Psychology Behind Chart Patterns – Quick Top 5 Key Concepts
Psychology behind chart patterns is the core foundation of trading chart patterns.
Do you know why chart patterns fail?
Because 80% of traders consistently fail to recognize the opportunities presented by chart patterns, it is critical to understand how the other 20% use psychology behind chart patterns in order to develop the proper mindset toward trading patterns.
Table of Contents
- Psychology behind chart patterns: Example
- The Psychology of Chart Patterns
- Understanding chart pattern psychology in most common chart patterns
In this blog, I will demonstrate the psychological link between traders and the psychology of chart patterns.
In the 1950s, psychologist Solomon Asch conducted a series of experiments which concluded: Whenever we are unsure how to act, we look to the group to guide our behavior. That is why most traders do not follow their time-tested strategy (which tells the truth), but instead listen to or read the opinions of others and are unable to see the truth.
The truth about trading is rather simple and perpetual.
If you look back in history and try to find the causes of war, financial crises, social revolutions, or any other mass human change, you will notice that they all occur as a result of the same behaviors of a majority of people thinking similarly.
Trading is no different than any other social ritual we have been practicing for thousands of years. In fact, trading has existed since the evolution of modern human beings, as has the behavior and mindset of all traders.
Psychology behind chart patterns: Example
Price movements are the aggregate result of market participants’ individual perspectives on what is high and low.
This collective behavior is what causes familiar patterns to repeat; however, be aware that these chart patterns may not appear as precisely as before because not all market participants think and act correctly at the same time.
That is why understanding what the majority of participants are thinking about price and focusing on price action rather than the visual appearance of these chart patterns are critical.
Because chart patterns are linked to traders’ mindsets, the psychology behind chart patterns is the best way to understand market sentiments.
The majority of traders are acting on behalf of market information that is the same for everyone, so it is more likely that most traders will understand it in the same way.
Let’s take an simple example to understand this:-
A bullish pattern is a continuation pattern, as illustrated in the above figure.
When the market is trending and prices are rising, everyone joins in the rally. Some participants may have entered the position at the beginning of the uptrend, which means they are now sitting on a large profit.
Some early participants are booking profits at this time, and if the market shows signs of exhaustion, some fresh sellers may join the correction, resulting in a temporary pause in the rally and sometimes even retracements, but there are many traders who missed the previous opportunity and want to participate.
Those who have booked a partial or full profit and want to rejoin are sitting tight in anticipation of any sharp up move; in such cases, the market behaves in very tight congestions, and volume may drop at intervals.
Now, if prices cross this narrow congestion pattern formed by two converging lines, it indicates that prices are above the level of uncertainty, which signals massive buy orders from both sets of participants: those who want to join the trend this time after missing it previously, and those who have booked profits and are initiating new positions or adding to previously held positions.
This leads to either a breakout or a gap up, and the trend continues.
The Psychology of Chart Patterns
To learn more about the psychology behind chart patterns, consider the following key concepts.
- Because every trader is connected to every other trader by only one means, namely price, it is safe to assume that price is the only factor that guides traders’ perspectives on what will happen next.
- Chart patterns emerge as a result of mass psychology and market participants’ repeated emotions of fear and greed.
- Every moment in the market is unique, which means that even if there is a visible chart pattern, it can become invalidated, which is why every chart pattern has a probability associated with it.
- The most important chart patterns are those that are easily identified; the psychology of chart patterns that are relatively visible appears to provide a much better understanding of trade entry and exit points.
- Chart patterns have a statistical edge, which means that if you trade a chart pattern with a high probability of profit repeatedly, you will almost certainly end up with a net overall profitable outcome.
- Understanding of psychology behind chart patterns help in accuracy and timing for trades.
Understanding chart pattern psychology in most common chart patterns
Now we will look at psychology behind chart patterns for most commonly occurring patterns
1. Head and shoulders
This pattern occurs usually after a bullish rally when bulls trying to push prices to certain level and then market reverses making a small peak, when in next few weeks more aggressive buyers jump into the rally to push prices to a new higher high and thus forming a head ( largest peak).
The possibility of a head and shoulder pattern is indicated when prices move higher for the third time but fall after failing to surpass the previous small peak; however, the pattern is not considered to be confirmed until neckline breakout, which causes a bearish reversal.
2. Flag and Pennants
Flag and pennant are both continuation patterns that indicate trend continuation in the direction of the major trend. The psychology behind a flag and a pennant is the same: they both indicate a short-term pause in a rally, usually due to price consolidation in a very narrow zone. In a flag, price congestion occurs between two parallel trend lines, whereas in a pennant, price congestion occurs between two converging trend lines, indicating the formation of a pattern.
3. Double Top & Double Bottom
When buyers are exhausted and unable to push prices higher than a certain level and have failed twice in their attempts, a double top pattern is formed; however, the pattern only becomes valid once the support level marked by the previous low has been broken.
In contrast, a double bottom pattern is a bullish reversal pattern. When bear selling pressure is insufficient to push prices below a certain level and fails twice, the double bottom pattern is formed.
Only when the previous high resistance line is broken does the double bottom pattern become valid.
4. Wedge Chart Patterns
When price consolidates between two converging trend lines, a wedge chart pattern forms.
Wedges can be rising (upward slope) or falling (downward slope) depending on the slope of the trend lines.
The psychology behind the wedge chart pattern is fairly straightforward: when price movement between two converging lines becomes less volatile over time, there is a possibility of breakout on either side, and when breakout occurs, it is visible to every trader / investor, and all market participants place orders in the direction of breakout.
There are other chart patterns as well which appear frequently like cup and handles, rounding bottom chart pattern and triangles, but the psychology behind the chart patterns is almost similar.
- To trade chart patterns with an edge, it is necessary to understand the psychology of chart patterns.
- Price action is the result of traders’ collective psychology, and thus it is more important than the visual significance of any pattern.
- Trading chart patterns is the same as it has always been because of two human emotions: fear and greed.
- The market provides the same opportunity and information to everyone; if the majority of participants work and act on the same information, it is more likely that they will follow a similar pattern; your job as a trader is to identify psychology of chart patterns and act on it.
- Market always moves in cycle and to increase your odds of success it is important to understand psychology of a market cycle and patterns.
- Even though each pattern has a statistical edge, it is important to remember that each market moment is unique and by understanding psychology of chart patterns, you can improve your edge.
- Chart patterns that are easily visible to all are more reliable and have a higher probability of profit.
- When working with chart patterns, volume analysis comes in handy; some traders even use order flow to understand market psychology.
Psychology behind chart patterns is a very important concept, in my personal opinion understand psychology of chart patterns gives traders an extra edge, combining your knowledge of price action with psychology of chart patterns gives accurate trading entries and targets.
Frequently Asked Questions
Do chart patterns actually work?
Chart patterns have a probability associated with them; there is no guarantee when a chart pattern will work, but they are statistically reliable in the long run.
Why do chart patterns fail?
Chart patterns fail for the simple reason that each market moment is unique. When a pattern appears, there is almost no chance that every trader will make the same decision at the same time.
Which chart pattern is most reliable?
To get the back-tested chart patterns read – most profitable chart patterns
How important is trading psychology in chart patterns?
Trading psychology is 60% important in any type of chart pattern trading. The rest is about trading strategy and risk management.
Author is Senior Technical Analyst
At Bulls Arena Trading