Recognizing Chart Patterns: A Guide to Spotting Price Trends
Wayne Thorp will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Most of us have heard the phrase “every picture tells a story.” In the context of investing, the same applies to the use of price charts. A price chart tells a story about how a particular security is acting, whether a stock, mutual fund, or a futures contract. If a security has been trending downward, the consensus of the market is negative; a rising price indicates that the market has a positive view of the security.
Technical analysis is based on the theory that the price movement of a security captures all relevant information. From the viewpoint of technical analysis, the study of fundamental data may miss one essential variable that will lead to an inaccurate conclusion and, therefore, result in incorrect investment decisions. In addition, supporters of technical analysis argue that the data does not always paint an accurate picture of the company’s performance because management can manipulate the figures. Some investors, however, select stocks using fundamental analysis, but time transactions using technical analysis.
Charts are invaluable resources for technical analysts, who use them to help identify developing trends in the price movements of a security. This article is an introduction to several charting formations that you can use as part of your investment strategy.
“Trade the trend”
This statement lies at the very heart of investing. Whether your trading positions are long or short, you are hoping to capture either the rise or fall in the price of a security. When studying charts, you are looking for trends in the price.
One of the main purposes of using stock charts is to identify price trends. Trendlines are one of the simplest tools one can employ when using stock charts. An uptrend is a period during which a security’s price exhibits higher highs and higher lows; on the flip side, successively lower highs and lower lows mark a downtrend.
Trendlines can be drawn over a multitude of periods but usually fall into the subjective categories of short-, medium-, and long-term. Short-term usually refers to a period of less than one month, medium-term ranges from one to six months, and long-term is generally any period greater than six months. However, your own definitions of short-, intermediate-, and long-term periods will correlate to your investment horizon. Day traders entering and exiting positions continuously throughout the day may have shorter time periods.
Creating a trendline is very simple. To plot an uptrend, you connect at least two low points, or troughs, with a straight line. For downtrends, you connect two or more peaks, high points, in the same manner. You can do this for line, bar, and candlestick charts in the same way.
Figure 1 shows examples of three trendlines. Point 1 illustrates the long upward trend of Johnson & Johnson JNJ, which began in April 1994 and was still in effect as of December 1998. During this period, the price tested the trendline numerous times, with the only penetration of it occurring in October 1997. Each time the price tested the trendline, however, it would reverse itself and continue upward. This trendline is also a good example of an upward sloping support line (support and resistance lines are discussed in the next section).
Point 2 in Figure 1 is an example of a trend within a trend. In June 1997, Johnson & Johnson experienced a drop in its stock price that lasted until August, at which point it entered a period of sideways trading (when prices move narrowly up or down) before reverting to the long-term trend. Further examination of Figure 1 reveals several points where countertrends such as this existed within the longer trend.
Once you have created your trendlines, your work does not end there. As time passes and prices continue to move, you will have to update the trendlines: shorter-term trends may become longer-term, and trends may reverse themselves. An indication that a trend may be reversed is when the price penetrates the current trend (falls below the line for an uptrend or rises above the line for a downtrend). Since the price did penetrate the long-term trend in October 1997, you may wish to draw a new trendline, as Point 3 shows. Had the price continued downward, this would have marked a reversal of the long-term trend. The question then is determining when the trend reversed itself. Many technicians believe that a trend has reversed if the stock price moves more than 5% in the opposite direction of a near-term high or low. In summary, no hard and fast rules apply to creating trendlines. Trendlines are in the realm of judgment and art.
Support & Resistance Lines
If you were to pick up a stock chart, chances are you will notice points at which a price that has been rising or falling reverses its course. Looking over an extended period, you may also see where these points are revisited and again the price changes direction, as if there were some invisible barrier keeping the price from going higher or lower. Technicians call these levels support or resistance, depending on the direction of the security price. These points illustrate the psychology of trading.
To draw support lines, look for price levels where a stock price “bottoms out” and then reverses course. Connecting the points where the price reversed itself creates the support line. Resistance lines are drawn using a series of peaks in stock price.
As the price nears one of these barriers, potential buyers and sellers are asking one of two questions: Is the stock strong enough to break through the resistance line? or, has the stock weakened to the point of no longer being able to maintain the support line? Depending on their position in the stock, investors will exit positions in order to minimize their losses or to cash in on their gains. They may also add to a position if they feel the stock is selling at a discount. If the price pulls back from these levels, their judgments are confirmed.
As stock prices rise and fall, existing resistance lines can become support lines and vice versa.
For some securities, there are periods of uncertainty as to what the next move in price will be. The price will tend to fluctuate, oftentimes within a well-defined price range. This is a period of congestion, and the range in which the security trades is called a trading channel. Trading channels are made up of both support and resistance lines. During such a period of trading, the price will repeatedly fall to a certain level, then reverse course and rise.
Figure 2 shows an example of a trading channel for Nucor Corp. NUE. For over three years, from November 1995 to July 1998, the price fluctuated between $44.50 and $62.50. Each time it neared the extremes of the range, it would shrink back. While there were slight moves outside the channel, for the most part the price stayed within this range until it broke through support.
