For a novice, stock price movements are puzzling. However, a trained eye can see patterns in these flows and make better predictions
One size does not fit all as far as investment strategies go. People are unique in their preferences, tastes, needs and requirements and so should be their investment styles. Depending upon their risk appetite, investors can either choose fundamental or technical analysis to invest in stock markets.
Fundamental analysis, both quantitative and qualitative, help people in picking up stocks for the long-term. While the fundamental analysis typically answers the question “what to buy”, the technical analysis provides key to the question “when to buy.”
Technical analysis or chart analysis is the study of market action, using price charts to forecast the price direction. The cornerstone of the technical philosophy is the belief that all factors that influence market price — fundamental information, political events, natural disasters and psychological factors — are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down.
Chart patterns are geometric shapes found in the price data that can help a trader understand the price action as well as make predictions about where it is likely to go.
The two most popular chart patterns are reversals and continuations and can be found across any timeframe. A continuation pattern signals that the trend will continue once the structure is complete, whereas a reversal pattern signals that a prior trend will reverse upon completion of the sequence.
However, reversal patterns are not usually sudden and dramatic. When an uptrend changes to a downtrend or vice versa, it slows down, pulls back, goes in the direction of the trend and comes back, till slowly it is reversed. A change in the perception of the price of a given stock results in the change in trend, which in turn changes either the demand or supply of these stocks. This eventually moves the stock prices either up or down.
In an uptrend, the demand for a scrip slowly increases its price, whereas in a downtrend, the low demand and high supply of the stock brings it down. This tug of war between buyers and sellers makes price swing between optimistic and pessimistic perception level and invariably creates reversal patterns on the charts before the trend changes to the opposite side. Continuation patterns, when they occur, indicate that a price trend is likely to go on and are a pause in the price action of varying durations as they generally occur mid-trend. A pattern is considered complete when it has formed and then “breaks out” of that mould, potentially continuing with the former trend. Continuation patterns can be seen both in bullish and bearish markets and are found in different shapes but for the most part, they look quite similar. Common continuation patterns include triangles, flags, pennants and rectangles.
Having a good knowledge of continuation chart patterns allows investors to speculate positively about the course of the trend. It allows them to add more to their existing position and helps investors to hold on for a longer period without worrying about temporary market setbacks.
Similarly, reversal patterns allow us to speculate positively about the end of the trend. We can square off our position at a right time to book maximum profits. It also allows us to take position in the opposite direction, at the right time. On the whole, good knowledge of reversal patterns allows us to have smaller losses and larger profits. Some of the common reversal patterns that an investor should keep a look out for are Head and Shoulders, Double Tops and Bottoms, Wedges and Rounding Bottoms.
Although chart patterns are an integral part of technical analysis, they alone may not be sufficient. Traders should combine these techniques with technical indicators and other forms of technical analysis to maximise their odds of success. Technical analysis, however, is not a long-term strategy, where actions are taken frequently by monitoring the ups and downs of the stock market constantly and speed is important.
Support and resistance are common concepts in the world of technical analysis. Traders usually buy and sell stocks at these levels because they indicate how well a stock might (or might not) perform. For a novice, stock price movements are haphazard up and down movements without any rhyme or reason. However, a trained eye can see patterns in these random movements.
(The writer is Assistant Professor, Amity University)
