Education

Chart patterns: do they really indicate future price moves?

By Paul Reid

14 February 2024

chart patterns guide

When it comes to technical analysis, chart patterns are said to offer traders a glimpse into the future course of an asset's price. Patterns such as head and shoulders, double bottoms, wedges, and triangles have long captivated traders' minds, promising to unlock the secrets of market behavior and guide informed trading decisions.

In some cases, traders believe them to be reliable indicators, and plenty of performance percentage claims online support that assumption. A study by Michael Kahn indicated that chart patterns exhibit a degree of accuracy in predicting price reversals, attributing an 89% success rate to the head and shoulder pattern.

Such an advantage would give any trader an abundance of profit over time, but is that optimistic percentage accurate? Do chart patterns really indicate coming price directions?

Chart patterns: what every trader should know

Chart pattern analysis is not without its critics. Skeptics argue that the assumption that current price movements are in some way connected to the past is flawed, as the dynamic nature of the financial market is influenced by a multitude of factors beyond historical data. News events, economic indicators, and investor sentiment can all significantly disrupt price trends, rendering chart patterns less than reliable.

While chart patterns can certainly offer insights and take away some of the guesswork, traders would be wise to rely on something other than just them when making informed decisions. Instead, traders might consider a more holistic approach integrating fundamental analysis and market sentiment considerations.

Fundamental analysis shows the current economic climate and performance and accounts for unexpected changes. Market sentiment assessment measures the overall mood of market participants, which often outweighs logic or statistical evidence. 

In contrast, there is one factor that could support the use of chart patterns and technical analysis, and it’s a concept that’s hard to dismiss.

The self-fulfilling prophecy phenomenon

The interplay between chart patterns, trader psychology, and market dynamics adds another layer of complexity to the discussion. When a significant number of traders recognize a potential reversal based on a standard chart pattern, their collective actions can influence the market's direction, potentially fulfilling the pattern's prediction.

Moreover, there are thousands of AI trading bots that also use chart patterns as a baseline for forecasting. These bots can open and close hundreds of trades daily based on forming chart patterns, and the combined actions of humans and bots can move the markets in the direction chart pattern traders expect.

This self-fulfilling prophecy phenomenon highlights the fragility of the market and the potential impact of their collective behavior on price movements.

Conclusion

Chart patterns, though offering insights, should be used in conjunction with other analytical methods. Market dynamics, trader psychology, and the potential for self-fulfilling prophecies all influence the effectiveness of chart pattern analysis.

As for the 89% accuracy claim of the head and shoulders chart pattern mentioned at the beginning of this article, this figure probably needs to be revised. While that percentage figure is widely circulated online, Kahn’s study is more of a myth than a methodology and may never have existed in the first place.

A more credible study by David Aronson in 1994, also available online, found that the head and shoulders pattern had an accuracy of 64% when used to predict reversals in downtrends. Of course, the validity of that figure is also hard to confirm, and you’ll need to buy Aronson’s book if you want to explore it further.

Aronson’s 64% may well be significantly lower than Kahn’s 89%. However, if it’s accurate, it could still give traders the advantage they are all looking for, especially when used with the compound effect to manage risk.


This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.


Author:

Paul Reid
Paul Reid

Paul Reid is a financial journalist dedicated to uncovering hidden fundamental connections that can give traders an advantage. Focusing primarily on the stock market, Paul's instincts for identifying major company shifts is well established from following the financial markets for over a decade.