Precision Patterns

A chart is a record of the price paid for a stock during the day. An end of day chart shows the opening price, the high and low price and the closing price for the day. Just as an electrocardiogram tracks several vital life functions, the chart display also allows the trader to track important aspects of price behaviour.

I use a chart to track the emotional state of the market crowd of people who are trading and investing in the company. Price is like a heartbeat on the hospital monitor. It tells us if the temperature is rising, if the patient is upset, or calm, or asleep. It also tells us if the stock is preparing for action.

This type of analysis brings together four features:

• The way individual reactions are replicated by many others
• Repeated patterns of emotional behaviour
• A measure of probability without using any mathematics
• Easily defined outcomes

Put all these features together and you have a precision pattern strategy based on chart behaviour. This is not a mystical process. It is commonsense and logic applied to understanding some of the other messages contained in the chart of price behaviour. How we react as individuals is often much the same way as our colleagues react and this helps to create a pattern of repeated behaviour.

Recently I watched a stock zoom up rapidly from $0.75 to $0.95. I missed this opportunity, but I was interested in trading the stock. I was not prepared to pay $0.95, but I was happy to pay $0.85. The diagram shows my buy orders in red. If price fell back to this level I would be a buyer. Price did fall, as shown by the blue lines, but only to $0.87 before it started to rally upwards again.

After the second rally, price fell again and I still thought it was good buying at $0.85 so I placed another buy order. Unfortunately price only fell to $0.90 before it started to rise. Why did it fall to only $0.90 instead of $0.87?  Other people who thought about buying the stock were worried they might miss out if they waited for price to fall lower. They wanted this stock more than I did, so they were prepared to pay $0.90. Their action created ‘buying support’ for the stock.

People who wanted to sell the stock did not have to offer it at lower prices because there were buyers at $0.90.

But what about me? I missed out again because I was not prepared to pay enough. I thought carefully and decided to lift my buying price to $0.90. When the next rally collapsed there would be a reasonable chance prices would fall back to the most recent low.

I was wrong. Prices fell to $0.92. Other buyers were more eager than me so they jumped to the head of the buy line with a higher offer. This tells me some interesting things and has an important effect on the way I think about the stock.

• First, other people have a lot of confidence in this stock which is why they are prepared to pay higher prices.
• Second, if I want this stock I need to bid a higher price, perhaps higher than the previous low
• Third, I am frustrated. I have tried to get this stock several times and missed out. I start to think emotionally about this stock that is eluding my buying efforts. Additionally, if other people are confident about the stock, then perhaps I ought to be more confident. This stock is worth buying, so if I am serious I need to pay a higher price. When other people are outbidding me then I get excited.

I  am determined to get hold of this stock so my next buy order is placed higher than the previous low. At $0.93 I get hold of the stock just before it bounces up again.

My thinking, my emotions and my reactions are exactly the same as those experienced by most of the other people who are also interested in buying this stock. I am not irrational, but I do get more excited as price continues to rise because it confirms my initial analysis that this is a good opportunity. My individual reactions are replicated by others. When people think the same way, they trend to react in the same way. It is the crowd at work. It is more than basic supply and demand because it includes an emotional factor.

If we apply some very basic chart analysis to this diagram we locate a pattern of crowd behaviour. Start with the ‘resistance’ level at $0.95. Many people who held stock had decided that $0.95 was about its correct value. Whenever prices reached this level, they offered their stock for sale. This consistent selling at $0.95 is a resistance level and it  is tracked using   horizontal line A. This shows an unchanging idea of value over time.

The lower line B is a trend line. It slopes upwards and tells us that this is a crowd who are getting excited. They are prepared to pay a higher price for the stock as time passes. The line shows a changing value over time. Think back to my reaction. Every time I missed out on buying the stock I decided it was probably worth more so I lifted my buyer bid higher until I was finally successful in getting the stock. Others did the same.

This repeated behaviour captures the build-up of crowd emotion and creates a simple upward sloping triangle pattern defined by line A and B. This is where it gets interesting in two important ways.

Firstly, this is a measure of probability. When we see this pattern we know there is a high probability that prices will ‘break out’ above the resistance level and move higher. This is not guesswork, but nor is it science. Observation of similar behaviour in many stocks in the past tells us that this is a most probable development. In a bullish market, the probability is around 80% that the breakout will move upwards.

This is the emotional impact  of supply and demand. This repeated behavioural pattern that creates the upwards sloping triangle also points the way to a high probability future development. And that is what we want to trade.

These precision chart patterns also allow the trader to estimate how high the price is most likely to rise. Sometimes the rise is lower, and sometimes higher, but again there is a high probability the target price will be achieved. This target shown by the thick black lines is a ‘measured move”.

The base or height of the triangle is $0.10. This value is then projected upwards $0.10 above the resistance level at $0.95 to set a price target at $1.05. This provides an easily defined reward for this type of trading situation. Nobody can really explain why these targets are so often achieved. For traders, what is important is that this are high probability targets that are based on using a  chart to understand the emotional activity of the crowd.

Chart patterns capture the development of crowd emotion.   The development of a small  group pf precision chart patterns alerts the trader that a range of outcomes is more likely than at other times. Chart patterns signal the probability of action and allow us to understand the exact emotion of the crowd.

In the next article we examine the way some indicators are used to understand trend behaviour.

Daryl Guppy is a full time trader and author of   Trend Trading, Trading Tactics and Better  Trading. He runs trading workshops  in Australia, Asia, China and the US. He can be contacted via www.guppytraders.com.

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