The principles of price pattern construction and interpretation can be applied to any time frame, from one-minute bars all the way to monthly or even annual charts. However, the significance of a price formation for a spe- cific time frame is a direct function of the formation’s size and depth.
We have already established that a rectangle whose boundaries have been touched many times is more significant than one whose boundaries have been touched only twice. We can extend this idea by saying thatthe longer a pattern takes to complete, the greater the number of fluctuations within it; and the deeper its trading range, the more substantial the following move is likely to be.
Let’s consider these three factors in turn.
1. Time Frames
The longer the time frame, the more significant the pattern. A pattern that shows up on a monthly chart is likely to be far more significant than one on an intraday chart, and so forth. In addition, the longer a pattern takes to develop in a particular time frame, the greater its significance within that time frame. Let’s say we are looking at a daily chart and we spot two for- mations. The first takes ten days to complete and the second four weeks.
Clearly the four-week battle between buyers and sellers is much greater and more involved than the ten-day encounter. Consequently, when the out- come is resolved, the ensuing price move is likely to be much greater. I use the word likelybecause this is a generality. Most of the time the larger pat- tern will be more important, but not every time. In technical analysis, we are dealing in probabilities, never certainties. This means that small patterns will occasionally be followed by large moves, but normally it is the larger ones that are.
Let’s compare an accumulation pattern at a price low with the construc- tion of a building. It is just as important to build a strong base from which prices can rise as it is to build a large, strong, deep foundation upon which to construct a skyscraper. In the case of security prices, the foundation is an accumulation pattern that represents an area of indecisive combat between buyers and sellers. During an accumulation phase, more sophisticated investors and professionals are positioning or accumulating the security in anticipation of improved conditions six to nine months ahead. As men- tioned earlier, ownership is being transferred from weak, uninformed traders or investors to strong and knowledgeable hands. Consequently, the longer the pattern takes to complete and the greater the level of activity within it, the more significant the accumulation process and therefore the stronger the technical position.
The reverse is true at market tops, where a substantial amount of distri- bution inevitably results in a protracted period of price erosion.
2. The Significance of Pattern Fluctuations
The greater the number of fluctuations within a pattern, the greater the sig- nificance of that pattern. When the price action has been at a stalemate for a long time and investors and traders have become used to buying at one price and selling at the other, a move beyond either limit represents a fun- damental change and has great psychological significance.
In 1972 and 1973 the commodity markets experienced a huge run-up.
Chart 6-2 shows the CRB Composite. You can see that the rally was preceded by a multiyear trading range. There was no way of knowing that the break- out from the range would be followed by such a spectacular advance. Even so, the sheer size of the battle between buyers and sellers over many years would have indicated that when a resolution finally did take place, it would most likely signal an above-average price trend.
3. The Significance of Pattern Depth
The deeper a pattern, the greater its significance. The depth of a forma- tion also determines its significance. Consider the trench war analogy once more. If the opposing trenches are very close together, say within 100 yards, this means that the victorious assault, when it comes, will be less significant than if they are separated by several miles. In that case, the battles will have been much more intense and the victory that much greater. The same is true in the financial markets. The breaching of a wide trading range gen- erally has far greater psychological significance than the breaching of a
narrow one. Psychology, as expressed in market prices, tends to move in pro- portion. The greater the (proportionate) swing within the pattern, the greater the subsequent move is likely to be. If you get wide price swings dur- ing the formation of the pattern, you are also likely to get wide swings after it has been completed.
Having said that, it is also important to note that whenever you see a very tight and constrained trading range, this indicates that the battle between buyers and sellers is very evenly balanced. This is especially true when the level of activity shrinks to almost nothing. When that balance is tipped one way or the other, you will often find that prices move quite quickly and to a greater degree than is suggested by the measuring implication. We see an example in Fig. 6-24, where a pretty sharp decline follows the relatively narrow rectangle. Perhaps the guiding light in this is to see how many times the upper and lower boundaries have been touched or approached. The greater the number of times, the greater the significance of the line as a support or resistance zone, and therefore the more decisive the victory.
Measuring Implications
Technical analysis is best at identifying trend changes at an early stage and not so useful in forecasting how far a trend will extend. Price pattern
. . . followed by a multiyear advance CRB Composite
Multiyear rectangle . . .
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Chart 6-2 CRB Composite, 1957–1982, daily.
interpretation is one exception, since the construction of these formations offers some limited forecasting possibilities.
Nearly all price patterns obtain measuring objectives from their depth.
The rectangle is no exception. Figure 6-9 shows a rectangle that has formed and completed a top (distribution). The measuring implication of this for- mation is the vertical distance between its outer boundaries, i.e., the distance between lines AA and BB projected downward from line BB.
In many cases, the price trend will extend beyond the objective. In really strong moves, it will achieve multiples of it. We can take the process a step further by stating that the various multiples of the objective can become important support and resistance areas in their own right. Time and again, these price objective areas turn out to be important support or resistance points. Unfortunately, there is no way to determine where the actual junc- ture point will be for any rally or reaction. This emphasizes the principle that in technical analysis, there is no known way of consistently determin- ing the duration of a price movement. It is possible only to speculate on the probability that a specific area will prove to be a support or resistance zone.
Consequently, while this measuring formula offers a rough guide, it is usu- ally a minimum expectation. An example for a multiple-objective downside break is shown in Fig. 6-10. Here we see the price sink by three times the original objective. These multiples of the objective can be just as important in forecasting a probable pivotal point on the way back up, as we can see in the very right-hand part of the chart.
Figure 6-9 Rectangle top measuring objective.