Financial Marketers' Guide to Pattern Recognition

by Nick Radge


Butterfly, Wolfe Wave, Gartley, 180’s; strange names given to different patterns recognised by technical analysts. These patterns are often spruiked by top level traders, some of whom featured in the Market Wizard book series by Jack Schwager. Does this mean we jump straight on these trades as we see them develop? In turn, should you jump on the patterns discussed in The Chartist ASX and Global Charting Analysis? The answer is no.

My goal of publishing The Chartist is not only to recommend trading opportunities, but to also point out, and question, price action in real time.

Real time analysis shows my weaknesses. The inability to overcome weakness, psychological or otherwise, is why such a vast percentage of people fail at trading.

Curtis Arnold’s book 'PPS Trading' changed my trading mindset, permanently. Reading that book did not make me a better trader. Reading any book will not make you a better trader. It’s what is done with the knowledge gained from the book that will make you a better trader. Do you read most of your trading books just once and then try to apply the theory immediately? Do you subscribe to a stock market advisory service and, if so, did you start trading and following their instructions immediately, without testing?

After reading PPS Trading I spent over 800 hours studying its implications before I placed my first trade. That’s not a typo. In 1996-97, I spent 2-hours a day, 6-days a week for 16-months before I placed my first trade. 800 hours of study. It drove my wife, Trish, up the wall. I intimately went through, by hand, every single commodity market over a 15-year period and applied the rules of the book. Now you may be thinking that it’s different these days because we have fancy computers with fancy software and the job can be done in a matter of minutes. Nothing could be further from the truth. Back then I did have a computer (I have omitted the word “fancy”).

I did have software (SuperCharts, which is the baby brother of TradeStation that I use now) but I chose to do it by hand. I am not the trader I am today because I read that book. I am the trader I am today because I did the research by hand and recorded all the trades in Excel.

Why is it so important? Because doing it by hand enables two very important elements that a computer simulation cannot do.

The first element is psychological. Generating a result by hand takes patience and every trader requires patience. Generating a computer simulation in a matter of seconds removes the emotional baggage of real time trading. With computer simulation, a result and an equity curve appear, and one just expects the account balance to also “just appear”. In other words a computer simulation fails to teach us that a trading result takes time to develop and during that development stage there are a lot of ebbs and flows that we need to be aware of and accept. An equity curve created by computer software looks a lot better than a legitimate trade pattern.

The second element is more important. A computer simulation cannot teach you about price action. The simulation can only output what you have input or asked for and is therefore limited by your imagination. By doing research by hand you will quickly start to see nuances in the price action that can have an amazing impact on the initial approach being tested. For example, when researching Micro Patterns I found they tend to occur at old highs and lows. The micro patterns that occurred at the actual high, or just above, had a much higher probability of success than the patterns that occurred just below a recent high. A computer simulation could not pick that up. I also found that after an accelerated or parabolic rise these Micro Patterns tended to be larger and almost always failed and reversed the trend.

A good example of the fallibility of computer simulation is the decline of simple breakout trading systems that were so successful during the 70’s and 80’s. The Turtles were a renowned trading group who made billions of dollars by trading a simple price pattern. However, as soon as people started using computers to find these patterns, they deteriorated and are now a losing proposition.

Computer simulations tend to be singularly dimensional in nature. Modern trading systems designed by the major trading fund managers around the world now take more complex inputs and these inputs can only be seen with the experience of the naked eye.

So how do you create a trading plan using the naked eye? The first step is to identify patterns on the chart. With TradeStation I am able to define certain price elements on the chart using markers above and below the bar or by colouring the bar a certain colour. The following chart shows some examples of patterns outlined in The Chartist Charting Analysis.

Note the “Coiling Zone”. This is a work in progress. In this example, I have asked the computer to define the zones where low price activity and low volume activity takes place. By researching these I can get a feel as to where they happen and what will occur over the coming days and then weeks. Questions to note when testing a new theory such as this:

Do they happen within a trend?
Do they precede a violent move?
Do they occur in range bound areas?
Are they more prominent in strongly trending stocks only?
Are they best traded during high volatility or low volatility?
Do they take shape a number of days before a large move?

Answering these questions you can start to see when and where these patterns occur and what the resultant price action is. Once you start to learn the nuances of the pattern you can then start to build more robust rules around the setup and if you get very lucky you may even end up with a tradeable pattern for your arsenal.

The bottom line is that trading is about understanding what occurs in and around your particular entry trigger. The more you understand these nuances, the better prepared you will be to manage the trade properly, or know when to stand aside. I know when a Micro Triangle will be explosive and I also now know when not to trade them. Don’t take my word for it. Find out for yourself and take the time to research properly.

Nick Radge

Nick Radge is the author of The Chartist, an advisory service for traders and active investors. Nick is currently writing his third book, titled ‘Unholy Grails – A Guide to Successful Momentum Investing’ which is due out in early 2012.

www.thechartist.com.au