No machine can do the work of one extraordinary man.»
In this way Alexander Elder, famous American Russian-born trader and technical analyst, defines those congestion areas that are capable to reverse a steady, well-established trend. The job of a technical analyst is easy to define, he has to recognize and classify graphic formations.
To recognize and classify “price model” is not easy at all. As a skilled hunter, it is necessary to track down the footsteps of the prevailing market forces and closely follow the scent of the wounded animal, an easy and yet dangerous prey. The reversal of a trend is hardly an easy and pain-free event, the prevailing of one market requires the other side to give up and, be sure that both bears and bulls put up a fierce struggle.
What graphic patterns represent
Chart formations, being them reversal or continuation models, represent a pause during a straightforward price tendency. When a reversal pattern appears, it clearly highlights a congestion, a balance between bear power and bull power that, in different ways, ends up creating a temporary equilibrium phase characterized by decreasing volume and investors’ interest.
These congestions are apparently not too much interesting as in this situation price doesn't move very much. Traders, on the contrary, research them and take them into serious consideration. Where a congestion appears, especially after a well defined and linear trend, there may be the change. A brand new trend to exploit from the beginning (in case of trend inversion), or a new entry point in a resumed trend (in case of a continuation pattern).
It is important to remember that markets mostly move sideways, they are trending only for the 20-25% of the time. On the other hand the 80% of the whole movement is done just in that short period of time in which the market resolutely moves in a tendency.
Therefore congestions phases, whether reversal or continuation ones, are really precious for any position trader.
Recognizing a graphic pattern
It is not easy to correctly recognize a graphic pattern, more than ever for a wannabe trader. Look at the following image, what do you see in that? What does the mountain represent? Does it look like a pattern?
Some of you just see a painting, some others see the top of the mountain as a nice triple maximum pattern (aka triple top pattern). A good bullish trend, a perfect triple-top pattern and a subsequent bearish trend.
This is the actual problem with graphic patterns! Many traders see patterns and chart formations everywhere, it is necessary to introduce a qualitative analysis of the examined price action, otherwise you will only see what you wish to see. Obviously this is a mere provocation, nevertheless the neophyte sees pattern everywhere. Great attention is to be given to details.
Learning to recognize and classify graphic patterns
We will first deal with those patterns that end an established tendency (inversion patterns), and we will go on with those formation met throughout a tendency (continuation patterns).
In all the following cases it is necessary to keep in mind: When the inversion area is very large, price fluctuation range in this area is very wide and it takes rather long for the formation to develop itself, the operative implications will be very important.
An head and shoulders which takes three months to complete will be quite more relevant than a three weeks built-up head and shoulders, as well as a continuous and extended price move will require a likewise extended pattern for its inversion: the concept is well expressed by the metaphor according to which in order to turn the motion of a heavy car running at 100 Km/h, first it is necessary have to slow the car down, then it is necessary to stop the car, after that it is necessary to turn the direction and then to step on the gas to finally get to the 100 Km/h speed again.