When analyzing charts, we look for patterns -- i.e., objects or shapes that call to mind an image of a similar event in the past. Because patterns repeat, we can use them to determine the probability of a certain outcome.
Technical analysis helps us distinguish between what is real and what we think is real -- whether the pattern is a figment of our imagination, an illusion, fact or fiction.
This, in my not-so-humble opinion, is often found in many other types of analysis. That's why I always say "The charts never lie." The only thing that is real is where a price is at the end of the day. Price is nothing more than investor emotions plotted on a grid in the form of lines or candlesticks that show what they feel about that particular stock or security.
It has often been stated that an individual difference in intelligence can only be detected through measures of complex processes such as memory, imagination, attention and comprehension. (I don't know who said it, but I do remember it being said, which is somewhat ironic, because, after all, I am talking about memory. But I digress.)
The Psychology of Technical Analysis
Memory, imagination, attention and comprehension all play a role in the success we have as traders and technicians. I want to explore the importance of being able to build on the strengths of what we remember, why imagination plays a vital role in pattern recognition, attention to object identification (which for years has been used to help aid memory), and why comprehension is roughly the same meaning as understanding.
In the study of technical analysis, let's break down M.I.A.C. (memory, imagination, attention, and comprehension).
1. Memory -- Statistics; the set of past events affecting a given event in a stochastic process.
2. Imagination -- The formation of a mental image of something that is neither perceived as real nor present to the senses.
3. Attention -- Observant consideration.
4. Comprehension -- Logic; the sum of meanings and corresponding implications.
Chart pattern recognition by definition is a grouping of "sticks on a grid" that display "sentiment," which has an outcome on the direction and distance something might move or break. With that outcome, we have attached different odds of probability to the success or failure of that pattern.
Each pattern identified typically forms a geometrical shape, and this is where memory and imagination come into play. First, you need to remember that different patterns have different outcomes, and different outcomes have degrees of failure and success. Second, you need to be able to see what others may not in an ever-growing world of technology that is in constant one-upmanship.
The object of the game is to identify the highest-probability chart patterns and milk them for all they're worth.
Skillful chart pattern recognition also requires the ability to remain constantly vigilant for the possibility that there is no "logic" in what we are looking at and trying to understand. We often call "expanding triangle" patterns "nut hut patterns" because they defy logic and refute the very things we instinctively know as human beings. We are told, "Higher highs are bullish." We are told, "Lower lows are bearish." The "nut hut pattern" houses both!
Here's an example of what the expanding triangle looks like: