Exposing Ideas to the Envelope of Serendipity

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Monday, July 27, 2009

Patterns of Persuasion

Learning to correctly recognize chart patterns and their many nuances can give traders a critical edge in navigating the markets, leading to significantly enhanced performance over time. While consistent profitability will come from drawing on an elusive combination of experience, discipline, psychology, and technique; proficiency in identifying and understanding chart patterns ranks at the top of my list of the most important trading skills to master. 

In recent days, there has been an increase in the number of blog postings and comments about high failure rates of various patterns, along with complaints that patterns simply "don't work".  While no indicator is foolproof and there will certainly be some patterns that fail, in my experience, chart patterns provide some of the most valuable and reliable clues as to future market direction. Reading them correctly, however, is another matter entirely, and frequently flawed analysis results in a high frustration rate and degree of skepticism. Successful pattern recognition comes from experience, but also requires a collaboration of technique, math, art, and visual skills. Some patterns are much easier to read than others, while others are more subtle or complex. 

The inverse head and shoulders pattern has punctuated much of the technical landscape in the recent rally off the March lows, with the bullish reversal pattern popping up in the major and sector indices as well as in scores of individual stocks. More and more sound bases and base breakouts are also occurring, resulting in some extremely nice patterns suggestive of considerable upside before the rally runs its course. The markets are overdue for a pullback after an unprecedented number of consecutive up days, and we may see that get underway early this week. A return to test new support at the neckline of the large inverse head and shoulders pattern on the $SPX would be very standard, and could lead to the next leg-up of the rally. When I think back through my personal trading history and then compare that with historical charts in a wide range of stocks and indices, the times when identifiable patterns begin to proliferate out of solid basing or topping action have led to the most profitable market periods.  When there are suddenly too many tempting patterns to choose from, odds are high that abundant trading opportunities are at hand. A scarcity of good patterns and clear signals, on the other hand, is generally an excellent warning to lay low until they set up again. Right now, they are setting up every which way, and any near-term pullback should present an excellent opportunity to initiate new long positions or to add to existing ones. As of now, my target for the $SPX is in the 1,229 area, which is both the resolution target of the pattern in play, as well as a major fibonacci level. Regardless of current projections and positive indications, it is always imperative that traders be continually reassessing conditions and market behavior at all times, striving first and foremost to maintain an open mind and objectivity in their approach to the market. 

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