Reading Chart Patterns

Reading Chart Patterns

Perhaps some of the more complicated chart patterns are able to reveal the future course of stock prices. For example, is the downward penetration of a head-and shoulders formation a reliable bearish omen? As one of the gospels of charting, Technical Analysis puts it: “One does not bring instantly to a stop a heavy car moving at seventy miles per hour and, all within the same split second, turn it around and get it moving bach down the road in the opposite direction.” Before the stock turns around, its price movements are supposed to form one of a number of extensive reversal patterns as the smart-money traders slowly “distribute” their shares to the “public”. Of course, we know some stocks do reverse directions in quite a hurry (this is called an unfortunate V formation), but perhaps these reversal patterns and other chart configurations can, like the Roman soothsayers, accurately foretell the future. Alas, the computer has even tested these more arcane charting techniques, and the technician’s tool (magician’s wand) has again betrayed him.

In one elaborate study, the computer was programmed to draw charts for 548 stocks traded on the New York Stock Exchange over a five-year period. It was instructed to scan all the charts and identify any one of thirty-two of the most popularly followed chart patterns. The computer was told to be on the lookout for heads and shoulders, triple tops and bottoms, channels, wedges, diamonds, and so forth. Since the machine is a very thorough (though rather dull) worker, we can be sure that it did not miss any significant chart patterns.

Reading Chart Patterns. Photo by Elena

Whenever the machine found that one of the bearish chart patterns such as a head and shoulders was followed by a downward move through the neckline toward décolletage (a most bearish omen), it recorded a sell signal. If, on the other hand, a triple bottom was followed by an upside breakout (most favorable augury), a buy signal was recorded. The computer then followed the performance of the stocks for which buy and sell signals were given and compared them with the performance record of the general market.

Again, there seemed to be no relationship between the technical signal and subsequent performance. If you had bought only those stocks with buy signals, and sold on a sell signal, your performance after brokerage costs would have been no better than that achieved with a buy-and-hold strategy. Indeed, the strategy that came closest to producing above-average returns (not accounting for brokerage costs) was to buy right after one of the bear signals.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.