Here’s Why Chart Patterns Work

Some traders look at charts and see actionable information. Warren Buffett is not a member of that group.

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  • Buffett has admitted that he tried to use technical analysis, the broad field of investment analysis that includes charts. He reportedly joked in a speech that, “I realized that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer.”

    Another skeptic is Burton G. Malkiel, a well respected economics professor at Princeton University and the author of A Random Walk Down Wall Street.

    Malkiel tested the usefulness of charts by providing students with a “given hypothetical stock that was initially worth fifty dollars. The closing stock price for each day was determined by a coin flip.

    If the result was heads, the price would close a half point higher, but if the result was tails, it would close a half point lower.

    Thus, each time, the price had a fifty-fifty chance of closing higher or lower than the previous day. Cycles or trends were determined from the tests.

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  • Malkiel then took the results in a chart and graph form to a chartist, a person who “seeks to predict future movements by seeking to interpret past patterns on the assumption that ‘history tends to repeat itself’”.

    The chartist told Malkiel that they needed to immediately buy the stock. Since the coin flips were random, the fictitious stock had no overall trend. Malkiel argued that this indicates that the market and stocks could be just as random as flipping a coin.”

    Rebutting Conventional Wisdom

    Malkiel’s work has been hotly debated. “In the late 1980s, professors Andrew Lo and Craig McKinlay published a paper which cast doubt on the random walk hypothesis.

    In a 1999 response to Malkiel, Lo and McKinlay collected empirical papers that questioned the hypothesis’ applicability that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH, which is an entirely separate concept from RWH.

    In a 2000 paper, Andrew Lo back-analyzed data from U.S. from 1962 to 1996 and found that “several technical indicators do provide incremental information and may have some practical value”. Malkiel dismissed the irregularities mentioned by Lo and McKinlay as being too small to profit from.”

    Undaunted, Lo later published:

    “Is It Real, or Is It Randomized?: A Financial Turing Test” which tested charts in the real world. The authors:

    “find overwhelming statistical evidence (p-values no greater than 0.5%) that subjects can consistently distinguish between the two types of time series, thereby refuting the widespread belief that financial markets “look random”.

    A key feature of the experiment is that subjects are given immediate feedback regarding the validity of their choices, allowing them to learn and adapt. We suggest that such novel interfaces can harness human capabilities to process and extract information from financial data in ways that computers cannot.”

    This test duplicated a video game and found traders incorporate information into the chart analysis.

    Lo’s results make sense since traders are seeking profits and will adapt their analysis as the data changes.

    Why Charts Should Work

    Because traders adapt, they will change their opinion when the trend changes in Malkiel’s coin flipping experiment. With a sound exit strategy, it is possible to profit from runs in the coin flipping experiment although it’s unlikely.

    But, as Lo demonstrated, prices move in trends. This is easily seen in the next chart.

    Traders are able to see the trend in the chart and the chart reflects the emotions of traders. As prices rose, traders became increasingly cautious. Their caution can be seen in the next chart which includes stochastics, a popular momentum indicator.

    Stochastics showed the excitement of buyers was diminishing as the price of the S&P 500 index moved higher. This is seen in the chart as a divergence with stochastics failing to make a new high while the price was making its final push higher.

    Chartists often add indicators such as the stochastic to their chart but even those who follow pure price action would have had a sell signal when prices broke to a new low. That is shown with the solid line in the next chart.

    Traders could have used a standing stop, trailing the stop level higher along with the market action to minimize risk. The break of the previous low is a sign that the trend has reversed since an up trend is defined as a series of higher highs and higher lows.

    In the chart, higher highs show buying pressure. Lower lows shows selling pressure. That is all the chart needs to show for a trader to profit. Pattern analysis can be used but common patterns, like a head and shoulders top, are simply catching breaks of previous highs or lows for trade signals.

    Charts should work for disciplined traders simply because they reflect the price action. The chart is simply showing whether buyers or sellers are acting with stronger conviction. The level of conviction of those two groups determine the trend and that is all that a chart captures.

    But chart analysis takes time and a willingness to change market positions when the market action dictates that a change is warranted. All market trading tools will require time and commitment to use.

    Many individuals discover that they are not able to complete the required amount of research because that can take an extended amount of time and they have other personal and professional commitments competing for their time.

    The service, PPK System, is designed to exploit patterns associated with market clues by looking for value and momentum in stocks and could spot the potential winners based on a variety of factors.

    This combination of value and momentum has been shown by many researchers to be the cornerstone of strategies that beat the market in the long run. The PPK System follows strict rules for buying and selling. You can learn more about this trading service by clicking here.

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