As a practicing technical analyst, one of the frequent items that we look for is some bullish or bearish pattern on the chart. If one is using candlestick charts – as most people do – then these patterns keep popping up on the charts every now and then. Obviously, what is found so frequently or so abundantly does not carry the same weight as something that is found once in a while. Hence, these candle patterns are often used by traders and technically oriented investors tend to wait for some more substantive patterns on the charts, such as the inverted head and shoulder or multiple bottom formation (triple, double etc.) or some rounding formation on weekly charts. People then act on such patterns whenever there is a resolution of the pattern in a trended direction.
This aspect is pretty much well laid out in the annals of technical analysis and everyone who learns TA has to go through the grind of learning about patterns. They may not use them much (preferring to use things like oscillators, most often) but every TA is indeed aware of the pattern. Those who are not TA oriented also are quite aware of the existence of patterns on charts like Head and Shoulder, Triangles and Cup with handle etc. These have been made famous in the print media and perhaps the exotic sounding names of candle pattern or even other patterns also makes them an attraction of idle curiosity.
But people outside the TA fraternity don’t take these patterns seriously and generally look upon them as some sort of frivolous way of analysis. That they have not bothered to inform themselves of why and how the pattern forms is entirely another matter. The very fact that pattern study has been one of the key elements within TA and that it has been around for over a century should be a pointer to the reliability (even statistically!) of the approach. Even the venerated US Fed Reserve, in a report found validity of a pattern like the Head and Shoulder! There is a white paper on this, authored, I think, by Andrew Lo, who has done some work in this area.
In this context, something that people who are of a fundamental persuasion have said about patterns may be of interest to the skeptics. Quoting Prof Sanjay Bakshi, a well-regarded name in value investing, “Take Charlie Munger. He talks about learning by studying great failures and great successes and identifying common elements. He wants you to recognize patterns. If there’s a pattern associated with success, he implicitly assumes causality. If there’s a pattern that’s associated with failure, he does that again. He said avoid the patterns that cause failure (all I want to know is where I am going to die, so I never go there). He says look for patterns which “produced” extreme successes and if you find them, back up the truck on them….. “He further adds that “Maybe, just maybe there’s a pattern which helps us understand what’s a good business and what’s a bad business ex ante and not ex post…..”
What is being discussed here is the identification of a pattern in business, in behavior. It is just that you have not chosen to give them any name. Perhaps, the reason is that such patterns of behavior or indeed, the study of them, has not been documented enough to become statistically reliable. Or, the chronicling of such patterns of behavior may be much beyond the capabilities of most people? But despite the lack of such records, Munger or Prof Bakshi and indeed, many of their followers are ready to look for such patterns and believe in them! Then why would they are anybody else have any difficulty to look at patterns on charts and believe what is holds out as a possibility for the stock? After all, pattern study within TA has been around for almost a century and their reliability, based on statistical evidence, is quite consistent. See the detailed studies done by authors like Thomas Bulkowski or Myers etc. who have done extensive work on the reliability of all kinds of patterns.
Just because some pattern is found more frequently cannot take away the validity of the same, especially if proved by long term study. And just because some pattern is available rarely but has not been proved to any degree because of lack of consistent data or research thereon cannot be reason for making it valid.
Everything is the way we see it. If we decide something is right, then it is. Equally, if we decide that something is not, it isn’t. But we cannot convert that into a universal truth by stating that patterns within fundamental study are valid but those within technical study are suspect! Ultimately, if one contemplates on this matter long enough, one will realize that all of our life’s behavior is nothing but a manifestation of patterns. We recognize one another, deal with one another, and understand one another thru the patterns of our behavior. Indeed, if patterns were not there, we would find it difficult to know what is right and what is not.
Remember that the next time you knock down somebody who claims excitedly when he spots a pattern on the chart! Every pattern speaks. It is just that we have to develop the ability to listen.