On Chart Patterns

The study of patterns on price charts is one of the most time-tested tools in technical analysis. Many successful traders of shares and commodities see chart patterns as an invaluable aid, including Peter L. Brandt (1990), William J. O’Neil (2009) and Mark Minervini (2013). It is commonly believed that the price chart reflects the aggregate psychology, and it often forms repetitive and statistically reliable patterns when an imbalance of demand and supply is about to occur, hence an analysis of price charts could give a probabilistic estimate of the future market direction.

However, critics of technical analysis often say that the study of chart patterns is too subjective and arbitrary to be considered a science  (Chesler, 2000). While it is true that chart patterns, as a measure of social behaviours, can never estimated with mathematical precision, experienced traders actually have certain rules to determine whether a chart pattern is valid.

Minimum Duration

The first characteristic of a sound pattern is a proper length of duration. From the perspective of a position trader, who usually holds his position for at least a few weeks (if not stopped out), a consolidation pattern should be given enough time to develop, so that the supply (or demand, in a bearish case) could be properly absorbed before making another thrust higher (or lower). O’Neil (2009) believed that a sound pattern should be no shorter than six weeks, and in most cases, it is usually longer. Brandt (1990) said he only consider patterns which are eleven weeks long, including the week of the final breakout. He also noted that if the final breakout is against a horizontal price level (as in the case of a rectangle) instead of a diagonal trend-line (as in the case of a wedge), the signal is usually more reliable.

Volatility Contraction

Another characteristic of a sound pattern is what Minervini (2013) called volatility contraction. It means that, during the development of a pattern, the magnitude of price swings shall be decreasing as it goes on. On a share price chart, such decrease in volatility is usually accompanied by a dry-up in volume as well (O’Neil, 2009). To provide an objective measure of volatility, Chesler (2000) suggested using the fourteen-day Average Directional Index (ADX), which shall show a smooth decline in value across the development of the pattern. It is beyond the scope of this article to discuss the details of ADX, but you can find more information in this link.

Cyclical Structure

The last characteristic of a sound pattern is a cyclical structure (Chesler, 2000). In a bullish consolidation, the peak-to-peak distance inside the pattern shall be similar to each other, as if it is following a sinusoidal wave. It is the same for the trough-to-trough distance in a bearish pattern. The stock market is a living organism which has its own pulse and rhythm, and it is important to recognise this, because most bullish breakouts usually comes at a time when the price reaches a cyclical top within the pattern, and vice versa in a bearish case.

Example

Here is a recent example which neatly illustrates all three of the above ideas:

Courtesy of Stockcharts.com

Amberella (AMBA) showed a consolidation from late March to early May in 2015. The pattern was seven week long. The fourteen-day ADX value was decreasing throughout the period. More importantly, the internal peaks also showed a cycle of seven to eight trading days. And here is what happened in the next two months:

Courtesy of Stockcharts.com

Amberella soon broke above the $79 resistance level and went up more than 50% in less than two months! Note that the final breakout day is nine days from the last peak, which is just one day after the seven-to-eight day cycle!

Reference:
Brandt, P. L. (1990). Trading Commodity Futures with Classical Chart Patterns. Cameron Park, CA: Advanced Trading Seminars.
Chesler, D. L. (2000). Volatility and Structure: Building blocks of classical chart pattern analysis. Market Techicians Association Journal, Winter-Spring, Issue 53.
Minervini, Mark (2013). Trade Like a Stock Market Wizard: How to achieve super performance in stocks in any market. New York, NY: McGraw-Hill Education
O’Neil, W. J. (2009). How to Make Money in Stocks: A winning system in good times and bad (4ᵗʰ edition). New York, NY: McGraw-Hill Education.