Price Patterns Illustrate Market Psychology

11/26/2008 12:01 am EST

Focus: STRATEGIES

S. Wade Hansen

Co-Founder, Profiting with Forex (PFX) and Learning Markets

Price patterns are a lot like the brake lights on the cars around you when you are driving in traffic. When you see the brake lights come on in the car in front of you, you know that the car is slowing down and that you need to slow down too unless you want to crash into it. What you don't know is whether the car is going to accelerate and continue moving in the same direction after it slows down or if the car is going to come to a complete stop and change directions. 

When you see a price pattern starting to form, you know that the stock you are watching is starting to slow down, or consolidate, and that you need to slow down, take a step back, and evaluate what is happening on your chart. What you don't know is whether the stock is going to break out and continue moving in the same direction after it slows down or if the stock is going to turn around and change directions.

Price patterns, as you will see in this video on Price Patterns, are a typically under-utilized, yet extremely valuable tool in your stock trading arsenal. It may take a little while to get comfortable with dealing with the subtle nuances and occasional ambiguity that are a part of price patterns, but once you do, you will almost be able to see into the future.

Price patterns are visual representations of market psychology. They tell you when traders in the market are excited and moving, when they need to take a moment to catch their breath and regroup, and when they are ready to get moving again.

All price patterns are made of the following four pieces:

  1. Old trend - the trend that the stock is in as it starts to form the price pattern
  2. Consolidation zone - a constrained area defined by set support and resistance levels
  3. Breakout point - the point at which the stock breaks out of the consolidation zone
  4. New trend - the trend that the stock enters as it comes out of the consolidation zone

chart

Price patterns are divided into two major categories: Continuation patterns and reversal patterns.

Continuation patterns tell you that the new trend is going to continue in the same direction that the old trend was moving. 

Reversal patterns tell you that the new trend is going to reverse directions and move in the opposite direction that the old trend was moving.

The only real difference between continuation patterns and reversal patterns is which direction the new trend is moving. Both types of patterns have an old trend, a consolidation zone, a breakout point, and a new trend.

Learning to identify price patterns enables you to get a glimpse into the future price movement of the stocks you are watching. Whereas technical indicators—like moving averages and the commodity channel index (CCI)—lag the current market price, price patterns project into the future. Once you have identified a breakout point, you can get a pretty good idea of where the price is going to go in the near future, and you can take advantage of that potential movement. However, you need to learn a little more about both continuation and reversal patterns before you can accurately set price targets in the future.

Click to watch the video on Price Patterns.

By Wade Hansen of LearningMarkets.com

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