There is a tremendous amount of confusion among investors when it comes to technical analysis. Many investors are convinced that technical analysis of stocks simply does not work since they can’t seem to make a profit using it. Other investors swear by technical analysis’s ability to accurately call market moves in advance.
What is the truth about technical analysis?
The truth about technical analysis is somewhere in between the two extremes above. Technical analysis does not predict the future with 100% accuracy. This is the error many investors encounter when dealing with technical analysis. Believing that a certain pattern or indicator can foretell the future 100% of the time is a sure way to the poorhouse in the financial markets.
The reason this belief is so prevalent is the fact that patterns only exist in the past so looking at them makes it appear that XYZ occurred every time the pattern occurred. However, truth be told, the pattern itself would not exist unless the final move occurred forming the pattern. By this time, it is too late to act as the move has already occurred.
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Trading psychologist’s call this “hindsight bias”. Hindsight bias is a very real problem with investors who have the wrong view about technical analysis.
The best way to think about technical analysis is as a framework to help with investing decision making. What this means is that if the fundamentals of a stock are bullish and you observe a bullish technical pattern being formed, it makes sense to go long the stock. However, no matter how powerful the fundamental bullish impetus and technical pattern, be ready to close the trade should the share price not confirm the predicted move. Investors get in trouble when they become attached to the position despite price making it clear that they are wrong.
Now that we understand the proper way to view technical analysis, let’s take a closer look.
The 5 Most Predictive Technical Analysis Patterns:
There are a few particular patterns in technical analysis that seem to be uncannily accurate in predicting what will happen next. While nothing in trading or investing is a sure thing, sometimes patterns repeat in an uncanny fashion.
One of these uncannily accurate patterns is called a gap. A gap occurs when price literally jumps across time to another level. Gaps can happen from session to session or after a stock has been halted due to pending news. In addition, gaps can also happen intraday due to massive amounts of buy or sell orders hitting the stock at the same time.
I like gaps because they are definite and easy to observe. Unlike most patterns that are nebulous, gaps leave no doubt that they are there.
Some technical traders strictly trade gaps. They are truly that powerful!
Gaps are areas on the daily chart where no trading occurs between trading sessions. Price closes for the session then reopens a distance away from the close. This opening and closing at different prices is what results in gaps on the stock market chart. Gaps can also arise intraday in the case of trading halts.
There are two primary types of gaps that increase the odds of a winning trade.
The two types are Exhaustion gaps and Breakaway gaps.
The difference between the two is where they occur in the price trend. Allow me to explain.
Exhaustion gaps occur on daily stock market charts after a speedy rise or decline in the stock price. The gap is in the identical direction as the previous move. In other words, near the top or bottom of a trading range, price will gap higher or lower in the same direction price was traveling. This type of gap signals that the upward or downward move is almost over making it time to take the contrary direction with your trade. Most frequently, Exhaustion gaps are used by traders looking to short an extensive upward move.
Breakaway gaps occur in either an upward or downward direction after a period of consolidation. This type of gap also occurs in the reverse direction of the prevailing price trend. Breakaway gaps indicate that price is likely to maintain in the same course of the gap.
- Double Tops
A Double Top can form at the end of an uptrend. Price moves up, then pulls back, consolidating, to thrusting upward again forming a pattern that looks like this:
Simply stated, the pattern looks like a peak, a valley, then another peak.
The time/distance between the peaks doesn’t matter, as long as it’s within the time frame you are trading.
Some traders like to see the second peak form at a lower price than the first peak as a confirmation of the pattern.
However, this is not necessary for a double top pattern to exist. The short entry signal is given when price moves past the lowest price in the valley between the two tops on the right side of the chart.
Here is an example of where the pattern trader would enter the trade short.
The long trader who rode the trend up, would exit the trade at this point. It’s important to note that volume should be increasing on the downside off of the second peak to further confirm the validity of the pattern.
3. Double Bottom
A Double Bottom is the reverse of a Double Top. It occurs after a down trend signaling the end and reversal of the down trend. A Double Bottom serves as an exit point for a trader who was short during the downtrend and an entry point for the trader looking to catch the next up move.
The pattern is described as price forming a new low, bouncing up, consolidating, dropping again, then bouncing up again past the high in between the two bottoms.
Descriptively, the pattern looks like a valley, a small hill or mountain, then another valley leading to another larger hill or mountain.
Ideally, volume will be increasing on the final bounce up prior to entry when going long on the pattern.
4. Descending Wedge
The Descending Wedge can be found in both up trends and down trends. It is normally a continuation pattern when it appears in an uptrend.
When a Descending Wedge is seen in an uptrend, its normally called a Bull Flag or a Pennant.
If it is seen in a downtrend, it’s regarded as a reversal pattern. A Descending Wedge, in a downtrend, looks like a triangle sloping downward on the price chart. It is formed by a shrinking trading range per bar. It is drawn on the chart with two trend lines, the upper line connecting the highs, and the lower line connecting the lows forming a triangle like pattern within the downtrend. When the point of the triangle indicates the maximum price contraction per bar, is where the reversal is thought to occur. If this contraction, at the triangle point, is combined with increasing volume, a break to the upside is believed to be imminent.
The theory is that the contracting range will suddenly expand and combined with a surge in volume will push the stock upward changing the trend for a period.
5. The Rising Wedge
The Rising Wedge pattern is often a reversal signal when found in an uptrend. It looks like a triangle sloping upwards on a price chart. The price bars show a contracting range with an upward tilt, cumulating in the point of the triangle where the trend changes to down at least temporally.
There can be multiple Rising Wedges in an uptrend with each one ending with a sharp decent, then the uptrend continuing.
When located within a downtrend, it is considered a continuation pattern and is called a Bear Flag. It is drawn on the chart with two trend lines. The steeper one connecting the lows with the less steep one on top connecting the highs. The lines cumulate at the tip of the triangle where the break down or change of trend is thought to occur.
Just like the Descending Wedge pattern, an increase of volume near the point of the triangle is thought to add to the likelihood of a trend change. Here is a visual example of the pattern resulting in a change of trend.