or enters the individual's area of self-control, if the behavior resulting from the desire conflicts with an individual's values or other self-regulatory goals.[10][11] A limitation to research on desire is the issue of individuals desiring different things. New research looked at what people desire in real world settings. Over one week, 7,827 self-reports of desires were collected and indicated significant differences in desire frequency and strength, degree of conflict between desires and other goals, and the likelihood of resisting desire and success of the resistance. The most common and strongly experienced desires are those related to bodily needs like eating, drinking, and sleeping.[11][12]
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Desires that conflict with overarching goals or values are known as temptations.[11][10] Self-control dilemmas occur when long-term goals and values clash with short-term temptations. Counteractive Self-Control Theory states that when presented with such a dilemma, we lessen the significance of the instant rewards while momentarily increasing the importance of our overall values. When asked to rate the perceived appeal of different snacks before making a decision, people valued health bars over chocolate bars. However, when asked to do the rankings after having chosen a snack, there was no significant difference of appeal. Further, when college students completed a questionnaire prior to their course registration deadline, they ranked leisure activities as less important and enjoyable than when they filled out the survey after the deadline passed. The stronger and more available the temptation is, the harsher the devaluation will be.[13][14]
One of the most common self-control dilemmas involves the desire for unhealthy or unneeded food consumption versus the desire to maintain long-term health. An indication of unneeded food could also be over expenditure on certain types of consumption such as eating away from home. Not knowing how much to spend, or overspending one's budget on eating out can be a symptom of a lack of self control.[15]
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Experiment participants rated a new snack as significantly less healthy when it was described as very tasty compared to when they heard it was just slightly tasty. Without knowing anything else about a food, the mere suggestion of good taste triggers counteractive self-control and prompted them to devalue the temptation in the name of health. Further, when presented with the strong temptation of one large bowl of chips, participants both perceived the chips to be higher in calories and ate less of them than did participants who faced the weak temptation of three smaller chip bowls, even though both conditions represented the same amount of chips overall.
Weak temptations are falsely perceived to be less unhealthy, so self-control is not triggered and desirable actions are more often engaged in, supporting the counteractive self-control theory.[16] Weak temptations present more of a challenge to overcome than strong temptations, because they appear less likely to compromise long-term values.[13][14]
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Satiation
The decrease in an individual's liking of and desire for a substance following repeated consumption of that substance is known as satiation. Satiation rates when eating depend on interactions of trait self-control and healthiness of the food.
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The 10 Essential Fundamentals for Both Car Enthusiasts and Investors
To make a broad generalization, European cars lust after curvy roads. American cars are more about the power, rumble and straight line 0 – 60 speed. There are key parallels between investors and car buffs, but clearly there exist cars for every possible taste, just as there are limitless options of investment methodologies for every investor. Having said that, there are essential commonalities amongst all car enthusiasts and all successful investors without which disequilibrium inevitably results.
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The famous Hollywood director Orson Welles was so captivating that it is said he could hold an entire audience in his hand by simply reciting a grocery list. It’s no secret that I’m captivated myself by the power of lists. I’m a “listaholic” of sorts because concise clusters of pithy ideas are relatively easy for me to memorize. When I discover a worthy list, I find that transitioning items from memory and integrating them into my trading methodology simply requires regular practice until they eventually become second nature and part of my trading intuition – which was the objective all along.
So how do I best lubricate the transition from memorizing these pithy ideas and effectively folding them into my daily trading intuition? I’m a car guy, so that’s easy. I use automotive metaphors.
1. SAFETY FIRST: You wouldn’t buy a car without airbags. As an investor, first take care of protecting your assets with insurance, estate planning, tax strategies and the like before you trade equities. After you begin trading, you should once again put safety first by utilizing proven money management skills and stops.
2. SERVICE & SUPPORT: I wouldn’t buy a Saab today because the maintenance and support are fading. Despite what some may believe, investing is not a solo gig. You should have the moral support of your family and the intellectual support of your trading circle. A supportive network increases the probability of success whether you are talking trucks or trades.
3. HONESTY: If you’re 6’5” tall and believe a Miata sports car is the car for you, you’re delusional. As an investor, if you can’t be honest with yourself, you’ll be blind to your weaknesses and investing will be a brief negative passage along the highway of life.
4. YOUR VISION: You have four teenage kids, you’re working two jobs and you put down a deposit for a new Corvette. Anything wrong with this vision? Think mini-van or SUV. Similarly, investors must do an inventory of their circumstances as well and personalize their trading vision to fit the trading time frame that matches their situation. Ask yourself these kinds of questions: Which markets will I trade? How am I planning to trade? How long do I plan to hold positions? Treat investing like a business.
