Let's start by looking at quantitative analysis, which is sometimes confused with technical analysis. Quantitative analysis is defined as the analysis of a situation or event, especially a financial market, by means of complex mathematical and statistical modeling. This is where people can get confused with technical analysis. They make the assumptions that you have to be mathematical, and there is a formula which can be solved to provide the answer to the question, "where will the market trade next?" Neither of these points are true.
Far too often analysts wish to dehumanize the markets as they try to find a fair market value of a stock based on what the fundamentals think it should be worth or in a more strictly quantitative environment, they will use the statistics and math to arrive at a fair price for the stock. While these forms of analysis may be great in theory, in reality, they completely ignore the most important influence on the price of a stock: the way the people feel about the stock they are trading.
By contrast, technical analysis is defined as a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. These statistical trends track human behavioral element of trading what we like to call market sentiment.
How the people who are trading an individual stock feel about that stock is the single most important piece of information, an analyst can use. People are the ones who are deciding to buy or sell a stock and people are ruled by emotions, not quantitative logic or fundamental justification.
When the fear of losing money outweighs the fear of loss of opportunity, the trader will sell the stock. Even if it makes little logical sense, the pure emotional fear of losing money will drive them out of the market. However, when the trader has a greater fear of missing out on an opportunity, that trader will buy even if it makes no logical sense. Why? The pure emotional fear of missing out on the opportunity.
Currently, there is no form of quantitative analysis or fundamental analysis which can take this emotion into account. There is no statistical formula that suggests, "Bonnie and Bill are going to react negatively to this news coming out of the middle east." However, there is speculation, which is the real driving force of the market.
Speculation is the main emotion that drives the market both up and down. It is a speculative feeling that such and such is about to occur, so we should trade accordingly. For example, what if Greece makes an announcement they are going to default on their debt. "Well, I think this is bad, so I should probably start selling today," says one trader. While another trader says, "oh, this isn't too bad, I skipped a few credit card bills myself once."
This dichotomy of thought, which is driven by speculation, is the real source of the battle of the Bulls and the Bears on Wall Street. When the majority of market participants interpret the data to be bearish, the market will move down, and conversely, when the majority of market participants interpret the data to be bullish, the markets will rise. This distinction between emotion and the assumption that one could put a mathematical equation on trading behavior, this is what distinguishes true technical analysis from quantitative analysis.
So you may be wondering: what does all this have to do with Chart patterns? The answer is Everything.
Chart patterns are little patterns of human behavior that show up in the price chart of a stock. While human behavior is not mathematical, it is predictable, and that is exactly why patterns are so powerful. Take as an example a trend in popular music. The first moment a new sound comes on the radio many people may not care much for the new music but after many repetitions of hearing the song played on the radio as well as hearing it as background noise, at some point those same people may find themselves in a club dancing and notice they are now enjoying this same song they used to hate. What would explain this phenomenon? The answer is herding behavior.
What once was a distinct opinion has now become blurred and even reversed because the majority of influencers felt the opposite. In this example, I'm talking about a song, but we could just as easily apply the concept to the stock market. Take a stock that is trading at $90/share after dropping from $110. A trader named Robert has traded this stock many times and has pre-determined that $90 is the ideal spot to buy again in anticipation of a rise. However, after a week of neutral trading, the stock drops below $90 and soon hits his stop at $85.
Robert now begins to change his opinion about the stock. "Perhaps $90 was a little bit high for a purchase". Notice, however, nothing has changed in the fundamentals! The price action on its own changed this trader's view. But as the stock continues to drop, it falls to $83, and then $81 and finally to $80/share. Now Robert may say "you know I think this one's going down, let's go short some shares."
At that moment this trader has just joined the herd. The herd was already running; it just so happened for that one trader named Robert it took a bit longer to realize the herd had shifted.
Unfortunately for Robert, the herd had run its course, and soon the trade began to move higher and within just a few weeks, was trading yet again at $90/share.
Feeling like you are late to the party only to arrive as everyone is leaving and preparing to return home? This story of Robert is a true story, and the stock is Caterpillar. While the name Robert is made up, his story is all too real. What Robert missed was the chart pattern known as a bear flag pattern that occurred at $90 a share, just as he was buying.
If Robert had known to recognize this pattern he would have recognized that stocks trade to previous turning points, and then some buying pressure from people like Robert will come into the market. But this provides a short-term bounce as the trade is simply sliding down the slope of hope while the stock continues to fall in its bearish trend.
Unknowingly Robert, like most traders, became part of the story. Robert traded the best he knew how. He bought when he thought the stock was undervalued. He waited to buy on the dip. It was a solid company that he could believe in, but he still lost money on the trade.
The amazing thing about human behavior is that it is predictable. Once a behavior starts, it tends to continue. That tendency to continue is what we call a trend. If Robert had known how to identify the trend he could have participated with the trend. Instead he was trying to place educated guesses based on statistical data, and in the end, his lack of understanding of human behavior cost him.
Imagine an aquarium. If you look inside the aquarium you can watch the fish swimming around.
As you watch, you notice a few smaller fish hanging out together, kind of schooling up. They swim up the aquarium together and back down. Clearly, they are fish buddies.
Now perhaps, you watch a shark swim around the corner, and you think "that little fishy better move or the shark is going to eat him! Then there he goes bye-bye little fishy.
The poor little fish, lost in his school of fish, never saw the big bad shark coming.
You can watch this fish behavior because you are outside of the tank. If the fish that was about to be eaten could have only seen from your perspective, he may not have become lunch. But instead, he got himself gobbled up. Trading is exactly the same way.
Little trading fish like Robert school up in certain locations, we call them pivot points. When they get to these spots they tend to hang out. For that moment in time, the buyers and sellers are somewhat agreed upon a fair price. In Robert's case, he took a new bullish position by purchasing the stock.
Soon however the herd started to ease down just a little bit. Before Robert knew what happened, a surge of selling pressure, we'll call them bear market sharks, came surging out of nowhere, and the stock started falling like a rock. That's when Robert finally got out, but not before giving up some cash as shark bait.
Simply put, chart patterns can help you become a stock market shark. The trader who lies in wait with the other sharks, waiting for the school of unknowing traders to swim around the corner so you can pounce on them; however, you can never be a shark if you only see from inside the tank.
In order to become a shark, you have to learn to look at trading behavior, chart patterns, from the outside in. If you can learn to disassociate your trades and look at them from a distance, you may be surprised to discover that herding behavior is all around you. Your job is to avoid becoming part of the behavior, but rather observe it from the outside.
If you can learn to do this, then you are now set up to take advantage of a pattern break. This is where you can literally lie in wait, and when the other traders finally pick a direction for the trade - you're in. You seize the moment and start gobbling up your profits.
Far too many people approach technical trading with the mindset that says, "if all the indicators line up, then we can place the trade." It's a desire to be very analytical and quantitative.But they miss the reality that trading is the act of observing human behavior in the marketplace and exploiting it for financial gain.