Chart Patterns

Chart patterns are a series of graphed stock prices forming recognizable patterns that can be used to forecast future stock prices. There are many well-known chart patterns, which are formations that technical analysts use to forecast the direction of future stock prices. Many technical analysts believe that by plotting prices over a period, they can predict how long a stock will advance or decline, as well as identify its support and resistance levels. After analysts choose the type of chart, they look for emerging price formations. See Figure 11–5 for a few examples of common formations. From volume and price chart patterns, trend lines, and support and resistance levels, technical analysts believe that they can predict the appropriate price at which to buy or sell a stock.

Interpreting the types of patterns can be difficult for beginning chartists. First, you have the nonemergence of common patterns (such as the example in Figure 11–5). Second, the buy and sell signals may not be obvious to the reader of the chart. Third, a technical analyst doesn’t care whether a double-bottom formation chart belongs to Intel Corporation or a speculative company—the double bottom means the same for Intel and the speculative company, and their future stock prices are expected to perform in the same way. This statement implies that stock picking is a simplistic exercise that does not require any financial expertise other than obtaining price and volume information on stocks and the market.

Figure 11-5
Chart Patterns


A trend consists of relatively constant price movements of a security or market over time. Technical analysts plot their charts and then look for trends in their charts. A trend is the direction of the movement of the price of a stock or the market. The direction could be upward, downward, or sideways. Prices generally move in a jagged pattern. A succession of high and low points higher than the previous data signifies an upward trend. The opposite is true of a downward trend. These upward or downward trends are illustrated in Figure 11–6. Investors who follow technical analysis presume that the momentum in the markets will continue to perpetuate these trends.

Figure 11-6
Trend Lines


A resistance level is the price at which a security or market encounters considerable selling pressure. During an upward or sideways trend, a pricing point to which the stock rises and then repeatedly falls below without breaking through is called a resistance level (see Figure 11–7). At this level of resistance, when the stock reaches the high side of its trading range, investors sell the stock in order to take profits. These sales prevent the stock from moving higher and breaking out of the resistance level.

Asupport level is the price at which a security or market encounters considerable buying pressure. Similarly, during a downward or sideways trend, a lower level of trading, called a support level might occur. At this level, the stock price bottoms out before increasing because investors are buying the stock. This concept also is illustrated in Figure 11–7, where the stock rises to around $30 per share only to fall back each time.

A breakout occurs when the price of a security or market moves above a resistance level or below a support level. Finally, the stock in Figure 11–7 surprises technical analysts by rising above the $30 level. For technical analysts, a breakout below a support level or above a resistance level is significant. Technical analysts believe that when stocks break out of their support or resistance levels, the stock prices will continue to move lower or higher, respectively, which establishes new levels of support or resistance. The analysts’ explanations for this momentum appear to be twofold. When investors see that the price breaks through the resistance level, they will want to own this stock, which perpetuates additional enthusiastic buying of this stock. Second, some positive fundamental information might have accounted for the breakout, and when the public hears about this information, the stock price has already reacted. At that point, small investors jump on the bandwagon to buy. The opposite is true for breakouts in the support level, where selling momentum pushes the stock lower.

Figure 11-7
Line Chart Showing Support and Resistance Levels


Technical analysts are not that concerned about fundamental information but rather about identifying trading patterns as a consequence of reactions to the release of information. Charting is much easier than fundamental analysis, and stock price information is easy to get at virtually no cost. However, the value of charting as a method for predicting future stock prices and profits has been questioned often by fundamental analysts and academicians. Table 11–2 discusses the views of fundamental versus technical analysts.

Many chartists attribute their successes to their charts, but the crux of the matter—when to buy and sell—may lie more in the chartist’s judgment than in the charts themselves. If charting were that simple, investors all would have the stock market sewn up by now, and we could be sitting on the beaches of the French Riviera! Many free sources on the Internet make charting information available, such as www.askresearch.com, www.stockcharts.com, and www.siliconinvestor.com. For the stocks of your choice, you can obtain line, bar, or candlestick charts along with moving-average trend lines.

Table 11-2
Should You Use Charts or Fundamentals to Choose Stocks

Technical analysis and fundamental analysis presented quite a different view of defense industry stocks. From a technical point of view, the prices of most of the defense stocks had fallen below their support levels, which indicated future negative trends. In contrast, the fundamentals for these stocks looked quite good, in that during the war with Iraq, the U.S. government would need to procure more weapons and develop new weapons systems. Figure 11–8 illustrates a five-year price chart of Boeing’s stock price that shows the breakdown of Boeing’s stock price below its support level. The chart pattern is a classic head and shoulders pattern (Zawadzinski-Edwards, 2003, p. 20).

Yola Zawadzinski-Edwards, an independent technical analyst, said that the drop in Boeing’s stock, having broken down to $26.52, below the neckline, indicated that the stock would continue to fall toward 0 over the following 10 months. The head and shoulders pattern is indicative of a bearish outlook, especially when the stock price continues on a downward trend from the right shoulder. The other negative from a technical point of view is that the stock price had fallen below the support level of around $19 to $25 per share.

Figure 11-8
Five-Year Stock Price Chart of Boeing


However, fundamental analysts were more bullish on Boeing’s prospects. The threat of future terrorist incidents and the war in Iraq caused a drop in airline traffic that resulted in declining orders for airplanes from Boeing. However, the flip side of the coin is that only two major commercial airplane manufacturers exist: Boeing and Airbus. When world events settled down, Boeing would see its commercial aircraft business return to normal levels. Boeing’s military business held the company’s sales and earnings together. In fact, Boeing’s low stock price was based on the valuation of the military business, whereas the commercial aircraft unit had no value. Consequently, an improvement in the commercial aircraft business caused Boeing’s stock to rise significantly in the following years.

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