Perhaps the greatest strength of classical chart patterns is their ability to help us participate in price trends. As trader and analyst William Gann noted, “…the big profits are made in the runs between accumulation and distribution.” Classical chart patterns offer traders a viable means of capturing these “runs” by highlighting the behavior which normally precedes significant trends.

In addition to highlighting specific trading opportunities, chart patterns can also be used to control risk by forewarning us of trend reversals. It is believed among most technicians that price trends do not reverse immediately, but rather go through a period of gestation before reversing. These periods often coincide with the development of a classical chart pattern. Those who wish to control their open position risk may find chart patterns useful in these situations.

Another strength of classical chart patterns is that they delineate when and at what price to buy and sell through the use of trendlines and price target objectives. Once the boundaries of a potential formation have been decided upon and marked off, these boundaries correspond to specific price and time coordinates that can be used to form specific trading and risk control strategy.

On the weakness side of the balance sheet, chart patterns are notoriously subjective entities. Surpluses of chart pattern examples exist in books and manuals with no corresponding supply of fixed pattern definitions. Thus there exists no simple way of determining whether or not an actual classical chart pattern has been discovered. Because all classical chart pattern definitions are essentially approximations, chart pattern analysis contains the potential for abuse by portraying the personal biases of the chartist rather than actual market indications.

The implied directional significance attached to specific chart pattern names, such as “Bearish Wedge” or “Bullish Triangle,” may also interfere with the chartist’s objectivity. To the extent that certain chart pattern shapes are associated with specific directional outcomes, the risk of taking on a preconceived directional bias by the analyst or trader seems inevitable. Correctly identifying classical chart patterns in time to act on the “breakout” is also problematic.

To borrow from Dow Theory parlance, how can one tell in what section of the line they are in until it is all over, and thus perhaps too late to take a position? Conversely, if we act too soon and pre-empt a chart pattern breakout, the result may be a series of “false starts,” also known as “whipsaws.”

THE MODEL

As mentioned earlier, the conceptual model separates chart pattern behavior into two components: the volatility component and the structure component. Both are equally significant and their order is presented arbitrarily. Below I have summarized the primary aims of the model:

- To offset the lack of classical chart pattern specificity by providing a less subjective though still not entirely fixed criterion for identifying patterns.

- To serve as a notional benchmark for distinguishing valid chart pattern behavior from other types of market behavior.

- To minimize the risk of implied directional biases by excluding the use of traditional “bull”, “bear” or pattern “shape” nomenclature.

- To enhance the timing of trading decisions by more narrowly defining the specific behavior that coincides with chart pattern breakouts.

 

By Daniel L. Chesler, CMT, CTA

Next: The Volatility Component

Summary: Index