Price Patterns 1

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 :

For the sake of a clearer study, the first item of action is classification. Patterns are classified into two categories :

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 :

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 :

Triple Top		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.