Pring on Price Patterns: The Definitive Guide to Price Pattern Analysis and Intrepretation

Copyright © 2005 by Martin J. Pring. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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Contents

Introduction

Acknowledgments

Part I. Basic Building Blocks

1. Market Psychology and Prices: Why Patterns Work

2. Three Introductory Concepts

3. Support and Resistance Zones: How to Identify Them

4. Trendlines

5. Volume Principles as They Apply to Price Patterns

Part II. Traditional Patterns

6. Using Rectangles, a Case Study for All Patterns

7. Head and Shoulders

8. Double Tops, Double Bottoms, and Triple Patterns

9. Triangles

10. Broadening Formations

11. Miscellaneous Patterns

Part III. Short-Term Patterns

12. Smaller Patterns and Gaps

13. Outside Bars

14. Inside Bars

15. Key Reversal, Exhaustion, and Pinocchio Bars

16. Two- and Three-Bar Reversals

Part IV. Miscellaneous Issues

17. How to Assess Whether a Breakout Will Be Valid or False

18. How Do Price Patterns Test?

Appendix Individual Patterns Summarized

Index

Introduction

In 2002, McGraw-Hill published eight of my books and book/CD-ROM tutorial combinations. As an author, I can tell you that that was a lot of work, and one of my 2003 New Year’s resolutions was that enough was enough and I would not write another book for many years. So much for resolutions, because 2003 has seen the birth of this book and the DVD presentation that is enclosed in the back, and 2004 will see their publication.

I first got the idea of writing this book after bumping into Rick Escher of Recognia. Recognia is an Ottawa-based software company that is dedicated to offering scanning techniques for investors and traders. Its principal vehicle for this was originally chart pattern recognition, although this has been and will be expanded to include other technical and possibly fundamental indicators. Accurate scanning software for chart pattern recognition has been one of the dreams of technicians for years, and the opportunity to work with Recognia on this project and the ability to offer it on our Web site at pring.com got me excited enough to come up with this book.

For those interested, the DVD enclosed at the back of the book offers a one-hour presentation taken from my Live in London video series. The contents have been selected to reinforce many of the topics covered in the book.

Several classic books on technical analysis have covered the subject of price patterns in depth. In the 1930s, R. W. Shabacker wrote several books on the stock market, of which Technical Analysis and Stock Market Profits is the most relevant. H. M. Gartley included a large section on this subject in Profits and the Stock Market. Perhaps the most notable has been Edwards and Magee, Technical Analysis of Stock Trends, originally published in 1951 and now, under the new editorship of Charles Basatti, expanded to include other technical and portfolio management subjects. There is therefore a raft of information available on this subject, so why offer more? The answer probably lies in the statement, There is more than one way to skin a cat. In the old days, when charts were plotted by hand, time horizons were much longer. Today, with the advent of intraday trading, more emphasis is being placed on the short term. While a substantial number of the examples featured here rely on daily and weekly charts, quite a few intraday situations have also been included.

The more I study market action, the more I am impressed by the fact that prices are determined by the attitudes of market participants toward the emerging fundamentals. Consequently, I have tried to expand on the discussions in other books concerning the psychological rationale for many of the patterns. If it’s possible to understand the logic behind these patterns, there is a greater probability that they will be more accurately—and, hopefully, more profitably—interpreted.

A whole section of the book has been devoted to what I call one- and two-bar price patterns. These formations typically indicate exhaustion and are often followed by sharp and timely reversals in trend. They are especially suited to the swing and day trader, who is forced by time constraints to act quickly. Earlier books covered some of these patterns, but one of the objectives of this book is to expand on this coverage with some ideas of my own.

In addition, I have tried to include a few patterns that are not described in the classic texts, along with a few personal variations. Also, there are some patterns that are described in other books, but that you will not find here. There are two reasons for this. First, it may be that they do not appear in the charts very often. If I have to hunt through hundreds of years of daily data and am hard-pressed to find an example of a specific pattern, that pattern is hardly of practical day-to-day use. Second, some patterns, such as orthodox broadening tops and bottoms, trigger signals so far away from the reversal point that much of the new trend’s potential has already been achieved. Discussion of such formations has been kept to a minimum or eliminated altogether. So, too, have explanations of patterns where the demarcation boundaries cannot easily and conveniently be drawn. Diamonds and rounding formations come to mind.

No indicator used in technical analysis is perfect, including price patterns. In this respect, Chapter 18 summarizes some of the research that Pring Research and Recognia have undertaken through the identification of 5,000 patterns between 1982 and 2003. The results indicate that the two types of formation tested, head-and-shoulders and double tops and bottoms, generally work when the signals develop in the direction of the primary trend. This demonstrates that correct interpretation and application, when combined with other indicators, will put the odds in your favor. I say odds because technical analysis deals only in probabilities, never in certainties. Because of this, it is of paramount importance for all market participants to first ask the question What is my risk? before asking the obvious What is my reward? This involves mentally rehearsing where the price would need to go in order to indicate that a pattern had failed. Any good driver looks through the rearview mirror prior to overtaking the car ahead. Traders and investors should do the same by identifying risk before assessing any potential reward

Acknowledgments

There are several people whom I would like to thank for their help and encouragement in writing this book. The idea originally came to me after I bumped into my new friends at Recognia, a Canadian software company devoted to pattern recognition software. In particular, I would like to thank the president of Recognia, Rick Escher, who has provided me with several ideas and has made possible the launching of a pattern recognition subscription service at our Web site, pring.com. My thanks go also to Bob Pelltier at csidata.com for kindly providing the historical data used for the research in Chapter 18.

