The Intersection of Patterns and Trends

• Posted by Derek
• on December 10th, 2011

“The big profits are made in the runs between accumulation and distribution”   W.D. Gann via Daniel Chesler

I have found few indisputable truths about markets.  A number of general principles and guidelines, yes.  But regarding those I consider 100% reliable, only the following qualify:

1) Contraction is always followed by expansion

2) The strongest uptrends don’t offer a chance to “buy the dip” so it always feels late

3) Trends in motion stay in motion until they don’t

Every now and then I read something reminding me that every trading concept has been studied at some point by someone before me.  I recently stumbled upon a paper that hammered home some ideas I’ve been making more formal in my analysis, and it felt so personal I couldn’t believe I hadn’t read the author’s work before.

This 2000 paper by Daniel Chesler, titled Volatility and Structure: Building Blocks of Classical Chart Pattern Analysis, offers insight into the conflict between chart analysis and trend following.  In sharing this find, I’d like to highlight the following nuggets to consider:

1) The forecasting value of chart patterns is subordinate to their main role of cordoning off the conditions that precede certain trends.

2) When prices have been in a trend and suddenly stop advancing or stop declining, they are now “doing something else”.  That “something else” is almost always the start of a classical chart pattern of one form or another.

3) The final stage of a pattern’s development is marked by a relative absence of price volatility vs. the earlier stages of the chart pattern’s development.  The market has reached a relative standstill and is positioned at the “tripwire” of an imminent breakout.

4) The structure component also incorporates the tendency of classical chart patterns to exhibit noticeably overlapping cycles.  During price trends cycles overlap minimally, and in the case of very strong trends cycles may not overlap at all.

5) By waiting for the market to indicate through a measurable decrease in volatility its readiness to breakout, and by ignoring the directional implications of specific chart pattern “shapes”, we do not find ourselves engaged in the tricky game of constantly anticipating the time of the breakout or its direction.

Kind of a play by play of how we can use awareness of market character to understand where to find the intersection of noise and direction.  Visualize a chart pattern too soon and we risk being exhausted by the time it plays out.  Follow a “breakout” without considering the preceding conditions and we risk being constantly chopped up.  Like others, I’ve made both mistakes this year in $SPX by straddling the fence between patterns and momentum.  It’s not a matter of picking one or the other, it’s recognizing the complementary nature of the two and getting in gear with the dominant force.

Low ADX, falling volume, and falling range all suggest that we are closer to the end of this market phase than the beginning.  While the timing of any resolution remains elusive to all of us, I believe we’ll look back on 2011 as one big range that preceded a large break, and the risk for 2012 in fighting the last battle instead of the emerging one.  In concluding his paper, Chesler breaks “The Model” into 4 aims, the last of which I find most compelling based on the chart above…“To enhance the timing of trading decisions by more narrowly defining the specific behavior that coincides with chart pattern breakouts”.

The paper is fantastic, whether you are a fundie or a techie or new or old.  Experienced technicians can skip the introductory paragraphs that lay out the history of charting from the Japanese rice market to Charles Dow to Richard Schabacker and Edwards & Magee.  But just a quick look at the resources used in compiling this 9 page paper show the depth of Chesler’s expertise.  Maybe we can even find a note of agreement between FA and TA when he quotes Schabacker’s famous “the fundamental factors suggest what ought to happen in the market, while the technical factors suggest what is actually happening in the market.”

Read the rest of Chesler’s paper

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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