Novice investors wishing to get acquainted with technical analysis would have been bemused by quaint terms such as head and shoulders, cup and saucer, neckline, double tops, rounding bottoms and so on, that appear frequently in technical analysis literature. What is more, these terms are often cited as a justification for supporting a buy or sell decision.
Though the above-mentioned terms sound like parts of the human anatomy or articles of everyday usage in homes, they are actually patterns that frequently occur in charts. John J Murphy defines price patterns as pictures or patterns that appear on price charts of stocks or commodities that can be classified into different categories and that have predictive value.
Let us take the daily chart of ACC as an example. This stock formed a head and shoulder formation between July 2007 and December 2007, as marked in the chart. This is a top reversal formation and implies that the stock is on the verge of declining sharply.
The stock price declined below the neck-line in January and is currently down 40 per cent from that level.
Most of the patterns use volumes to corroborate the signals. For example, the breach of the neck-line ought to be accompanied by a spurt in volumes in order to qualify as a classic head and shoulder pattern.
Similarly, continuation patterns or sideways moves ought to record a decline in the traded volumes.
That brings us to the classification of patterns. The two broad categories into which chart patterns can be classified are, reversal patterns and continuation patterns.
Reversal pattern signal the termination of a prevalent trend and the beginning of a new trend in the opposite direction.
Continuation patterns, on the other hand, unfold during a trend and the price action following the pattern would be in the direction of the prevalent trend.
Traders can anticipate the future movement of a stock based on the pattern that in unfolding in the chart and take an appropriate position (long or short) in advance. Periods of lull during which continuation patterns unfold are very useful for traders who are betting on the continuation of the prevalent trend to take position.
The chart above of Gammon India depicts a symmetric triangle formation. This continuation pattern was followed by the stock continuing further. Traders could have gone short while this triangle was unfolding to reap profits in the subsequent decline.