The DVD at the back of the book was shot as part of a Live in London video series. Permission to include the excerpts featured in the DVD was generously given by my friend and the sponsor of the conference, Vince Stanzione, at www.commodities-trader.com. United Kingdom–based traders looking for some quality instruction may well want to look him up.

Finally, and as usual, exceptional thanks goes to my wife, Lisa, who steadfastly applied herself to re-creating all the illustrations featured in the book from my miserable original specimens despite a house move and personal sadness caused by a close family bereavement.

To Lisa, who never fails to surprise me on the upside

PART I Basic Building Blocks

1 Market Psychology and Prices: Why Patterns Work

The more I work with markets, the more it becomes apparent that prices are determined by one thing and one thing only, and that is people’s changing attitudes toward the emerging fundamentals. In other words, prices are determined by psychology. The great technician of the 1940s, Garfield Drew, once wrote, Stocks don’t sell for what they are worth, but for what people think they are worth. If it were not for the fact that these changing attitudes move in trends and that trends tend to perpetuate, market prices would be nothing more than a random event, which would mean that technicians would be out of business.

Changing Attitudes and Changing Prices

A classic example of changing attitudes that affected prices developed in the 1970s and early 1980s. In 1973, a group of stocks known as the Nifty Fifty peaked after a phenomenal rise during the 1960s. These were known in the trade as one-decision stocks, because their earnings went up every year, as did their prices. People came to the conclusion that there was only one decision to make where these stocks were concerned: just buy! These stocks included such growth names of the time as Kodak, Xerox, McDonald’s, and IBM. During 1973 and 1974, they declined substantially in price, along with the rest of the market. Over the course of the next nine years or so, the earnings for the group as a whole continued to rise, but the index did not make a new post-1973 high until nine years later.

Thus we arrive at a situation where prices bear no reality to the earnings trend. Perhaps prices were too high in 1973 relative to the earnings; perhaps they were not, and they should have continued rising throughout the 1970s as earnings rose. Who knows? Who can tell? Technicians would say, Who cares? Why? Because technical analysis assumes that the changing attitudes toward these emerging fundamentals are reflected in price action as displayed in charts. It’s not dissimilar to a medical technician looking at a patient’s chart. He doesn’t have to know that the patient is groaning with pain to diagnose a problem. It’s all there in the chart. The chart tells him that the patient’s vital signs are deteriorating to the point where danger lies ahead and that remedial action should be taken. In a similar way, to the technician, poor price action signifies a weak price trend and the probability of trouble ahead in the form of a serious price decline. The technician does not have to know the reason why; he merely observes the condition and takes the necessary action.

Chart 1-1 shows the 1990s price action for Key Corp., a money-center bank. The bank’s earnings are shown in the lower panel. Note that there are two periods when the price came down for a prolonged period, the first in the 1980s and the second in the late 1990s. In both cases the earnings rose, demonstrating once again that it is the attitude of market participants toward the emerging fundamentals rather than the fundamentals themselves that is important. This is not the same thing as saying that earnings are not important; of course they are. If we had known that earnings were going to rise at the beginning of both these periods, it would have been reasonable for us to assume that the price would rally as well. Only a review of the technical position could have helped us to conclude otherwise.

Chart 1-1 Key Corp. 1990–2002 vs. earnings. (Source: Telescan.)

Chart 1-2 shows another example, featuring eBay. Once again we can see that the earnings increased pretty dramatically throughout the period covered by the chart. However, the price fell slightly, showing the futility of buying and selling stocks based purely upon accurate earnings estimates.

Chart 1-2 eBay 1998–2003 vs. earnings. (Source: Telescan.)

History repeats, but never exactly, and as prices approach a turning point, people react in roughly the same way. It is this similarity of behavior that shows up in identifiable price patterns or formations, and that is the subject of this book. Later on we will classify these various formations, establish their reliability, and explain how they can be used as a basis for trading.

Technical Analysis Defined

At the outset, it is very important to understand that technical analysis is an art form. Indeed I define it as "the art of identifying a trend reversal at a relatively early stage and riding on that trend until the weight of the evidence shows or proves that the trend has reversed." You have probably noticed that I have emphasized the words weight of the evidence. This is because price patterns should be looked upon as one indicator in the weight-of-the-evidence approach. In other words, we should not look at price patterns in isolation, but consider them in conjunction with several other indicators. Over the years, technicians have developed literally thousands of indicators, so it is obviously impossible to follow them all. By weight of the evidence I mean four or five indicators that the user feels comfortable with. The world’s great religions are all primarily concerned with finding the truth, but each has its own way of getting there. So, too, with technical analysis; what one person sees as a great indicator another may discard as useless. It’s important for you as an individual to decide which indicators to adopt in your trading by testing them over a period of time. If you do not have confidence in your choices, I can assure you that you will make wrong trading decisions once the trend goes against you.