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6. CONFIGURE YOUR METHODOLOGY: I used to have a Mini Cooper S. They claim that with the number of options they offer, it’s possible to configure over a million different Minis. Investors, too, are offered a smorgasbord that’s much larger in scope, and because of it, they have the power to thoroughly overcomplicate their trading methodology. If it were a car, it would never even start! Focus on clarity and simplicity and you will build a profitable trading system.
7. SET GOALS: Dream big and motivate yourself. I was inspired to work especially hard last year because I wanted to buy a Porsche. We all have different hot buttons. I stayed engaged emotionally, mentally and physically in the markets, motivated in large part by that goal. True, some days were just work but I know “from whence my passion springs!”
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9. NEGOTIATION & EXECUTION: Here’s the hard part. It’s where the pedal meets the metal, where the rubber meets the road. Can you pull the trigger and do the trade? If you don’t have an action-oriented ability to execute your trades (or your dreams), investing should be farmed out to the professionals.
10. READ THE MANUAL: These days, one can’t truly enjoy and experience the full potential of a Porsche or a BMW without reading the manual. (Sorry, guys!) Whether you are a car enthusiast or an investor, you must be capable of embracing this new reality. I used to drive a 1971 Volkswagen Beetle. No manual required. Today, investors must continually embrace change, take classes, find mentors, and participate in seminars. In other words, read the manual. You won’t figure out “launch control” without it!
11. DISCIPLINE & SELF MOTIVATION: Racing school will shock and awe you as to the capabilities of your modern car. To achieve self-mastery on the road or within your brokerage account, you’ll need practice. Consistently applying yourself and pushing from within the framework of high performance routines will result in the stock market mastery you seek. If you maintain your passion for the stock market, your own capabilities over time will awaken that same sense of shock and awe.
12. DETERMINATION: Cars get tired. Investors get tired, too. Just try not changing the oil in a car for 30,000 miles or ignoring that red light on the dashboard! Traders will have tough days and tough weeks. They’ll have 3-4-5 losses in a row. But then you change the oil, get a tune-up, do whatever you need to do to get re-energized and believe in yourself and your methodology again.
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Investing requires determination and faith, as well as all of the nine preceding fundamentals.
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The 4 Crucial Beliefs Of Successful Investors
If you don’t believe in yourself as an investor and have absolute faith in your methodology, trading the markets will be like trying to nail Jello to the wall.
We use to joke that my high school buddy, Brian Maxwell, was a force of nature – so much so that the weather would follow him wherever he went. In truth, it was his beliefs that fueled his behavior. Brian was a world-class marathon runner. When he created PowerBar, he believed beyond the shadow of a doubt that its formulation would allow him to break through the inevitable 21-mile wall that all runners hit in a marathon race. His absolute belief in his PowerBar formulation allowed him to aggressively run to 21 miles knowing he would blast through “the wall”. The faith he had in his methodology facilitated his near-evangelical zeal as he pedaled PowerBars out of his van at numerous race events. His beliefs resulted in the building of a 300-person company that he eventually sold to Nestle for $375 million.
Ask yourself this: what do you believe?
Similar to my friend Brian, I know that my beliefs in four crucial areas determine how my trading profits will stack up at the end of the year. These are the four “touchstones” I ask myself each week:
Do I still believe 100% in the methodology I have written down in my trading plan?
Do I believe I still have the ability to control my emotions and produce the appropriate behavior necessary to trade the market?
Is my faith in my tools and indicators still unwavering such that I can confidently risk my capital based on their readings?
Do I still believe in the “law of probabilities” and that by consistently executing my system, I’ll earn a profit?
In embracing these four beliefs, I see myself as part trapeze artist and part quarterback. As a trapeze artist, I am able to let go of the bar trusting that a partner will be there to catch me; as quarterback, I throw the ball to X believing that the receiver will be where he should be. My beliefs become my trading partners.
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In my experience, it’s been uncanny how my beliefs and my ability to envision certain outcomes – both athletically and professionally – have contributed to events becoming reality.
Bottomline: As an investor, you must be intimately in tune with your beliefs at all times and be aware of those symptoms that might suggest your beliefs are drifting off course. Understanding your own beliefs about investing will empower you to produce consistent profits in a manner no other personal attribute can do.
In his Market Wizards books, Jack Swagger interviews an outstanding collection of renowned investors, traders and money managers. The single most common thread that each mentions as being a major contributor to their success is their money management skills.
The challenge is to understand what they mean by money management. The internet is full of definitions, ranging from simplistically useless to overly complex and potentially harmful. In past years, I’ve surveyed my classes for their personal definitions. On two separate occasions a decade apart, we constructed in class definitions that I believe accurately capture what these market wizards meant when they attributed their success to their money management skills.
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What both groups of the investors I surveyed agreed upon was the notion that money management is a process. In its most basic form, it involves setting goals, getting organized and executing a written investing plan. Both groups also agreed that money management is very personal and individualistic in nature. It will change over time as the investor’s needs shift, but honesty and candor are essential ongoing ingredients in any effective written money management plan.
