Traders around the world are typically divided into three different categories - depending on the way they make decisions: some operate on what they hear, some base their decisions on solid facts, and others base their commitments on reading supply and demand.
Those who follow the hype, rumours and latest news often end up incurring significant losses, even those who read the fundamental market data. While on the other hand, those who read graphs tend to achieve more success - why is it so? Is it THAT important to learn how to analyze graphs?
Detailed classification of traders
Traders based on rumors
Traders who operate solely on what they have heard or what news is going around make up a significant portion of unsuccessful traders. They may be new to trading or simply do not have the time or effort to read market conditions. Often these types hope to get something for nothing; they are hungry for tips and tend to follow ongoing rumors. If there’s one important rule these traders follow, then it’s “inside information”.
Traders operating on facts
These are traders who operate based on solid facts (earnings, growth etc.). They aim to buy when prices are low and select, for example, stocks with consistent dividends and growth. These traders are frequently more successful than those who operate on guesswork, however, when they analyze these values (the so-called fundamentals analysis) they tend to enter or exit the market at the wrong time.
Richard Wyckoff, a famous Guru in trading and the founder of “The Magazine of Wall Street” (in 1907) once stated: “Even J.P Morgan himself does not know how the street will make a certain announcement or what the impact of his buying and selling will be. Always keep in mind that no one can predict what the supply and demand will be 5 seconds, 5 minutes or 5 days ahead. No one knows what will in the future induce others to buy and sell. This is why no one can predict the market with 100% accuracy, not even market manipulators.”
Traders based on supply and demand
One thing successful traders do know is what large operators are doing and what supply and demand levels are.
They are all reflected on the charts. If we take an example of the recent BTCUSD chart such levels can be palpably seen: the level of $8.2K represents BTC resistance or supply level, whereas the $7.6K level represents the current BTC demand or support:
Every transaction plays a part in forming supply and demand levels, otherwise known as resistance and support levels. When it comes to outsiders, the greatest supply often comes near the bottom of breaks, and rarely at the top, mostly due to panic trading. Supply from insiders however, often appears at the top of small rises and at the end of booms. The demand is just the reverse. Successful traders therefore must be able to judge when a movement has run its course.
Richard Wyckoff concluded that the losers are principally those who trade on what they hear, as well as those who work on facts or what they think are facts, but:
“The most successful class of traders are those who work on Supply and Demand, or simply, read the graphs.”
The core price patterns
In graph reading and technical analysis, the transition between rising and falling trends are often signaled by price patterns. By definition, a price pattern is a recognizable configuration of a price movement which is identified using a series of trendlines and curves. When a price pattern signals a change in trend direction, it is known as a reversal pattern; a continuation pattern occurs when the trend continues in its existing direction following a brief pause. Technical analysts have long used price patterns to examine current movements and forecast future market movements.
- Pennants, constructed using two converging trendlines.
- Flags, drawn with two parallel trendlines.
- Wedges, constructed with two converging trendlines, where both are angled either up or down.
Pennants are drawn with two trend lines which eventually converge. A key characteristic of pennants is that the trendlines move in two directions – that is, one will be a down trendline and the other an up trendline. Figure 1 shows an example of a pennant. Often, volume will decrease during the formation of the pennant, followed by an increase when the price eventually breaks out.
Flags are constructed using two parallel trend lines which can slope up, down or sideways (horizontal). In general, a flag which has an upward slope appears as a pause in a down trending market; a flag with a downward bias shows a break during an up trending market. Typically, the formation of the flag is accompanied by a period of declining volume, which recovers as price breaks out of the flag formation.
Wedges are similar to pennants in that they are drawn using two converging trendlines; however, a wedge is characterized by the fact that both trendlines are moving in the same direction, either up or down. A wedge that is angled down represents a pause during an uptrend; a wedge that is angled up shows a temporary interruption during a falling market. As with pennants and flags, volume typically tapers off during the formation of the pattern, only to increase once price breaks above or below the wedge pattern.
