Understanding price patterns | Fin24

Understanding price patterns

Apr 10 2019 08:00
Petri Redelinghuys
Petri Redelinghuys

Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.

An important component of technical analysis is price patterns. 

The easiest way to understand price patterns is probably to start with an explanation of trade action. 

Every day investors, traders, professional and institutional as well as private individuals all buy and sell securities on the exchange. 

The numerous types of market participants are buying or selling for their own unique reasons, with their own unique views, ideas and beliefs around what the securities they are trading are worth. 

The meeting point of buyers and sellers, for whatever reason they are acting, is price. 

No trades can take place unless both the buyer and the seller agree on a price. 

This drives the price of securities… buyers bring with them demand for a security while sellers bring supply. 

The market runs like a continuous auction throughout the day, with buyers and sellers competing with each other to get the best possible price. 

From time to time a larger market participant like an investment bank, or a unit trust or hedge fund (or even a really wealthy individual) will take a view and execute a trade. 

When these really large participants want to buy, for example, the number of shares that they want, it could represent days’ worth of the average daily volume traded in a particular stock. 

In a totally hypothetical scenario, for the purposes of example, let’s say that Balanced Fund A wants to take a portion in FirstRand and because of the fund's sheer size, needs to buy 15m shares in order to fill its order.

Now, FirstRand only really trades an average of 5m shares a day, so the fund will have to buy three days’ worth of trading volume in order to fill its order. 

If they had to try and buy that number of shares in just one day, it would represent a huge amount of demand and undoubtedly drive the price significantly higher. 

The same would happen if they tried to do it over three days, as they would have to be the buyer to every seller and therefore compete for the best price. 

In doing so, they’ll drive the price significantly higher. 

Their objective is to get the best price possible for the purchase of the shares, but also to complete the purchase of the shares in ten trading days. 

As much as they don’t want to ‘show their hand’ to the market, they still need to be aggressive buyers in order to buy 15m shares in ten trading sessions. 

They decide to step in and buy whenever the share price comes down from a dip. 

They’ll then continue buying until they find a large seller, at which point they stop buying and allow the stock price to dip again. 

This process is to be repeated until they have all the shares they need. 

Buying will become more aggressive as they move closer to their ten-trading day deadline. 

Simultaneous to this buying process, let’s suppose that Balanced Fund B is looking to sell 7m FirstRand shares over the same period. 

They too want the best possible price for their stock but have decided to be more patient and not accept a cent less than the price they want. 

They wait until the price comes up to the level they are willing to sell at and then only sell at that price. 

The more people are willing to buy at their price, the more they are willing to sell.

Now we have a situation where on the buy side of the market a participant is aggressively buying up stock when the price dips, facing off against a participant who is standing their ground and selling only at a specific level. 

Over time, say a week-and-a-half, a price pattern has emerged. 

Consecutive higher lows, with consecutive highs at the same level. 

Also known as a flat top triangle. 

Eventually, Balanced Fund B has sold all they have to sell, but Balanced Fund A still needs stock and they need it fast because their deadline is looming. 

So, when the overhead supply dries up, there are no sellers left to keep price down. 

But Balanced Fund A still needs to aggressively buy stock. 

The formation breaks and price moves rapidly higher, with the large buyer being forced to pay up for stock. 

Scenarios like the fictional one above play out in the market almost constantly. 

That is the very nature of the market and the driving force behind longer-term price trends. 

Large institutional investors take views and drive prices for days, weeks, or months at a time, employing all sorts of tactics to attract buyers or sellers to a specific level so that they can transact and take positions. 

This, coupled with herd mentality and the interaction of millions of different participants for as many reasons, forms price movement patterns that stretch over extended periods of time and can be used to make probabilistic forecasts on where price might move in future. Petri Graph

Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.

This article originally appeared in the 4 April edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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