Why Chart Patterns Work. The Psychology behind Price Patterns

Chart patterns are without a doubt one of the most useful tools in technical analysis because they can help us make short-term and long-term forecasts. Because the markets are fractal in nature, these cart patterns work across all time frames. Additionally, because human psychology is the main driving force of price action, these chart patterns work across all asset classes starting from stocks, bonds, Forex currencies and even cryptocurrencies.

Most technicians assume that the price of any asset inherently reflects everything that needs to be known about that particular instrument. The price reflects all the fundamental information, including market sentiment and the perceived fair value. If you hold this belief to be true, then chart patterns should answer all your questions regarding where the market is heading.

Chart patterns need to be analyzed in the context of the trend.  This is key to successfully trading chart patterns. Determining the dominant trend is paramount because only then can we use chart patterns to know whether the current trend is more likely to continue or more likely to reverse.

To better understand why chart patterns work, it’s important to look at the psychology behind the price and the supply and demand forces that give these chart patterns their shapes.

The Psychology behind Chart Patterns

The basis of chart patterns is market psychology because these price formations reflect the buying and selling pressures in a visual format. The supply and demand forces are the ones that shape these price patterns. So, a chart can give us a complete pictorial record of all trading activity and can provide us with a framework to analyze the battle raging between the bulls and the bears.

Most importantly, chart patterns can assist us in finding out who is winning the bulls and bears battle. Trading is all about determining who is winning this battle because this will allow you to take trades according to the market sentiment.

No matter the time frame you use to trade these chart patterns, they still work because emotion and supply and demand are universal laws. So, what gives the shape to a price chart is the buy and sell orders or the supply and demand forces.  Since orders are submitted by human beings, to get a  sense of the price you need to read the charts through a lens that shows what other market participants are thinking.

Every chart pattern has a story that creates the current shape of the pattern. For example, a bullish flag, simply shows that the bulls are not buying anymore, but they hold and defend their positions by keeping the price in a narrow range. Broadly speaking, flag patterns are a powerful price action because it incorporates the trend in the price structure.

A top-down approach to trading chart patterns incorporates three main steps.

  1. The first step is to decide on the time frame you want to trade, which should reflect the type of trader you are. The intraday charts like the 5 and 15 minutes are usually used for day trading or scalping the market. The 4hr and the daily can be used for swing trading and the weekly and monthly time frame for position trading.
  2. Secondly, you need to identify the dominant trend of your preferred time frame.
  3. Thirdly, you can use chart patterns to time the market.  Once you see the dominant trend, you can then spot chart patterns to time the market. You need to avoid trading only based on chart patterns without having established a framework because you’ll end up trading on pure randomness.  Context is the backbone of good decisions in trading.

Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.