APPROACH

First, I will review the histor y of price charts along with the background and basic tenets of classical chart pattern analysis. While these may be tired subjects for many readers, they are worth revisiting as they reflect the conventional views that we seek to expand. I will also discuss the role that classical chart patterns play within the broader scope of market analysis. Some of the practical strengths and weaknesses of classical charting will also be covered.

Next, a simple conceptual model will be presented, which attempts to depict classical chart patterns in terms of two basic components: the volatility component and the structure component. Individually these observations will not constitute new or unique theory on the subject of bar chart patterns or price behavior. Taken together, however, they should help reduce the degree of separation between what is typically perceived as a diverse range of classical chart pattern definitions. Using recent examples from the US stock market, I will show how the model can be used to simplify pattern recognition and enhance the timing of chart pattern-based trading decisions.

Again, my goal is not to advance a particular view of chart pattern analysis into the realm of verifiable science. Rather, I hope to add a measure of order to what some technicians view as the ambiguous process of finding and trading classical chart patterns.

PRICE CHART PRIMER

The earliest use of price charts has been traced back to 17th century Japan where it is believed price charts were first used to record and analyze the movements of the Japanese rice market. The use of price charts in the United States, however, did not develop until the late 19th century. Prior to the widespread use of charts in the U.S., price and volume analysis was generally limited to what one could observe and memorize as live quotes ran across a mechanical ticker tape. This practice became known generally as “tape reading.”

In the late 1800s, the number of active stocks was few. However, as this number increased, following the list of active stocks on the tape became more difficult. Summarization of the data into price charts was the inevitable result. Thus, a price chart is merely a graphic record of price and volume activity over a length of time – a graphic ticker tape so to speak. In this context one can understand how price and volume relationships gleaned from the practice of tape reading ultimately shaped charting principles. As one technician aptly put it, “tape reading was just primordial technical analysis.”

The earliest charts used in Western technical analysis are believed to be point-and-figure charts and existed at least fifteen years before the advent of bar charts. Point-and-figure charts differ substantially from bar charts in that they do not specifically record time and volume data. They are noted for their ability to highlight “consolidation” zones, which generally imply either accumulation or distribution activity. The subject of this paper, however, relates only to bar charts and bar chart patterns. Bar charts, probably due to their ease of construction, have been the most popular form of price charts since their introduction in the late 1800s.

Each “bar” consists of a vertical line representing the range of prices traded over a defined period: an hour, a day, a week, a month, etc. Prices are plotted on the vertical axis and time on the horizontal. Bar charts often include a graph along the bottom of the chart depicting volume activity and in the futures markets the open interest. The vertical axis of a bar chart is generally plotted on either an arithmetic or logarithmic scale, with the arithmetic scale being the more popular form. A logarithmic scale shows equal percentage increments of price rather than equal absolute increments as with an arithmetic scale.

By Daniel L. Chesler, CMT, CTA

Next: Classical Chart Pattern Evolution

Summary: Index