The Psychology Of Chart Patterns

By Loren Fleckenstein

More than once, finance profs have told me that chart patterns don't work. After
all, why should the market obey a chart pattern?

This misses the point about patterns. Patterns don't dictate to the markets.
Human collective behavior dictates to the markets. And as a species, human
beings act today just we did thousands of years ago when we first came together
to trade in markets. We chase the prospect of profits. When returns become
overabundant, the crowd turns greedy. When price turns against us, the herd
becomes anxious, anxiety gives way to fear, fear gives way to panic. Then in
come the bargain hunters, and the whole process starts again.

Variations on this theme have recurred throughout history. Valid chart patterns
are simply the graphic record of these recurring turns in the crowd, expressed
through price and volume.

The trading literature does a pretty good job describing patterns and how to
recognize them. I am going to go a step further. I want you to grasp the forces at
work behind patterns. In my own experience, I found this understanding
improved my ability to interpret charts as well as my skill at pattern recognition. I
will take you step by step through a chart pattern. As the pattern unfolds, I will
explain the underlying shifts in the balance between bullishness and
bearishness, demand and supply.

For our behind-the-scenes technical analysis, I've chosen the cup-with-handle

pattern because it's easily the best-known chart formation to the intermediate-
term trader. The pattern is also known as the saucer-and-platform. Gilead
Sciences (GILD), a Foster City, Calif.-based biopharmaceutical company, traced
an example of one in 1999 prior to making an explosive advance.

The following chart employs a logarithmic price scale and 50-day moving
average lines for price (in red) and daily volume (in blue). As you can see, Gilead
shares peaked at 57 1/2 on March 19, 1999. In the next session, March 22, the
stock gapped down and fell further on 2.6 million shares, five times its average
daily volume.
Fear Ascendant

This is a decisive break. Trust your eyes. Let the stock talk to you. All the signs
point to more downside ahead. A sharp price decline (15% from close to close), a
U-turn to the south, a close in the bottom half of the daily range. Lending clear
authority to these signs are the dramatic expansions in both volume and daily
price range.

What are all these signs telling you? Fear is taking hold of shareholders. And no
one is coming their rescue. People are heading for the exits, and whoever
remains in the stock must be reaching for the Rolaids. That may sound obvious,
but you'd be surprised how many people try to trade against such powerful
directional movement.

Panic & Capitulation

For a few days, the stock tries to make a stand just above 45 7/8, the intraday
low of the selloff session. Note the progressive decline in volume. Fewer and
fewer buyers are willing to step up to the plate and take shares off the hands of
anguished shareholders.

Sellers next resort to dropping their ask price in an effort to entice more buyers to
market, and the price crumbles further. Meanwhile, those holding on in desperate
hopes that the stock will recover come under increasing strain.

Efficient market theory holds that markets act quickly to adjust prices in response
to new information. Over the long run, that's correct. But in the short run,
emotions, not rationality, can prevail. A large number of remaining shareholders,
shaken by the selloff, now are being subjected to water torture as the price slowly
deteriorates. Pain and fear build slowly until panic ensues.
At some point, the price will go into freefall once enough shareholders facing
mounting losses run for the exits. I never try to predict the breaking point. That's
a function of the unknowable mix of personalities within the shareholding crowd
and their cost basis in Gilead shares. I let the market tell me.

Shareholders capitulate on April 19, sending the price down 12%. The following
session, on April 22, the smart money comes in. Gilead shares reverse and close
up 15% on volume of 880,000 shares. (See Point A in chart.) That amounts to a
60% increase above normal volume as averaged over the past 50 sessions. Only
institutions marshal that kind of buying or selling clout.

Overcoming Weak Holders

The April 22 session marks the bullish complement to the March 22 selloff: a
sharp price gain and close in the upper half of the day's range, with the added
credibility that comes with expanded daily range and volume. However, the stock
remains unsuitable for the intermediate-term momentum trader. The stock still
must overcome the problem of overhead supply posed by weak holders.

Overhead supply is the amount of shares in the hands of shareholders with

paper losses. Wall Street calls these people weak holders. In the wake of severe
price decline, the weak holders want out of the stock. They tend to use rallies as
an opportunity to exit. You want the weak holders to exit a stock before you buy.
Once you go long, you want your fellow shareholders to hold tight. This reduces
the selling supply of stock coming to market at the current best ask price, forcing
would-be buyers to bid up the share price.

