Trading patterns play a primary role in technical analysis as confirmation of directional movements. Market analysts monitors price and volume charts by methods to forecast probable price trends. In order to forecast the direction of the market more accurately, professional analysts combine their pattern studies with volume spread analysis (VSA). The buying and selling activities that are observed using trading patterns significantly impact the volume level of a stock; whereas increases in volume confirms breakouts, and lack of it usually leads to pattern failure. This paper will provide an overview of the head and shoulders, cup and handle, and triple bottom trading patterns along with the volume spread analysis approach.
The study of trends associated with volume helps analysts pin point price tops and bottoms. Volume analysis was introduced to the trading platform by some of the icon traders in history, most known of them are Tom Williams, Richard Wyckoff, and Jesse Livermore. Pioneer traders hypothesized that the footprints of big volume data could be used by individual investors in order to understand the movements of institutional investors. The investment management “natural economies of scale” and the increasing pool of investment capital creates an environment of massive trading of large stocks. When stock price movements are observed based on price only, the investor is limited within the scope of emerging signals. Therefore, methods of reading trend line patterns for heavy volume became common practice, with the exception that trend line patterns with light volume may be false indicators; as low volume indicates an overall lack of conviction from the buyers.
Trading patterns manifest itself naturally in the market, they are a representation of the constant tug of war between buyers and sellers. As the demand on a particular stock increase, its prices will also increase, this in return attracts more sellers to step into the market and supply it, which in return shifts the price lower. These shifts in price sometimes create well known shapes or "patterns" that have very predictable outcomes. Some of these well known patterns include the Head and Shoulders; Cup and Handle; Simple and Complex Pullbacks; Triple Bottom and Triangles. There are trading patterns not discussed in this paper, also note that trading patterns are considered one of the main areas of technical analysis. (Thomsett, 2003) differentiated between fundamental market analysis and technical analysis in that fundamental approaches provide insight as to why the stock price moves; while the technical analysis provides insight into the timing of the movements. Further, the uptrend and downtrend trading pattern lines represent support and resistance, respectively; while the channels between the trend lines are referred to as consolidation lines and stabilization lines. The objective of trading pattern information is to support market entry and exit decisions that will yield eventual gains. (Gervais, Kaniel & Mingelgrin, 2001) supported that when an individual stock is trading in a significantly small price range within daily and weekly periods relative to the trading volume; the subsequent month is characterized by significantly large returns.
The Head and Shoulders trading pattern is an indicator of a reversal in the main trend. The “head” of the patter is the highest peak, the two lower peaks are labeled as the “shoulders”. The “neckline” depicts resistance and is connector between the lowest trough points, or shoulders. Breaks beneath the neckline are interpreted as bearish signals that typically produce outcomes of a continued fall in the stock price. The head and Shoulders pattern may be used to predict how far down the stock price will fall by finding the head measurement and applying it to the break in the neckline and continuing the measurement downward:
Figure 1. Head and Shoulders Pattern (Learnstocks, 2013)
The formation of a head and shoulders trading pattern is an indicator that the stock movement is progressing against the trend. The pattern is confirmed when the neckline of the pattern is broken; at which time short term traders are likely to take positions. The downward trend is a signal of decreased stock visibility. The head and shoulders pattern could also be bullish, the inverse of the prior is true for that, The head will have the lowest peak while the shoulders will have two higher lows. Volume should be analyzed with the head and shoulders pattern, and traders should look for large spikes of volume at the break of the neck line.
The Cup and Handle trading pattern is categorized as a bullish continuation that forms during uptrends. The pattern is an outcome of stock consolidation periods; which indicates a time to buy when the stock breaks out above the handle to the upside. Figure 2 shows the cup and handle pattern, which is completed at the handle:
Figure 2 Cup and Handle Trading Pattern (Zedler, 2015)
The cup and handle has a high chance of success if its traders are cautious enough to analyse the volume behind the breakout, if the breakout was associated with relatively high volume than the pattern might have a very predictable outcome, however if there was any lack of interest which is seen in low volume levels, traders should be warned and avoid the pattern all together. Remember, if a trader is not shooting from a point of strength, he shouldn't be shooting at all. The lack of volume doesn't guarantee pattern failure, but the probability of success is reduced significantly.
The primary concepts of volume spread analysis are (1) no buying demand; and (2) no selling pressure. This paper only covers the basic concept of volume spread analysis, there are a lot of details that goes into it that are not discussed in this paper, please read our book review on !!!!volume price analysis complete guide!!!! for more details on this approach. The volume analysis approach may be used in the stock markets, futures and forex. Forex market trade volume is replaced by tick volume which is still a viable resource to conduct this type of analysis with. Figure 3 shows a VSA for 20 periods of a simple moving average that locates the trend replacements using no demand or selling pressure for Deere & Company:
Figure 3. Volume Spread Analysis (Woods, 2014)
The no demand bars confirm that the market shows little interest in the bullish run. Box number 1 shows a potential change in trend at a price that is below the simple moving average.Box number 2 pin points the bars where no buying interest is observed, Box number 3 shows potential opportunities for shorting. The VSA approach adhere’s to Wyckoff’s 3 trading tenets of Volume and Price; Effort and Result; and Cause and Effect. Other common VSA approaches include anchor bars; low volume pullback; and on-balance volume.
Assessments of trading activity is a fundamental component of an in-depth comprehension of economic market interactions. The ability to read the trading patterns and the trends relative to variations of time and the psychology that drives the trading pattern provides critical information that can be used to plan market entry and exit points. (Lo & Wang, 2000) supported that the assumption of price and quantity as the basic units of market interaction theory clarifies the significance of trading volumes in asset market models, such as the capital asset pricing model (CAPM). Such is the consensus in regard to the use of trading patterns and volume analysis to track and to interpret price movements that may have otherwise been weak or ambiguous.
(Thomsett, 2003) described stock market support and resistance as a representation of the “value consensus” of all participants in the market at any time. However, determinations of the trade side that is supported by smart-money investors is an established strategy based upon evidence-based outcomes of the significance of the institutional trader footprints. Therefore, observations of trading patterns, particularly in regard to trade volume are most beneficial when applied to large stock trades. Thomsett also confirmed that “observations of accumulation and distribution of stock price, along with changing volume observations on the buy side or the sell side, may confirm price trends that are also used in support and resistance analyses”. Generally, the trading patterns do not present absolutes for asset trading; however, the patterns highlight significant aspects of the securities that can support valuable investment gains.
Gervais, S. Kaniel, R. Minglegrin, D. The High-Volume Return Premium. The Journal of Finance, LVI(3), 2001.
Learnstocks. 2013. Head and Shoulders. The Hot Penny Stocks. Retrieved from http://www.thehotpennystocks.com/learn/head-and-shoulders/
Lo, A. Wang, J. Trading Volume: Definitions, Data Analysis, and Implications of Portfolio Theory. The Review of Financial Studies, 13(2), 257-300, 2000.
Thomsett, M. 2003. Support and Resistance Simplified. Marketplace Books.
Woods, G. 2014. Your First Guide to Volume Spread Analysis (VSA). Trading Setups Review. Retrieved from http://www.tradingsetupsreview.com/guide-volume-spread-analysis-vsa/
Zedler, B. 5 Stock Chart Patterns to Help Maximize Profit. Trade Education. Retrieved from http://www.trade.education/5-stock-chart-patterns-help-maximize-profits/