Read an Excerpt
Martin Pring on Price Patterns
The Definitive Guide to Price Pattern Analysis and Interpretation
By Martin J. Pring
The McGraw-Hill Companies, Inc.Copyright © 2005Martin J. Pring
All rights reserved.
Market Psychology and Prices: Why Patterns Work
The more I work with markets, the more it becomes apparent that prices are determined by one thing and one thing only, and that is people's changing attitudes toward the emerging fundamentals. In other words, prices are determined by psychology. The great technician of the 1940s, Garfield Drew, once wrote, "Stocks don't sell for what they are worth, but for what people think they are worth." If it were not for the fact that these changing attitudes move in trends and that trends tend to perpetuate, market prices would be nothing more than a random event, which would mean that technicians would be out of business.
Changing Attitudes and Changing Prices
A classic example of changing attitudes that affected prices developed in the 1970s and early 1980s. In 1973, a group of stocks known as the "Nifty Fifty" peaked after a phenomenal rise during the 1960s. These were known in the trade as "one-decision" stocks, because their earnings went up every year, as did their prices. People came to the conclusion that there was only one decision to make where these stocks were concerned: just buy! These stocks included such growth names of the time as Kodak, Xerox, McDonald's, and IBM. During 1973 and 1974, they declined substantially in price, along with the rest of the market. Over the course of the next nine years or so, the earnings for the group as a whole continued to rise, but the index did not make a new post-1973 high until nine years later.
Thus we arrive at a situation where prices bear no reality to the earnings trend. Perhaps prices were too high in 1973 relative to the earnings; perhaps they were not, and they should have continued rising throughout the 1970s as earnings rose. Who knows? Who can tell? Technicians would say, "Who cares?" Why? Because technical analysis assumes that the changing attitudes toward these emerging fundamentals are reflected in price action as displayed in charts. It's not dissimilar to a medical technician looking at a patient's chart. He doesn't have to know that the patient is groaning with pain to diagnose a problem. It's all there in the chart. The chart tells him that the patient's vital signs are deteriorating to the point where danger lies ahead and that remedial action should be taken. In a similar way, to the technician, poor price action signifies a weak price trend and the probability of trouble ahead in the form of a serious price decline. The technician does not have to know the reason why; he merely observes the condition and takes the necessary action.
Chart 1-1 shows the 1990s price action for Key Corp., a money-center bank. The bank's earnings are shown in the lower panel. Note that there are two periods when the price came down for a prolonged period, the first in the 1980s and the second in the late 1990s. In both cases the earnings rose, demonstrating once again that it is the attitude of market participants toward the emerging fundamentals rather than the fundamentals themselves that is important. This is not the same thing as saying that earnings are not important; of course they are. If we had known that earnings were going to rise at the beginning of both these periods, it would have been reasonable for us to assume that the price would rally as well. Only a review of the technical position could have helped us to conclude otherwise.
Chart 1-2 shows another example, featuring eBay. Once again we can see that the earnings increased pretty dramatically throughout the period covered by the chart. However, the price fell slightly, showing the futility of buying and selling stocks based purely upon accurate earnings estimates.
History repeats, but never exactly, and as prices approach a turning point, people react in roughly the same way. It is this similarity of behavior that shows up in identifiable price patterns or formations, and that is the subject of this book. Later on we will classify these various formations, establish their reliability, and explain how they can be used as a basis for trading.
Technical Analysis Defined
At the outset, it is very important to understand that technical analysis is an art form. Indeed I define it as "the art of identifying a trend reversal at a relatively early stage and riding on that trend until the weight of the evidence shows or proves that the trend has reversed." You have probably noticed that I have emphasized the words weight of the evidence. This is because price patterns should be looked upon as one indicator in the weight-of- the-evidence approach. In other words, we should not look at price patterns in isolation, but consider them in conjunction with several other indicators. Over the years, technicians have developed literally thousands of indicators, so it is obviously impossible to follow them all. By "weight of the evidence" I mean four or five indicators that the user feels comfortable with. The world's great religions are all primarily concerned with finding the truth, but each has its own way of getting there. So, too, with technical analysis; what one person sees as a great indicator another may discard as useless. It's important for you as an individual to decide which indicators to adopt in your trading by testing them over a period of time. If you do not have confidence in your choices, I can assure you that you will make wrong trading decisions once the trend goes against you.
By this point you may be asking, "What does he mean by indicators?" Well, I mean oscillators such as the RSI, stochastic, KST, and so on. Other approaches include Elliott, Gann, or the Wykoff method. Still others rely on cycles, volume, or trend-following indicators, such as moving averages and trendlines. Price patterns are therefore one indicator in this weight-of-the-evidence approach. I strongly believe that they should not be used in isolation, but rather should be used in conjunction with several of these other indicators with which you feel comfortable. Price patterns should not be used blindly; they should be interpreted and applied with a full understanding of the underlying psychology that gives rise to their development. If you understand roughly how and why they work, you will be in a better position to interpret them in difficult situations.
Price Patterns and Psychology
I have used the word trend several times, but what is a trend? In my view, a trend is a period in which a price moves in an irregular but persistent direction. There will be a lot said on the subject of trends in the next chapter, but for now all we need to know is that there are various classes depending upon the time frame under consideration. For example, a 60- minute bar chart will reflect very short trends, and a monthly bar chart will reflect trends of much greater duration, lasting for years. However, the principles of interpretation are identical. The only difference is that reversals of trends on intraday charts have nowhere near the significance of those on the monthly charts. It should be assumed that the longer the time span, the more reliable the signal. It is important to understand that this last statement is a generalization, since some short-term signals can be very reliable and some long-term signals less reliable. The reason why longer-term trends have a habit of being slightly more reliable is that they are less subject to random noise and manipulation.
When a trend is underway, it means that either buyers or sellers are in control. During an uptrend, it is the buyers, and during a downtrend, the sellers. I have often heard people respond to the question, "Why is so and so going up?" with the flippant answer, "Because there are mor
Excerpted from Martin Pring on Price Patterns by Martin J. Pring. Copyright © 2005 by Martin J. Pring. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.