Experienced traders appreciate the connection between technical analysis of the financial markets and the psychology of the market participants. Find out how psychological drivers lead to pattern formations that are used regularly by traders and investors.
Technical analysis is often lumped in with black magic. Yet a simple review of some of the underlying pattern psychology that technicians use would help us all understand and appreciate better why price patterns are used — sometimes exclusively — by some traders and investors. In some emerging markets, where it can be difficult to find fundamental data that is both reliable and historically complete, technical analysis is hugely popular. Recent research in behavioral finance has exposed some new ideas and taken some of the magic out of how markets work. And both magic and technical analysis have a basis in psychology. Looking at patterns with an understanding of the psychological drivers that can lead to the pattern formations themselves will make you a better trader.
Here, we explore how technical analysis has a basis in human psychology. We’ll also explore how these drivers lead to pattern formations that are used by traders and investors. You will be able to judge individual patterns for quality based on the attributes of the patterns themselves.
Most of the geometric attributes of popular patterns have a psychological basis. Let’s review a few.
Take, for example, the ascending continuation triangle. This pattern has a price geometry characterized by at least two higher lows, plus multiple attempts to penetrate resistance that is apparent at the price level defined by the near-horizontal upper boundary of the triangle (Figure 1).
FIGURE 1: ASCENDING CONTINUATION TRIANGLE. This pattern is characterized by at least two higher lows and several attempts to penetrate resistance at the upper boundary of the triangle. Once there is a price breakout in a well-established rising trend, you can expect the uptrend to continue.