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Three Important Keys To Understanding Price Patterns

08/08/11 12:26:24 PM
by Billy Williams

Fundamentalists and technicians have long been at war over approaches to profiting from the market, but price patterns have been three keys to sizing up stocks for strong profit potential.

Security:   SPX
Position:   Hold

In the trading community, there is a war among traders fought in the realm of ideas instead of guns and bullets, yet each side is just as tenacious for each side. This war is made up of opposing ideas who fiercely claw about, trying to gain a place in your mind for preeminence over how you invest and trade your capital in the market.

Fundamentalists are vocal about how earnings, low debt, revenue growth, competitive advantage, and other tangible factors should be the highlight of any sound investment decision that you or any sane, rational person should make.

Technicians, on the other hand, can be just as shrill about making their own personal views about how price is reflected in the charts, and no amount of profit or sales growth will make you any money unless a stock is in a clearly defined trend. They go on to argue that fundamentals do not move markets, but it is only moving markets that can make you money.

This war of ideas has gone on ever since traders started speculating on tulips in 16th-century Holland as well from under the first buttonwood tree in early colonial America, which went on to become the financial epicenter that is known as modern-day Wall Street.

Both sides have merit, yet there is one inescapable fact -- markets are made up of people and tend to reflect the participants' behavior, which materialize in the form of price patterns. Price patterns are traded almost exclusively by many traders, but many more struggle in trading these patterns because they fail to understand three key factors: the principle of expansion and contraction, mass psychology, and the use of trading volume.

Price patterns form in a stock's price, developing in recognizable shapes during periods of contraction and expansion (Figure 1). The principle of expansion and contraction states that when a stock or market is in a clearly defined trend making higher highs and higher lows during a bullish trend or lower highs and lower lows during a bearish trend, then it is experiencing a period of price expansion.

FIGURE 1: S&P 500. For the last decade, give or take a couple of years, the SPX has been a prolonged price contraction but still managed to form a double-bottom price pattern even on a long-term time frame. A long-term buy signal is confirmed once price rises up through its old price highs.
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When price develops a price range by failing to meet either one of these two conditions, then it is in a period of price contraction where it will continue trading within a range or form some type of price pattern until one side -- bulls or bears -- take control of the trend, forcing price back into a period of expansion.

The second key to understanding price patterns is that they are the result of mass psychology, not fundamentals.

Fundamentals such as sales growth or landing a big government contract may give a reason to be optimistic about a company's future prospects albeit share value increased but those are just reasons, not the true result of price expansion, but the participation of the speculators themselves that are the cause, not the effect of solid fundamentals.

When price pulls back and forms a pattern, it is reflective of the hesitation by traders and investors. As fear, hope, greed, and other emotions take hold, price will ebb and flow, rise and fall until one side grows in confidence and/or fear to take control of the stock's price action and force back into a trend.

This is where volume enters the scenario as a means of gauging both the strength and level of commitment once a side shows by the amount of trading volume that enters the market and when it enters the market.

Price and volume are two sides of the same coin, meaning that they have a complimentary relationship. When price is in contraction, volume tends to dry up, which affects the direction and follow-through price exhibits. When price is in expansion, volume tends to rise with it, which can be identified in the 20-day volume average, which can, and often does, rise steadily over time.

When price appears to emerge from a pattern it can be an important point since it is a move that is often confirmed by a surge in volume that will reveal to you that either the bulls or bears have indeed entered the stock to take control of the trend again or instead show a lack of follow-through and that price is not ready to enter into expansion just yet.

These three key cornerstones form the basis for understanding how price patterns fit in with the overall market and its corresponding price action. They also act as the underlying basis behind market movement and the real reason price rises or falls and how volume affects price action especially after a pattern has formed. You can also get an indication of when to trade the resumption of a trend and when to step aside, avoiding a fake thrust in that direction.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 08/08/11Rank: 1Comment: 

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