My first investor group formulated a money management process consisting of 8 issues constructed as questions that challenged each individual investor to answer in writing in a manner most appropriate for him or herself.
How do you get your money? What are the sources of your cash flow and are they dependable or variable?
How do you feel about money? Did you inherit your wealth and see money management as a burden or part of your lifestyle? What is your tolerance for risk?
Where do you move your money? What percentage of your assets are you comfortable placing in various asset baskets? Do you see yourself as an investor, a trader or a watcher?
How do you move your money? What are your investment analysis routines and which trading methodology do you employ?
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Why do you move your money? How will you decide it’s time to invest?
How do you protect your money? What sell disciplines do you have in place? Have you adequately insured yourself and your family to protect all your assets?
How do you spend your money? What are your lifestyle priorities? How much money will you invest, spend and distribute?
When will you spend your money?
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Habits exist to save our brains effort
“Habits, scientists say, emerge because the brain is constantly looking for ways to save effort. Left to its own devices, the brain will try to make almost any routine into a habit, because habits allow our minds to ramp down more often.”
Biologically, we form habits to save energy, so anything we do regularly will become a habit.
Cue, routine, reward
“This is how new habits are created: by putting together a cue, a routine, and a reward, and then cultivating a craving that drives the loop.”
“Cravings are what drive habits. And figuring out how to spark a craving makes creating a new habit easier.”
Habits are a simple action loop that consists of a cue, a routine, and a reward. For example, waking up in the morning might be the cue that drives the routine of brushing our teeth, which yields the reward of having a clean and refreshed feeling in our mouth. The habit loop is driven by cravings. For instance, we might crave the feeling a clean and refreshed mouth, which will lead us to go through the routine of brushing our teeth when we get the cue of waking up. To understand and change our existing habits, in addition to creating new ones, it’s essential we understand the cue, routine, reward habit loop.
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The Golden Rule
“The Golden Rule of Habit Change: You can’t extinguish a bad habit, you can only change it.”
Habits are hard-wired into our brains. So while it would be nice to be able to erase this hard-wiring, it’s not possible. So we have to be intentional about changing our bad habits into good ones, rather than focusing on eliminating the bad ones from our system.
How to change habits
“Rather, to change a habit, you must keep the old cue, and deliver the old reward, but insert a new routine. That’s the rule: If you use the same cue, and provide the same reward, you can shift the routine and change the habit. Almost any behavior can be transformed if the cue and reward stay the same.”
“However, to modify a habit, you must decide to change it. You must consciously accept the hard work of identifying the cues and rewards that drive the habits’ routines, and find alternatives. You must know you have control and be self-conscious enough to use it”
If we want to change our habits, we should keep the cue and reward the same, but change the routine. For example, imagine that we smoke a cigarette every time we drink coffee in the morning. The coffee is the cue, smoking a cigarette is the routine, and the high we get from the cigarette is the reward.
To change this behavior, we need to first consciously choose to do so and then identify the cues and rewards around the routine we would like to change. For instance, we can replace the smoking a cigarette routine with something else when we drink our morning coffee. We might, for example, do a short exercise routine after we drink our coffee that releases endorphins and gives us a high that feels as good as the high from cigarettes.
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Keystone habits
“…some habits have the power to start a chain reaction, changing other habits as they move through an organization. Some habits, in other words, matter more than others in remaking businesses and lives.”
“Keystone habits transform us by creating cultures that make clear the values that, in the heat of a difficult decision or a moment of uncertainty, we might otherwise forget.”
Keystone habits are habits that have the power to change habits in other areas of our lives. For instance, exercise is a keystone habit. When we start exercising regularly, we often start doing other healthy behaviors naturally. If you get done with a good workout, instead of grabbing the usual cheeseburger and french fries, we’re more likely to grab a healthier snack, such as a protein shake.
We also are more likely to get better sleep and feel happier due to the endorphins that are released from exercise. Collectively, these changes will likely make us more successful in our personal and professional lives. If you want to improve your life, identifying keystone habits that move you in the direction you want to go is a great way to do so.
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The importance of agency
“When people are asked to do something that takes self-control, if they think they are doing it for personal reasons—if they feel like it’s a choice or something they enjoy because it helps someone else—it’s much less taxing. If they feel like they have no autonomy, if they’re just following orders, their willpower muscles get tired much faster.”
“Simply giving employees a sense of agency—a feeling that they are in control, that they have genuine decision-making authority—can radically increase how much energy and focus they bring to their jobs.”
If we need to do something that requires self-control, our sense of agency has an important role in how taxing that activity is on our brains. For activities we feel that we have chosen, it requires less willpower to accomplish the activity
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Understanding Fear
When traders get bad news about a certain stock or about the economy in general, they naturally get scared. They may overreact and feel compelled to liquidate their holdings and sit on the cash, refraining from taking any more risks. If they do, they may avoid certain losses but may also miss out on some gains.
