Education: Dynamic Analysis vs Linear Analysis (Chart Patterns)

As the stock market evolves so must investors. Most retail investors trying to learn technical analysis are all reading the same books written decades ago. They come up with the illusion of magical chart patterns that should form in a specific way. But what most investors do not realize is these books were written before the market was dominated by algorithms, high frequency trading firms, dark pools and a multitude of alternative trading systems for matching orders.

Historically, stock charts were created with primarily price and time. Volume was rarely included because there were only a handful of exchanges for executing orders. Candlesticks were not introduced to the West until the 1990’s.

​I often get investors questioning me on the validity of chart pattern’s because they are not symmetrically defined as they were taught, or at times because they cannot even recognize the pattern. What retail investors often do not realize is a majority of time chart patterns do not pan out like they are supposed to. It is not meant to be easy. The market has one job, and that is to make as many participants look as foolish as possible. Often an investor has read a book and has memorized a bunch of chart patterns with names like falling wedge, symmetrical triangle or cup & handle. Then they are constantly looking for these patterns to form exactly as drawn in the book. When in reality the big money is made when most participants do not recognize the chart pattern.
Professional traders and algorithms take advantage of these conditions by using dynamic analysis as opposed to linear analysis. The first image below shows a typical movement taught in most traditional technical analysis books when in reality the next 3 outcomes are usually how the chart pattern plays out.

Cup & Handle Pattern Taught in Books (Linear Analysis)

Linear analysis is used to minimize a linear function subject to some linear constraints.

Cup & Handle Pattern Most Likely to Happen in Real-Time (Dynamic Analysis)

Dynamic analysis is used to make a series of decisions in such a way as to maximize some function. The key is that the set of decisions available at any given time depends on what one has already decided previously.

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