Patterns are a major theme in William J. O’Neil’s book, “How to Make Money in Stocks: A Winning System in Good Times and Bad.” They come with both fundamental and technical analytics, and drive his investments and his system for finding stocks: CAN SLIM.
In chapters one and two of the book, O’Neil discussed technical charts, comparing them to X-rays and other medical technologies that allow doctors to see what may not be outwardly visible. In his words, “In almost every field, there are tools available to help people evaluate current conditions correctly and receive accurate information. The same is true in investing.”
He went on to say, “A chart records the factual price performance of a stock. Price changes are the result of daily supply and demand in the largest auction marketplace in the world. Investors who train themselves to decode price movements on charts have an enormous advantage over those who either refuse to learn, just don’t know any better, or are a bit lazy.”
In analyzing charts, O’Neil said that chart patterns, which also may be called “bases,” refer to areas that show price corrections and then consolidation, after an earlier price advance. Such movements are most likely to arise out of corrections and advances in the general market than because of changes in an individual stock.
To understand O’Neil’s approach, remember this maxim: History repeats itself, and it repeats because human nature does not change, nor does the law of supply and demand. As noted in the book’s introduction, there are seven enduring traits that keep unfolding. They were summed up in the acronym CAN SLIM. Thus, price patterns of the great successes of the past can serve as models for future stock picks.
The most common, and one of the most important price patterns, is called “Cup with Handle.” Seen on a chart, this pattern resembles a side profile of a cup with a handle:
This generic version, which O’Neil sourced at Daily Graphs Online, has several key parts:
- The top left side of the chart shows a previous high, just before a “needed natural correction” begins.
- The “U” area shows the correction and partial recovery. This correction occurs as speculators and uncommitted holders sell out.
- The handle, represented by the line extending to the right, is a temporary setback that occurs while the stock is in recovery.
When the handle ends and the stock begins to climb again, technical investors see a buy signal. The upper lines in this chart for Sea Containers (which has been delisted) shows a real-world example:
A couple of notes on this chart: It also shows the relative price strength line and a volume chart, both of which will be discussed later. The price chart is shown in the candlesticks format, in which the high of the day is seen in the top crossbar, the low of the day in the bottom crossbar and the closing price in the middle crossbar. The height of the vertical line shows the amount of price variation during a day (or session).
Investing legend Jesse Livermore referred to the upside buy point, north of the handle, as the “pivot point” and many investors also use that term. They also use the word “breakout” to refer to the quickly rising prices that may occur beyond a buy point.
In addition to price history, investors also look at the volume of trading to help determine the buy point (or pivot point). This chart, showing Microsoft (MSFT, Financial) prices shortly after its initial public offering, has very high volume at the pivot point:
O’Neil argued that a day’s volume should shoot up at least 40% to 50% above normal at the pivot point to confirm the buy signal is strong.
On the subject of volume, analysts use the terms “accumulation” and “distribution,” with accumulation referring to buying by institutional buyers and distribution referring to institutional selling. Because institutions (i.e., pension funds and mutual funds) buy in such large quantities, their activities can move stocks and even whole markets.
More broadly speaking, volume is the best measure of supply and demand, and is thus a key metric. O’Neil recommended watching a stock’s weekly volume, saying it is a positive sign when the share prices are moving up for several weeks, along with above-average volume.
The author reported that 80% to 90% of price patterns are created during market corrections, which can list for anything between a few months and a few years.
Other common patterns include:
“Saucer with Handle,” which is similar to cup with handle except the saucer section holds for a longer period. An example is shown in this chart of the Jack Eckerd Corp. (no longer public):
“Double-bottom” refers to a pattern that looks like the letter “W.” Here is an example from Price Co. in 1982:
Other important but less common patterns are the “Flat-base,” “High, Tight Flags,” “Ascending Bases,” “Wide-and-loose Price Structures” and “Head-and-Shoulders.”
As noted above, the relative price strength line also shows up in these charts. O’Neil recommended buying stocks that are performing better than the general market—just as they emerge from sound base-building periods. This line shows how a stock’s price performance compares with the performance of the overall market.
Finally, there is a concept called “overhead supply," which refers to areas of price resistance in a stock as it resumes its upward trend after a downtrend. Resistance occurs as investors sell their stocks when the price once again reaches the price at which they bought.
Finally, it is worth repeating O’Neil’s core conviction that history repeats itself, because human nature remains the same.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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