By this point you may be asking, What does he mean by indicators? Well, I mean oscillators such as the RSI, stochastic, KST, and so on. Other approaches include Elliott, Gann, or the Wykoff method. Still others rely on cycles, volume, or trend-following indicators, such as moving averages and trendlines. Price patterns are therefore one indicator in this weight-of-the-evidence approach. I strongly believe that they should not be used in isolation, but rather should be used in conjunction with several of these other indicators with which you feel comfortable. Price patterns should not be used blindly; they should be interpreted and applied with a full understanding of the underlying psychology that gives rise to their development. If you understand roughly how and why they work, you will be in a better position to interpret them in difficult situations.

Price Patterns and Psychology

I have used the word trend several times, but what is a trend? In my view, a trend is a period in which a price moves in an irregular but persistent direction. There will be a lot said on the subject of trends in the next chapter, but for now all we need to know is that there are various classes depending upon the time frame under consideration. For example, a 60-minute bar chart will reflect very short trends, and a monthly bar chart will reflect trends of much greater duration, lasting for years. However, the principles of interpretation are identical. The only difference is that reversals of trends on intraday charts have nowhere near the significance of those on the monthly charts. It should be assumed that the longer the time span, the more reliable the signal. It is important to understand that this last statement is a generalization, since some short-term signals can be very reliable and some long-term signals less reliable. The reason why longer-term trends have a habit of being slightly more reliable is that they are less subject to random noise and manipulation.

When a trend is underway, it means that either buyers or sellers are in control. During an uptrend, it is the buyers, and during a downtrend, the sellers. I have often heard people respond to the question, Why is so and so going up? with the flippant answer, Because there are more buyers than sellers! Well, strictly speaking, this is not true, because every transaction must be equally balanced. If I sell 1,000 shares, there must be one or more buyers who are willing to purchase that 1,000 shares. There can never be more, and there can never be less. What moves prices is the enthusiasm of buyers relative to that of sellers. If buyers are more motivated, they will bid prices higher. On the other hand, if sellers are more motivated, then the savvy buyers will wait for the sellers to come down to their bids, and prices will decline.

Technicians have noted over the years that prices do not usually reverse on a dime. There is usually a transitional period between those times when buyers have the upper hand and those when sellers are pressing prices lower. During these transitional phases, prices experience trading ranges. This ranging action often takes the form of clearly identifiable price patterns or formations. If these transitional periods are classified as a horizontal trend, it follows that there are three possible trends: up, down, and sideways. Occasionally prices will resolve these horizontal price movements in favor of the previous prevailing trend. In this case, the temporary battle between buyers and sellers turns out, in retrospect, to be a period of consolidation. Such formations would then be termed consolidation or continuation patterns, since the prevailing trend would continue after their completion. By the same token, if a pattern separates an uptrend from a downtrend or a downtrend from an uptrend, the formation would be called a reversal pattern.

It is a generally known fact that rising prices attract bullish sentiment and vice versa. When prices begin their ascent, most people do not anticipate a large sell-off. This is because the news background remains very positive and people generally extrapolate the recent past. It is only after prices have been falling for some time that bad news becomes believable. This means that when we spot a bearish-looking pattern after a previously bullish trend, it is unlikely that we will believe its bearish omen. In fact, we could say that the less believable the pattern, the greater the odds that it is going to work.

Let’s look at it another way. Say the gold market has been rallying for months and there are widespread media reports telling us that gold and gold shares have outperformed the stock market. In this kind of environment, analysts and other market participants typically expect more of the same. It’s possible that there is also a scary geopolitical background; for example, oil supplies may be threatened. However, the gold price forms a reversal price pattern. At the time it would be inconceivable that this pattern could work, but that is precisely the time when it is most likely to do so. The tip-off might come if the news becomes exceptionally bullish as a result of some destabilizing geopolitical event, but the price does not make a new high. That will give the bearish technical case substantial credibility, for if unexpected good news (for gold) cannot send the price higher, what will? Nothing, because this news is already factored into the price. Such action tells us that the underlying technical position is not as strong as it appears on the surface. It’s the market’s way of saying, forget the media hype, bullish sentiment, and what you hope will happen. Instead, focus on what the market is actually telling you and act on that. The problem is that when everyone around you is convinced that a specific trend is going to extend, it is very difficult to take a different stance. Only after taking a series of losses because you believed the crowd rather than the market action are you likely to learn the lesson that the market speaks the truth and crowds speak with forked tongues.

2 Three Introductory Concepts

Introduction

Before we proceed to a discussion of price patterns themselves, it is important for us to lay the groundwork by describing a few introductory concepts. By doing so, it is possible to obtain a firmer foundation and a better understanding of how markets work, and we will then be in a better