Traders need to understand what fear is: a natural reaction to a perceived threat. In this case, it's a threat to their profit potential.
Quantifying the fear might help. Traders should consider just what they are afraid of, and why they are afraid of it. But that thinking should occur before the bad news, not in the middle of it.
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Fear and greed are the two visceral emotions to keep in control.
By thinking it through ahead of time, traders will know how they perceive events instinctively and react to them, and can move past the emotional response. Of course, this is not easy, but it's necessary to the health of an investor's portfolio, not to mention the investor.
Overcoming Greed
There's an old saying on Wall Street that "pigs get slaughtered." This refers to the habit greedy investors have of hanging on to a winning position too long to get every last tick upward in price. Sooner or later, the trend reverses and the greedy get caught.
Greed is not easy to overcome. It's often based on the instinct to do better, to get just a little more. A trader should learn to recognize this instinct and develop a trading plan based on rational thinking, not whims or instincts.
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Setting Rules
A trader needs to create rules and follow them when the psychological crunch comes. Set out guidelines based on your risk-reward tolerance for when to enter a trade and when to exit it. Set a profit target and put a stop loss in place to take emotion out of the process.
In addition, you might decide which specific events, such as a positive or negative earnings release, should trigger a decision to buy or sell a stock.
It's wise to set limits on the maximum amount you are willing to win or lose in a day. If you hit the profit target, take the money and run. If your losses hit a predetermined number, fold up your tent and go home.
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Snap Decisions
Traders often have to think fast and make quick decisions, darting in and out of stocks on short notice. To accomplish this, they need a certain presence of mind. They also need the discipline to stick with their own trading plans and know when to book profits and losses. Emotions simply can't get in the way.
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chart patterns
There are hundreds of thousands of market participants buying and selling securities for a wide variety of reasons: hope of gain, fear of loss, tax consequences, short-covering, hedging, stop-loss triggers, price target triggers, fundamental analysis, technical analysis, broker recommendations and a few dozen more. Trying to figure out why participants are buying and selling can be a daunting process. Chart patterns put all buying and selling into perspective by consolidating the forces of supply and demand into a concise picture. As a complete pictorial record of all trading, chart patterns provide a framework to analyze the battle raging between bulls and bears. More importantly, chart patterns and technical analysis can help determine who is winning the battle, allowing traders and investors to position themselves accordingly.
In many ways, chart patterns are simply more complex versions of trend lines. It is important that you read and understand our articles on Support and Resistance as well as Trend Lines before you continue.
Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly or monthly and the patterns can be as short as one day or as long as many years. Gaps and outside reversals may form in one trading session, while broadening tops and dormant bottoms may require many months to form.
An Oldie but Goodie
Much of our understanding of chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, Technical Analysis and Stock Market Profits, laid the foundations for modern pattern analysis. In Technical Analysis of Stock Trends (1948), Edwards and Magee credit Schabacker for most of the concepts put forth in the first part of their book. We would also like to acknowledge Messrs. Schabacker, Edwards and Magee, and John Murphy as the driving forces behind these articles and our understanding of chart patterns.
forex signals Pattern analysis may seem straightforward, but it is by no means an easy task. Schabacker states:
The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula.</box>
Even though Schabacker refers to “the science of chart reading”, technical analysis can at times be less science and more art. In addition, pattern recognition can be open to interpretation, which can be subject to personal biases. To defend against biases and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions drawn. While many patterns may seem similar in nature, no two patterns are exactly alike. False breakouts, bogus reads, and exceptions to the rule are all part of the ongoing education.
Careful and constant study are required for successful chart analysis. On the AMZN chart above, the stock broke resistance from a head and shoulders reversal. While the trend is now bearish, analysis must continue to confirm the bearish trend.
Some analysts might have labeled this Novellus (NVLS) chart as a head and shoulders pattern with neckline support around 17.50. Whether or not this is robust remains open to debate. Even though the stock broke neckline support at 17.50, it repeatedly moved back above its support break. This refusal might have been taken as a sign of strength and justified a reassessment of the pattern.
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Continuation Patterns vs. Reversal Patterns
Two basic tenets of technical analysis are that prices trend and that history repeats itself. An uptrend indicates that the forces of demand (bulls) are in control, while a downtrend indicates that the forces of supply (bears) are in control. However, prices do not trend forever and as the balance of power shifts, a chart pattern begins to emerge. Certain patterns, such as a parallel channel, denote a strong trend. However, the vast majority of chart patterns fall into two main groups: reversal and continuation. Reversal patterns indicate a change of trend and can be broken down into top and bottom formations. Read more on https://www.gold-pattern.com/en
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