In this article, we explore how technical analysis has a basis in human psychology. We’ll also explore how these psychological drivers lead to pattern formations that are used regularly by traders and investors.
Let’s face it. Technical analysis is often lumped in there with black magic. Yet
a simple review of some of the underlying psychology of the patterns 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 the area of behavioral finance has exposed some new ideas and taken some of the magic out of how markets really do work. And arguably, both magic – and technical analysis – have a basis in human psychology.
Looking at patterns with an understanding of the psychological drivers that
leads to the pattern formation itself will make you a better trader. You will
be able to comparatively judge individual patterns for quality based on the
attributes of the pattern 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 pattern. This pattern has a price geometry that is characterized by at least 2 higher lows, plus multiple attempts to penetrate resistance that is apparent at the price level defined by the horizontal upper boundary of the triangle. With a well established rising inbound trend and a final breakout of the pattern to the upside, we expect a continuation of the earlier uptrend. Psychologically, most triangle patterns signify a collective pause as participants rest and test the new price level. Individual price pivots occur as buyers and sellers map out the supply and demand curves for this stock.
The following diagram shows Supply and Demand curves, the resultant Cobweb Diagram and a representative triangle pattern that might have occurred in a market defined by the Supply and Demand curves shown...