exceptional souls who have passed the bottom-line test over long periods of time using nothing but chart patterns. Doubtless they bring to the party an acute market sense that has nothing to do with charts, as well as great discipline.
Since the advent of computers, quite a lot of work has been done on the predictive validity of price patterns. The conclusion of this work has been that price patterns taken as a whole, do not have predictive value –at least this was the conclusion in the 1960s, when academics came to agree that prices traced out a random walk. This conclusion has not been publicly disproved. But more recently it has come to be recognised that changes in volatility can be predictive. In particular, significant increases in volatility tend to coincide with turning points. The Mint Group, for one, makes no secret of the fact that it uses volatility as an early warning indicator of trend changes in its computerised trend-following systems.
Speaking only for the currency markets, there are 3 patterns associated with volatility which can be useful to us, I think.
1) The key reversal* .This pattern is highlighted in a single bar stroke in the chart below, which illustrates all three “patterns that work” .It’s a simple formula which is easier seen than described. A price reaches a new high (or low) during the day; but its closing price is lower (or higher, if the trend is down); and its daily range is outside that of the previous day. Strictly speaking, the key reversal applies to futures* prices; and a “new high” (or a new low) is defined as a new high for specific futures contract, like the IMM June Yen. This pattern is more often seen at an extreme than in mid-trend, on the evidence of the dollar parities of the past decade. In terms of psychology, this must be that familiar moment when late speculators are capitulating to the trend with some abandon, while existing position-holders are cashing in at prices they barely hoped for. It is most reliable as a turning
point when volatility is greatest.
The “key reversal” is either apparent as a move that happens in one day (a key day reversal*) or in a week (a key week reversal*). It’s most reliable when the range on the single key reversal day encloses the range for an entire week –as happened in June 1989 (see chart). On the rare occasions when that happens, pay attention. It’s a cherry worth picking.)
2) ‘Trampolining’*. I think this term may have been invented by David Fuller, editor of FullerMoney. Volatility sometimes shows, as depicted in the chart above, in several violent bounces; and again this is a pattern which seems to occur more often at extremes than in mid-trend – in other words they are bounces from a floor or off a ceiling. Again, it’s worth paying attention to. The above chart illustrating key reversals is also a good example of trampolining.
3 ) Island reversal. Another pattern that seems to occur more often at extremes than mid-way, this pattern is a great favourite of chart followers. So “consensus realists” will give it due weight. It has more in common with the key reversal than with the trampoline, but may not be too reliable in the currency markets –if only because the price “gaps” that cause an island reversal only exist in the IMM, not in the 24 hour interbank market. Psychologically, you could say that when you see a trading area being left behind like this, the trend is “exhausted”. New speculators have plunged into a vacuum and are easily countered by older positions moving out.
When we see any of the above patterns confirming an original diagnosis that a trend is due for reversal on the basis of our sentiment gauges, we can sit up and take notice.
Most of the other patterns beloved of chartists consist of breakouts of one form or another from consolidation* areas. The realist will keep an eye ou t for such patterns because of their self-fulfilling power. They seem to me mostly to be patterns which work better in retrospect than in real time, but I believe they can be helpful for timing when they confirm an existing analysis. The breakouts in the Swiss franc and D-Mark in mid-1990 are examples –though note that the DM offered a trap (a “false” breakout) in May. The well– defined, short consolidations include the “wedge”*, the “flag”* and the “pennant”*, patterns that are well described by their names.
In all these cases what is happening in theory is that a phase of uncertainty is being resolved in one direction or another.
Support and resistance levels can have validity because of the number of people who believe in them. But they may be of more use to very short-term traders than to those trading the multi-week moves.
Of the charting systems developed by R. N. Elliot* (“Elliot Wave”) and W. D. Gann* and I know-not who else, all one can say is “use them if they consistently help you make money, but watch out that you don’t fool yourself”. The bottom line is what counts.
Finally, if currencies tend to trend in narrow channels more often than they should do by pure chance, why should this happen? What can be going on? Obviously, any move starts with an imbalance between supply and demand for whatever reason. Once started, a familiar process is liable to takeover – namely that those who are congenitally disposed to buy rises and sell falls are drawn to the market, in increasing numbers.
Included among these will be trend-following chartists; and there may be a further phenomenon which comes into play here. Many price-based
players are highly sensitive to risk-reward figuring. They are on the lookout for situations which allow them a tightly limited loss –normally controlled by a stop* order –with an open-ended profit potential. Such a situation occurs when a rising price has eased to the bottom of its up trend channel (or when a falling price blips to the top of its channel). At this point it seems to offer a very low risk play for the trend-follower: the price cannot fall more than x points without breaching its trend channel, in which case the simple trend-follower wants to be out of it anyway.
Consequently there may be an unusual concentration of speculative buyers right near the point which defines the trend –and a certain absence of sellers, since so many traders would not dream of selling while the trend is intact. Thus the trend perpetuates itself: and the easiest route for it to take is a channel, with a well- defined southern border, if it’s an uptrend, or northern border if it’s a downtrend.
Those then are some of the cherries to be found in price analysis. There’s no doubt that they can help us, not only in corroborating our analysis of the underlying trend, but also in alerting us, at times, to the need to re- examine the equation. Looking for inspiration in charts does have the advantage that it puts the right brain* (the right-hand hemisphere of the brain) to work: and most inspired trading decisions come from a balanced interaction between the left, analytical side and the right, pattern-recognising side.
In so far as we do use price patterns and open interest patterns to help us trade, we are using what is generally called “technical analysis”. That’s fine: let’s use any tools that help us trade.
Now it’s time to turn from analysis and forecasting to actual trading.
PART II 