Perhaps the most useful story told by support and resistance lines and trading channels is what happens after these barriers are broken. Typically, once the barrier has been penetrated, the price will make a significant move—upward for resistance lines and downward for support lines.
When Is It Over?
“What goes up, must come down” is another adage tossed around by technicians. To this end, the current direction of a security’s price movement usually must reverse itself at some point. Therefore, you must always be vigilant for reversals: points where the current trend, whether it be up, down, or sideways, changes. Most technicians confirm a pattern reversal when the price alters its course by at least 5%. Depending on what type of investor you are, you may find either a smaller or a larger retracement as defining a reversal.
Some trends found in charts can actually be used to estimate the magnitude of a trend reversal. The most popular and easy-to-identify reversal patterns are “head and shoulders” and double and triple “tops and bottoms.” These trend reversal patterns derive their names from the way in which they appear on a chart. As you become more accustomed to examining charts, they are easier to identify.
Double tops and bottoms are common patterns in chart analysis. They are identified by the peaks or troughs formed by the fluctuation of the security price. For double tops, the pattern resembles an “M” on the chart with two distinct high points near the same price level. As the price nears the price level of the previous peak, it will continue either its upward trend or retreat from this level. If it continues upward, the trend is intact. However, if the price fails to rise beyond its previous peak, you may very well be witnessing a double top in the making.
A double bottom is simply a double top flipped over (see Figure 3). In this case, the pattern resembles a “W” with two prominent lows near the same price level. As the stock price nears the level of the previous trough, two things can occur: If the price continues downward, the downtrend resumes and the reversal pattern does not develop; however, if the price rebounds from this level, a double-bottom pattern may be forming.
Triple bottoms and tops are similar to double tops and bottoms except that they are made up of either three peaks or troughs at roughly the same price level. These patterns are less common than double tops and bottoms.
Head and shoulders patterns, the best known of all reversal patterns, consist of three prominent peaks (see Figure 4). The first peak, called the left shoulder, is created when the price tops out and then falls. The head, which is the second peak, forms when the price rises above that of the left shoulder, only to again drop to a level that is near that of the trough created after the left shoulder. The right shoulder forms at a level below that of the left shoulder. The right shoulder is an indication of weakness, since the price cannot achieve the level reached at the head. At this point, the price will often drop and, in confirmation of the reversal pattern, keep dropping.
Inverted head and shoulders patterns are a flipped version of the regular head and shoulders pattern. The shoulders are created when the security price tops out at a similar level. The head, formed between the two shoulders, is its low point before it climbs to the level of the right shoulder.
How is the magnitude of the trend reversal determined?
Referring back to Figure 3, you see that two (nearly) horizontal lines have been drawn. The top marks the point to which the price of AGCO Corp. (AG) rose after creating the first trough of the double bottom. Once the second trough has been created, at roughly the same level as the first, we have a trading range for this pattern—roughly three and a half points. We can use this range as an estimate for the minimum price move AGCO will make once the breakout occurs. In this case, the pattern did indeed continue upward and, after a small retracement, surpassed the price target two months later.
The head and shoulders pattern evident in the United Technologies’ UTX chart (Figure 4) shows the right and left shoulders as well as the head. By connecting the troughs formed after the left shoulder and before the right shoulder, a neckline is formed. The distance between the head and the neckline (seven points) can serve as an estimate of the minimum price decline should the pattern be confirmed. In this example, the price falling below the neckline confirms the pattern. Just days later, United Technologies had fallen beyond the seven-point target.
Hindsight is Always 20/20
You may say that it is very easy to scan years of data to find a pattern well after the fact, but how do you know that a pattern is forming at this very moment?
Much of the answer lies in experience. As you use charts, plot trends, and identify pattern reversals, you may become more adept at spotting those patterns that are indeed reversals and those that are merely hiccups on the way up (or down). The easiest, and perhaps worst, thing that could happen is that you are correct in flagging a couple of pattern reversals and make profitable decisions based on your discovery. Thereafter, you may be tempted to charge off at full steam with your newfound method, only to miss the next reversal or fail to get off at the top.
Where Do You Go next?
As is the case with all investment strategies, do your homework. Begin charting your favorite stocks and watch to see if patterns form and if you can determine future trends. Many investors choose to combine fundamental analysis with technical tools—first identifying companies with strong fundamentals to determine a buy list and then relying on technical tools to help establish buy and sell points.
As computers have become more commonplace as an investment tool, numerous technical analysis programs have entered the market. The programs speed the analysis process and several offer educational functions as well. The May/June 1998 issue of Computerized Investing compares some of the more popular technical analysis programs on the market (a copy of the comparison, titled “Technical Analysis Software,” is available for $4 by calling AAII at 1-800-428-2244). If you are looking to learn more about charting techniques and pattern recognition, two of the better books are “The Visual Investor” by John Murphy and “Profitable Charting Techniques” by Brian J. Millard (both published by John Wiley & Sons, 1-800-225-5945).
Without question, stock prices can be analyzed for past trends. The question to be answered is: Are historical patterns useful in identifying future trends?