When you buy or sell stocks, do you use technical analysis as a way to affirm or disprove your thesis of where the stock is going in the short term? The world’s stock exchanges have seen drastic change in recent years since high frequency trading came to the market. If you’re unfamiliar with high frequency trading, simply put, computers are able to buy and sell stocks at a very rapid rate based on certain technical indicators.
Since computers can’t evaluate the quality of management, the future customer demand, or other less objective metrics, computers can only relay on the technicals of a stock. In other words, the chart. This is why learning some basic chart patterns is another tool in your stock evaluation toolbox but beware of one important fact about chart reading: Things don’t always work out the way the chart says they should.
Although we can find plenty of examples of the chart accurately predicting the future direction of a stock, there are just as many instances where a chart pattern emerged and didn’t do what the pattern predicted. With that in mind, let’s look at two patterns that may indicate a move to the upside.
Reverse Head and Shoulders
The head and shoulders pattern comes in two forms: The head and shoulders and the reverse head and shoulders. The reverse is simply the head and shoulders pattern upside down. Here’s an example:
Think of a person standing upside down. You can see their head that represents a short term bottom in the stock price and the two shoulders on either side of head. The neckline represents the breakout point. If the stock price climbs through the neckline on heavy volume, that will confirm a breakout of the pattern. When that happens, investors expect the stock to go considerably higher.
Our pattern above is a very textbook example but they rarely look that clean!
The ascending triangle pattern is another pattern that may indicate and explosive move to the upside. Here’s an example:
Looking at this chart, you can easily see the tension building in the stock. Notice that the top level (Which we call resistance) has held for more than two months but the bottom continues to rise. The trading range of this stock is being squeezed and at some point, it will be forced to break out of its pattern either to the upside or downside.
Also notice that the volume (shown by the blue line towards the bottom) is falling as the bottom of the pattern continues to rise. When you see the trading range being squeezed and the volume heading lower, that’s a good indication that an ascending triangle is forming. Once the stocks breaks out, the volume will return to high or normal levels and a breakout should be the result.
I personally believe that the best way to make money in the markets is to purchase quality companies and hold them for a long period of time but for those who enjoy stock trading, an understanding of technical analysis is key to predicting how professional investors may react in the short term. In part three of the series, we’ll look at bearish patterns.