CHARTING


Exploring The Basis Of Classical Chart Patterns

Cycles, Volatility, And Chart Formations

by Daniel L. Chesler, CTA, CMT

Understanding the building blocks of classical chart patterns can improve your analysis and trading results. Here's how.

Anyone who has studied or traded with classical chart patterns for several years knows the unmistakable feeling when a good pattern develops. The better patterns tend to stand out from the marginal ones, regardless of their shape or classification. This led me to realize that it was the similarities between chart patterns that were important, rather than the differences as defined by pattern names such as head-and-shoulders, triangle, and so on. It became apparent that a model was needed to bridge the gap between the minutiae of classical chart pattern definitions and the common features shared by chart patterns in general. Specifically, the model's goals are to:

  • Offset the lack of classical chart pattern specificity by providing a less subjective though still not entirely fixed criterion for identifying patterns.
  • Serve as a notional benchmark for distinguishing valid chart pattern behavior from other types of market behavior, such as trending and exhaustion behavior.
  • Minimize the risk of an implied directional bias by excluding the use of traditional "bull," "bear," or pattern shape terminology.
  • Enhance the timing of trading decisions by more narrowly defining the specific behavior that coincides with chart pattern breakouts.

    • INTERESTING VERSUS IMPORTANT

    While the terms formation and pattern are nearly surrogates, they are also just different enough to make a point. Pattern implies something that is proposed to imitate, whereas formation implies an arrangement of things acting as a unit or a process by which one unit is formed from others. Thus, I use the phrase chart formation to shift the emphasis away from the "gee-whiz" pattern and shape aspects of classical chart patterns, and toward the more important process or unit aspect of the chart formation itself. My rationale is simple: No one gets rich from distinguishing, say, the subtle differences between a complex cup-and-handle and an irregular inverted head-and-shoulders pattern. However, focusing on specific market situations that lead to reliable price breakouts and trends makes us money.

    Among newcomers and the uninitiated, there is a tendency to think about chart patterns in terms of curiously intricate names and ability to predict the course of market prices. The fault probably lies more with classical chart pattern definitions, which tend to emphasize stylistic shapes and are often categorized according to a directional bias. In reality, classical charting has always been less about price forecasting than it has been about trading and tactics.

    To address these issues, I rely on a more compact and user-friendly approach that breaks chart formations into two components: the cyclic or structure component, and the volatility component.

      ...Continued in the July 2003 issue of Technical Analysis of STOCKS & COMMODITIES

    Excerpted from an article originally published in the July 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.


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