How Price Patterns are formed?

Apurva Sheth
Today I am going to talk to you about one of my favorite topics - price patterns. But before I show you specific chart patterns and their implications, let us understand what price patterns are and how they form.

Simply put, price patterns are slightly more complex trendlines. Price patterns helps us identify current trends and upcoming reversals in trends. Price patterns develop on all time frames - intraday, daily, weekly, and even monthly and quarterly.

Price patterns aren't what most people think. They aren't the end-all, be-all to technical analysis. Nor is there anything magical about an ascending triangle or a head and shoulder that make a stock move.

More important than the pattern or its name is the psychology of people creating and trading these patterns.

So let's look deeper into that and see how these patterns form.

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I have illustrated below how interaction between various groups of people creates price patterns.

Interaction between various groups of people creates price patterns
Source: Profit Hunter

The stock stabilizes after a downtrend. It starts trading in a range. A smart group of investors spot this range bound activity. Group A enters the stock at the lower end of this range. The stock starts moving up and later retraces back to the higher end of this range.

This is when Group B spots an opportunity to enter the stock. Demand from this group pushes the price up again. Spotting higher levels, Group A sells their stock at a profit. Selling by Group A pushes the price lower, but not for long, as many participants who feel left out enter the stock. This pushes the price to an even higher level. Eventually, Group B sells their stock at a profit.

Group C, which has been sitting on the fence, now buys the stock around the trendline. This trendline, however, fails to support the stock as it plunges further down. The break below the up trendline indicates the end of the uptrend.

Group B, which had tasted success earlier, enter the stock again at lower levels. The price bounces back, giving Group C an opportunity to exit at breakeven. Selling pressure from Group C does not allow prices to move up any further. They form lower tops and lower bottoms. The stock is now in a well-established downtrend.

The stock now quickly changes hands from one group to another. Group D buys the stock. The minor up-move meets resistance from selling from Group B. The stocks moves further down where Group E makes an entry. Stock fails to retest previous lows. Group D eventually sells the stock at a loss. The panic selling by Group D pushes the stock to new lows.

Group F enters the stock spotting an opportunity amidst gloom. The buying from Group F lends support to the stock. This leads to a bounce back. Group E exits at breakeven. Group F again enters the stock at lower levels. Buying from Group F further reinstates support for the stock at these levels. The downtrend is over and the stock now starts trending up. The cycle begins again.

Spotting Price Patterns
Source: Profit Hunter

The interaction between various groups of people right from the start of the cycle to the end of it could create a number of price patterns.

These people may not be consciously aware of it, but their interactions tell a lot about their view of the stock. Here we have spotted two important reversal patterns.

First is the head and shoulder pattern. This is a bearish reversal pattern formed right at the top of the trend. A break below the purple support line confirms this pattern.

Second is a double bottom pattern. This is a bullish reversal pattern. A breakout from this pattern suggest that the downtrend is over.

So you see price patters don't have magical powers. They're a combination of trendlines, supports and resistance, nothing more.

Price patterns help describe the emotions of the people participating in a stock in a much better way than simply watching the price action go up and down. Here the psychology of the people making and trading these patterns of utmost importance.

Next time when I write to you, I will delve in greater detail about the psychological aspect of price patterns and how understanding it can give us an advantage.

Do you know how price patterns are formed? Share your views in the Club or share your comments here.

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7 Responses to "How Price Patterns are formed?"
devendra
26 Dec, 2015
detail Like 
Ambro
16 Aug, 2015
Thanks a lot Apurva. You explained in simple terms how the price-patterns are shaped by the emotional-patterns of people. Like 
K V Rajeev
13 Aug, 2015
Thank you for making it simple for grasping. But where is the shorting guy in the figure?Like 
Jaidev Kumar Mwndiratta
13 Aug, 2015
Realy nicely explained pricw pattern through chartwhich includes group of different people wih emotions. Reques to further explain factors of increaing & decreasing price of axon any besides individuals emotion & sentiments. Rgds Mendiratta J.K.Like 
Ranjit Ganguly
13 Aug, 2015
It is beautiful to attach "Psychology" that plays a major role indeed!Like 
Sundaravaradan
12 Aug, 2015
Hi, Well explained, important aspect: why a stock keeps going up & down, without any change in Business Fundamentals (I am an Investor). An investor could have a pre-defined BUY rate & SELL Rate, to benefit from THESE psycho Traders! (Market Makers).!Like 
ARUP
12 Aug, 2015
Apurva--Thanks a lot ... heard of these terminologies so many times ... now became crystal clear ...!!!!Like 
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