Between the generous ridicule hurled at charting by well known market commentators and the often exaggerated claims made by overzealous chartists, it is probably safe to assume that classical chart patterns are a misunderstood subject. I have even known experienced technicians who mistakenly view classical chart patterns as a kind of esoteric knowledge for divining the future direction of stock prices. In the following section I will utilize quotes from various sources to help clarify the role of classical chart patterns. It must be understood that chart patterns were conceived primarily as a “timing” or “trading” technique used for individual trade selection.

Though Schabacker did find chart patterns useful as indicators of the general market, he did not view them as a long term investment or market forecasting strategy; for this he considered fundamentals the more important of the two approaches: “Our study has been devoted chiefly to consideration of the technical factors affecting stock market fluctuations. We have previously seen that such factors work much more swiftly and profitably than do the fundamentals. The technical side of the market is of special importance for the short-swing stock market trader – he who tries to take his quick profit and run, and then renew his operation in some other issue where technical considerations suggest another movement is about to materialize.”

“The technical approach to the market…is based upon factors which relate chiefly, or at least more directly, to the market itself, to the price movement which results from the constant interplay between those who want to buy…and those who want to sell…” “In other words, the fundamental factors suggest what ought to happen in the market, while the technical factors suggest what is actually happening in the market. It is, therefore, the more important of the two angles for the trader…” Thus Schabacker emphasizes the point that “technical factors” are particularly well suited to serving the needs of traders, or those who operate on shorter time frames. For Schabacker this specifically meant the use of bar chart patterns as a means of highlighting accumulation and distribution activity in individual stocks for the purpose of providing buy and sell signals.

The notion of chart patterns as a tool of the “timer” is as accepted among knowledgeable observers today as it was by Schabacker seventy years ago. For example, Gerhard Aschinger, Professor of Economics at the University of Fribourg, Switzerland, makes an indirect but à propos reference to the nature of charting in a 1988 Swiss Bank Corporation article as follows: “ ‘Speculators,’ … are defined as basing their investment policy on the behavior of the market itself, using recent patterns to predict future trends. … In reality, many chartists would fall into this category. … The point is that ‘fundamentalists’ usually follow a longer-range investment strategy, whereas ‘speculators’ have a basically short-term orientation.”

Aschinger implies that speculators are more concerned with matters of timing than with long-range “strategy.” He also links the use of “recent patterns” with the objectives of “speculators” as an accomplished fact. These views echo Schabacker’s and support the idea that chart patterns represent a technique belonging chiefly to traders. Peter Brandt, one of Commodity Corp.’s most successful traders for many years, and a speaker at the 14th Annual MTA Seminar in Naples, Florida, claims to rely almost entirely on classical chart patterns for making trading decisions. Brandt explains his views on classical charting in a 1990 book interview as follows: “Classical charting is … useful only to highlight a certain defined trading opportunity. It is vital to keep in mind that over 50 percent of chart formations fail to deliver profitable trades. This may be an indictment of classical charting as a forecasting tool, but not as a trading tool. Classical charting principles do not explain all the markets all the time …. I am just looking for market situations that meet certain guidelines” Thus, Brandt discounts any directional inferences of classical chart patterns. He views classical chart patterns as useful for the purpose of identifying and organizing individual trading decisions rather than for the purpose of outright prediction.

For Brandt, chart patterns serve as a sort of bookmark that enables trades to be made with reference to a particular set of price levels, risks and potential outcomes. The notion that classical chart patterns do not serve as a means of prediction is not necessarily a new idea. In the following quote attributed to legendary trader Jesse Livermore, Livermore appears to counsel that it is best not to place directional significance in chart patterns: “In a narrow market, when prices are not getting anywhere to speak of but move within a narrow range, there is no sense in trying to anticipate what the next big movement is going to be—up or down. The thing to do is to watch the market, read the tape to determine the limits of the getnowhere prices, and make up your mind that you will not take an interest until the price breaks through the limit in either direction.” One can assume that the “limits of the get-nowhere prices” which Livermore speaks of correspond to the boundaries of a classical chart pattern of some type. More importantly, Livermore reserves judgement regarding the future direction of prices “until the price breaks through the limit.” Thus, Livermore suggests that the forecasting value of chart patterns is subordinate to their main role of cordoning off the conditions that precede certain trends.

If we accept the idea that classical chart patterns are at best mediocre forecasting tools, then it follows that the successful use of chart patterns is dependant on the occurrence of a sufficient number of sustained trends to offset an even greater number of “false” signals. In this context, classical chart patterns are by necessity allied with the technical trend-following philosophy, which states that once a trend begins it is likely to continue. In sum, two main points emerge regarding the role of chart patterns. The first point is that chart patterns are intended chiefly as an aid to trading and speculation of individual securities, although other uses such as general market analysis are also possible. The other is that chart patterns are not particularly useful as a means of predicting the future direction of prices; waiting for a decisive “breakout” in order to confirm the validity of a chart pattern would be unnecessary otherwise.

By Daniel L. Chesler, CMT, CTA

Next: Strenghts and Weaknesses of Chart Patterns

Summary: Index