Chart Patterns

Chart patterns may occur in various time frames. You may find a head and shoulders pattern formed over several hours during a day, or over several months.

Patterns are formed by support and resistance levels and by trendlines. We concentrate on the patterns formed by support and resistance levels as these tend to have a sounder conceptual base.

A criticism of patterns is that they are also evident in random data, charts generated using random numbers. If the patterns appear in data where there is no trend then what is their significance?

  1. Go back to the largest possible time frame: the Dow Industrial Average commenced in May 1896 at a level of 40, today the index stands at more than 10,000 - a steady up-trend for more than a century. The data is definitely not random.
  2. You may observe head and shoulders and similar patterns in random data, but you will not observe support and resistance levels. Studies of foreign exchange markets have shown that limit orders are not scattered randomly in the market, but are clustered around support and resistance at round numbers.
Abstract from Paper by Carol L Osler, Associate Professor at Brandeis University
Osler, Carol L. “Currency Orders and Exchange Rate Dynamics: An Explanation for the Predictive Success of Technical Analysis.” The Journal of Finance vol. 58, no. 5, 2003, pp. 1791–819. JSTOR, Accessed 23 July 2023.
  1. Empirical tests carried out on various point and figure chart formations, by Professor Earl Davis of Purdue University were profitable between 70 and 90 per cent of the time in bull markets and between 80 and 90 per cent in bear markets. Average gains (on profitable trades) were 2 to 3 times as large as average losses (on unprofitable trades). Thomas Dorsey describes the results of the 1965 study in Point & Figure Charting, including which formations had the highest success rates.

Chart patterns appear on all the various Chart Types:

Colin Twiggs

Author: Colin Twiggs is a former investment banker with over 30 years experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary newsletter.

Colin also writes The Patient Investor newsletter which focuses on the global economic outlook and key macro trends.

In addition, he founded PVT Capital (AFSL No. 546090) which offers investment strategy and advice to wholesale clients.