1.8. CHART PATTERNS
Books like How I Made $2 Million in the Stock Market, by the famous ballroom dancer Nicolas Darvas, figure into O'Neil's concepts of "bases," which Darvas termed "boxes." O'Neil, however, took it quite a bit further with his colorful, descriptive cataloguing of consolidation patterns or bases that he termed "ascending," "cup-with-handle," "double-bottom," "square box," "flat base," and "high, tight flag," among others—the chart patterns from which, as O'Neil observed, big, winning stocks emerged as they started their huge upside price romps. As well, these patterns represented the "continuation" that patterns hugely performing stocks form on the way up as they naturally and normally pause and digest their gains during an overall intermediate to longer-term price run before proceeding higher.
Like O'Neil and his bases, Darvas's "box theory" emerged from his own direct observation and study of stock charts and tables: "I started to realize that stock movements were not completely haphazard. Stocks did not fly like balloons in any direction. As if attracted by a magnet, they had a defined upward or downward trend which, once established, tended to continue. Within this trend stocks moved in a series of frames, or what I began to call boxes. They would oscillate fairly consistently between a low and a high point. The area which enclosed this up-and-down movement represented the box or frame. These boxes began to exist very clearly for me" (Nicolas Darvas, How I Made $2 Million in the Stock Market [New York: Carol Publishing Group, 1998], 51).
O'Neil is far more specific, however, about the precise structure of these "boxes" or "bases," and his work goes into much detail about the exact shapes, durations, and magnitudes of these various price consolidation structures. But, like Darvas, O'Neil recognizes: "Chart patterns are simply areas of price correction and consolidation, usually after an earlier price advance. The primary challenge in analyzing price consolidation structures is to diagnose if the price and volume movements are normal or, instead, signal significant weakness or distribution" (How to Make Money in Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 161).
It is, however, important to understand that Darvas's "box theory" is nothing more than a very rudimentary, initial version of O'Neil's chart pattern zoo. Darvas never bothered to measure the minimum durations for his boxes to determine whether a longer duration was preferable to a shorter one, nor did he measure the magnitude, or range, of these boxes to determine any meaningful characteristics thereby. As he puts it, "I found that a stock sometimes stayed for weeks in one box. I did not care how long it stayed in its box as long as it did—and did not fall below the lower frame figure" (How I Made $2 Million in the Stock Market [New York: Carol Publishing Group, 1998], 52).
O'Neil also went way beyond the simplistic "box theory" by recognizing the importance of applying historical precedent in his work. O'Neil observed that the chart patterns formed by market-leading stocks in one market cycle often repeated themselves in the market leaders of a later cycle. As an example, O'Neil has discussed in public forums how a big pull-back by America Online (AOL) to its 50-day moving average back in 1998 reminded him of another big winner he played, Syntex Corp., in 1965. In this manner, Syntex served as a "historical precedent" for AOL in 1998, and served as an invaluable guide in helping O'Neil handle the position for what turned out to be massive gains. We know—we were there when it happened.
The idea of historical precedence, of course, can be seen as derived from Jesse Livermore, who declared in How to Trade in Stocks, "I absolutely believe that price movement patterns are being repeated. They are recurring patterns that appear over and over, with slight variations. This is because markets are driven by humans—and human nature never changes" (Greenville: Traders Press, 1991, 96). And, as O'Neil says, "It's just history repeating itself over and over again, human nature continually on parade" (The Successful Investor, 3rd ed. [New York: McGraw-Hill, 2004], 84). Wyckoff also observed that, "In a certain sense, reading charts is like reading music, in which both endeavor to interpret correctly the composer's ideas and the expression of his art. Just so a chart of the averages, or of a single stock, reflects the ideas, hopes, ambitions, and purposes of the mass mind operating in the market, or of a manipulator handling a single stock" (Stock Market Technique Number 2 [New York: Richard D. Wyckoff, 1933], 136).
O'Neil is often pejoratively dismissed as a "chartist," as if this is proof that he should be written off as some sort of investment pariah. But we should not forget that while he was a pioneer in figuring out how to automate the production of printed stock charts, he was not the first to recognize the usefulness of charts in stock forecasting. In Stock Market Technique 2, Richard Wyckoff devoted a short chapter to answering Why You Should Choose Charts and summed up his assessment of the usefulness of consulting stock price charts by writing, "The ticker records stock market history on a long strip of tape. The charts record the same history transposed into another form, more convenient, more valuable for the purpose of studying past performance as an aid in forecasting—I should say invaluable" (1933, 66).
For O'Neil, technical analysis and the use of charts is all about determining the actions of institutional investors as they set about systematically accumulating stocks. In this way O'Neil does not approach the use of charts in a mechanical way, without incorporating any aspects of judgment, but rather as a tool to determine what the big players, the institutions, are doing. In this manner he is similar to Wyckoff, who advised that investors study charts in order to uncover the "motives behind the market action to interpret the behavior of stocks" (Charting the Stock Market, The Wyckoff Method, ed. Jack K. Huston [Seattle: Technical Analysis, Inc., 1948], 13, 16).