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A picture is worth a thousand words, it is said, but when it comes to trading the thousand words can be replaced by thousands of rupees. Advent of technical analysis saw new strategies being developed. Dow Theory was among the first steps towards making a sense of the charts. Since then many analysts have worked on chart to ‘discover’ different signals and images. Non-believers call it mumbo-jumbo or looking at clouds to see figures. But if the same images reappear at regular intervals and generally give the same outcome, there is more to these than mumbo-jumbos.
Many events in daily life of humans, animals and in nature display a repetitive pattern. The same is also the case with chart patterns that are formed by random buying and selling by various investors. The beauty of chart patterns is that there is no deliberate attempt by any investors to make the pattern, it is a random act.
What chart patterns tell us of the battle between bulls and bears is which side is likely to win, given historical evidence of the same. Some of the oldest traders are hardcore pattern traders and swear by chart patterns and have made their fortunes on it. Many new professional traders use these patterns to trade on an intra-day basis, or on other smaller time frame. Irrespective of time frames, what has stood the test of time is that these chart patterns work. Money management of course plays a major part in ensuring that the trades are profitable and those that are not, do not damage the account much.
We shall look at some of the most common and widely used chart patterns in Indian context.
Head and Shoulder
A Head and Shoulder pattern has a head in the middle which is a small peak above two peaks on both sides of the head which look like shoulders. This form of pattern normally occurs at the top. Though there are reverse head and shoulder patterns at the bottom, both carry the same message – that a trend reversal has taken place.
The head and shoulder are joined by a line which is known as the neckline. The beauty of head and shoulder pattern is that it tells us with uncanny perfection of how far the market can go if the neckline is broken. The distance between the peaks of the head to the neckline is the price to which the stock or the market can fall.
We shall take an example to understand his concept.
Nifty recently saw a head and shoulder pattern at the top. It took nearly four months for the pattern to form, with the left shoulder forming between July and September 2016. The head was formed in September – October 2016 and the right shoulder from October to November 2016.
The distance between the head and the neckline was 500 points. But when the neckline was broken, it took the market only a matter of just over a week to reach the 500 point target, which is where the market has consolidated as visible in the chart.
(Nifty – Head and Shoulder Pattern; chart from Spider Software)
Double Bottom and Double top
One of the most commonly occurring patterns is the double bottom and double tops, which are also reversal patterns.
Double bottoms or the ‘W’ are reversal pattern and offer a good risk reward ratio. Here the premise is that price will test the previous bottom and bounce back from there. The first target here is the previous top that or the center peak of the letter W.
Nifty made a double bottom in February end which was the bottom for most part of the year.
Double Tops or the letter ‘M’ is the opposite of double bottoms and signal a reversal of the uptrend, if successful. The first target here is the center of the lowest point correction between the two peaks.
A double top in Nifty was made a few months before the double bottom – December 2015.
A triangle is often referred to as a coil where the market grinds itself tightly making lower tops and higher bottom. It gets so tightly bound that a move in either direction can be a fast one. These patterns are generally a continuation pattern.
There are three types of triangle patterns – symmetrical, ascending and descending triangles. In a symmetrical triangle there is a lower tops and higher lows formation till the pattern approaches the apex point.
In ascending triangle there top is flat at the resistance line while there are higher lows giving the shape of the triangle with a rising trend line. Descending triangle on the other hand has lower tops while the lows hold on to the support line.
An important point to note is that this pattern also gives an indication of the profit target, which is generally the width of the triangle. Another observation of this formation is that the apex or the center point of the triangle is normally tested.
Nifty between April to May 2016 moved in a narrow range of higher lows and lower tops, coiling itself slowly till it shot up after a gap opening, meeting the price target. An opportunity to re-enter was also there when Nifty came down to re-test the center.
Flag and Pennant
These are again continuation patterns, which are a favorite of many day traders. These are formed after a pause in a sharp move indicating that the move is likely to continue in the same direction and similar distance. In other words the flag in retrospective will look like it is at half-mast.
Flags and Pennants differentiate from the fact that Flags have a flat top and bottom while Pennants have a tapering formation like Symmetrical Triangles. Both are very strong trading patterns, and generally occur in individual stocks rather than indices on a daily time frame.
The SBI chart below show a great rally which gave many opportunities to traders through a Flag and Pennant formation.
There are many chart formations, with new ones being discovered by many technical analysts. For the trader it is important to stick to a few or rather one chart patterns, master it before moving ahead.
A word of caution here would be not to look too hard for a pattern. If it is not easily located, it probably is not there.
Though chart patterns have been popular there are a few drawbacks. Their occurrence is infrequent, they take a lot of time to form, especially the reversal patterns and risk reward is normally not favorable if one trades strictly as per the chart.