There are several tests that I use to determine whether a stock has overcome
overhead supply. A stock must pass these tests before I even consider looking
for entry points. First, I insist that a stock has overcome its 50- and 200-day
moving price averages. Gilead began trading in December 1998, so it had not
traded long enough to establish a 200-day average in this example. So we'll use
just the 50-day average.

Second, I also require the stock to exceed its mid-level, the halfway point
between its pre-correction intraday high and the subsequent intraday trough of
the correction. To find the mid-level, you sum the two prices and divide by 2. That
yields a mid level 46 11/16 for Gilead in this example.

It's also important to see the stock follow through to the upside on strong volume.
First, strong volume lends authority to the direction of accompanying price move.
Second, strong volume means turnover. You want to see lots of shares change
hands, a sign that bulls are replacing more weak holders, changing the
composition of the shareholder in favor of the bulls.

On April 30, Gilead shares surged higher on 2.1 million shares, more than triple
normal volume (see Point B in chart). Clear accumulation. The stock also
cleared its 50-day moving average.

After a tug-of-war around the 50-day, the stock headed higher but soon
encountered resistance around its mid-level. This is normal. Then Gilead peaked
at 48 3/8 on May 20 (Point C) and pulled back.
This is normal and potentially even healthy. You don't want V-shaped correction-
recovery patterns. These are failure prone as sharp gains over brief time frames
tempt profit-taking by bottom feeders and loss-taking by weak holders. You want
a stock to advance on strong volume, then consolidate, even pull back on weak
volume, indicating more weak holders are getting out of your way.

Personality Change

Gilead obliged. The May-June pullback came on average-to-sub-par volume. In

another constructive sign, the stock held well above the low of the correction,
then resumed its advance. This amounts to a positive change in the stock's
trading behavior. The pullback did not precipitate a new rush for the exits. Bulls
appear to be gaining the upper hand. Some of the weak holders may be taking
heart.

Over the remainder of June, the stock crossed back above its 50-day moving
average, then its mid-level. Now you can start looking formation of a handle. On
June 18, the stock put in a new peak at 51 1/2 (Point D). That's your pivot point.
If the stock forms a proper handle from here, you buy if the share price crosses
1/8 point above the pivot on strong volume.

Interpreting Handles

Why do you want handles to form? Once you buy shares in a stock, you want
your fellow shareholders to hold tight. You want as little selling as possible
because if selling pressure (supply) exceeds buying pressure (demand), the
share price will drop. If demand outstrips supply, buyers must bid up the price in
order to entice sellers to market.

As a recently corrected stock forges higher, two groups of shareholders feel an

increasing temptation to sell – the weak holders and the bottom buyers. The
question is, will they dump large amounts of stock? Or is the vast majority of
shares outstanding now in the hands of bulls, people who will hold on in hopes of
further price appreciation? A sound handle suggests the latter condition is the
case.

If the stock falls on strong volume, the situation remains too dicey. But if the
stock drifts lower on light volume, and volatility contracts (as evidenced in
tightening daily price ranges in the handle), chances are, shareholders are
holding tight while the last of those pesky weak holders are dribbling out of the
stock.

Gilead formed a handle with the desired volatility and volume contractions.
Notice the tightening daily price ranges. Finally, look at the corresponding trading
volume, which like the price is wedging downward (both movements underlined
or over-lined in green).

Notice also that the handle did not pierce appreciably below the resistance at
May 20. A bullish sign is when past overhead resistance becomes a support
level. The lows of the handle also formed above the mid-level. Another good
sign.
Breakout

As I said before, powerful volume lends credibility to a price move. Powerful

volume means institutions are piling into the stock. These institutions cannot
possibly hope to take significantly sized positions without affecting price. If you
act quickly and buy as soon as the stock clears the pivot, you improve the
chances that you're getting on the leading edge of an institutional buying wave.
This gets you in with your relative small position with ample buying power
pressuring the stock higher after your entry. Gilead broke through its pivot June
30 on nearly four times normal volume (Point E).

Here's a larger view showing the stock's trading activity through Dec. 13, 1999.
As in the prior chart, Point E indicates the June 30 breakout.

Copyright © 2001 by TradingMarkets.com, Inc.