Triangles are among the most popular chart patterns used within technical analysis since they occur so frequently compared to other patterns. The three most common types of triangles are symmetrical triangles, ascending triangles and descending triangles. These chart patterns can last anywhere from a couple weeks to several months.
Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur – not the direction. Ascending triangles are characterized by a flat upper trend line and a rising lower trend line and suggest a higher breakout is likely. On the other hand descending triangles have a flat lower trend line and a descending upper trend line which suggests a breakdown is likely to occur. The magnitude of breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle, as shown in the figure below.
Cup and Handles
The cup and handle is a bullish continuation pattern where an upward trend has paused, but will continue when the pattern is confirmed. The ‘cup’ portion of the pattern should be a “U” shape which resembles the rounding of a bowl rather than a “V” shape with equal highs on both sides of the cup. The ‘handle’ forms on the right side of the cup, in the form of a short pullback resembling a flag or pennant chart pattern. Once the handle is complete, the stock may breakout to new highs and resume the trend higher. A cup and handle is depicted in the figure below.
Reversal patterns are price patterns which signal a change in the prevailing trend. These patterns signify periods where either the bulls or bears have run out of steam. The established trend will pause and then head in a new direction as new energy emerges from the other side (bull or bear). For example, an uptrend supported by enthusiasm from the bulls can pause, signifying even pressure, which then eventually gives way to the bears. This results in downward trend. Reversals which occur at market tops are known as distribution patterns, where trading instruments are in more actively sold than bought. Conversely, reversals which occur at the market bottom are known as accumulation patterns, where the trading instrument are more bought than sold. As with continuation patterns, the longer the pattern takes to develop, and the larger the price movement within the pattern, the larger the expected move once price breaks out.
When prices reverse after a pause, the price pattern is known as a reversal pattern. Examples of common reversal patterns include:
- Head and Shoulders, signaling two smaller price movements surrounding one larger movement.
- Double Tops, representing a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level.
- Double Bottoms, showing a short-term low swing, followed by another failed attempt to break below the same support level.
Head and Shoulders
Head and shoulder patterns can appear at the market top or bottom as a series of three pushes: an initial peak or trough, followed by a second and larger one, and then a third push mimicking the first. An uptrend which is interrupted by a head and shoulders top pattern may experience a trend reversal, resulting in a downtrend. Conversely, a downtrend which results in an inverse head and shoulders will likely experience a trend reversal to the upside. Horizontal or slightly sloped trendlines can be drawn connecting the peaks and troughs appearing between the head and shoulders, as shown in the figure below. Volume may decline as the pattern develops, and can spring back once the price breaks above (in the case of a head and shoulders bottom) or below (in the case of a head and shoulders top) the trendline.
Double tops and bottoms signal areas where the market has made two unsuccessful attempts to break through a support or resistance level. In the case of a double top which often looks like the letter M, an initial push up to a resistance level is followed by a second failed attempt, resulting in a trend reversal. A double bottom on the other hand, looks like the letter W and occurs when the price unsuccessfully makes to attempts to push through a support level. This often results in a trend reversal, as shown in the figure below.
Triple tops and bottoms are reversal patterns which aren’t as prevalent as head and shoulders or double tops or double bottoms. But, they act in a similar fashion and can be a powerful trading signal for a trend reversal. These patterns occur when a price level tests the same support or resistance level three times and is unable to break through.
Gaps occur when there is an empty space between two trading periods, caused by a significant price increase or decrease. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or news updates. There are three main types of gaps: breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps near the end.
The Bottom Line
Price patterns are often found when prices "takes a break," signifying areas of consolidation which can result in a continuation or reversal of the prevailing trend. Trendlines are important in identifying these price patterns that can appear in formations such as flags, pennants and double tops. Volume plays a role in these patterns, which often decline during the pattern's formation, and increases as price breaks out of the pattern. Technical analysts look for price patterns to forecast future price behavior, including trend continuations and reversals.