There has been a lot written about reliability in patterns in trading.  However, much of this is difficult to interpret and effectively apply in real time.  This has driven many people to abandon this highly effective trading technique.

The correct identification and use of patterns for the technical trader can be a very profitable trading strategy. For it to be effective we need to be able to determine, with a high degree of probability, that: we have correctly identified the formation; know what is going to occur when and if the breakout occurs; and know what to do if the breakout does not occur as expected.

Patterns can tell us not only the expected direction of price action but also how far we can expect the price action to travel, thereby showing us a price target which it should achieve.

As there is too much to write about patterns for inclusion in a single article, this information will be provided in a series of articles over the next few months.

In this series of articles we will cover some basics of patterns and their uses, including:

• Their shapes.

• Their correct identification.

• Their target determinations.

• How this can help us in our trade entry determinations.

• How they can aid us in our risk management applications for trading purposes. 

• How they can allow us to enter some very profitable transactions. 

• How they can also help keep us out of potentially harmful transactions.

• Their applications in bull and bear markets. 

For the highest probability of effectiveness, all patterns should move through the following phases:

• Formation

• Identification

• Development

• Breakout

• Confirmation

As the pattern begins to form, we then need to be able to identify it, and its potential, in real time.  Once the boundaries to this formation are identified we watch the pattern develop to breakout.  Upon breakout, we need the correct confirmation that the pattern has broken and will continue its current price direction; this greatly increases the reliability of the pattern by filtering out most of the non-successful patterns.

Ironically it is this confirmation technique that is lacking from current writings regarding patterns, yet these techniques significantly increase the probability that the pattern will complete satisfactorily, greatly increasing its reliability.

When this progression is synchronised we have a high probability situation that allows us to enter a transaction or not, depending upon how this fits within our risk management parameters.

Applying this process to the many patterns available, two types stand out as potential trading aids.  They are:

• Direction/Trend change patterns:

o Head & Shoulders – Inverted Head & Shoulders.

o Double Top – Double Bottom.

o V-Top – V-Bottom.

o Rounding Top – Rounding Bottom.

• Continuation patterns:

o Flags

o Ascending Triangle

o Descending Triangle

o Symmetrical Triangle

o Pennants

Directional change patterns confirm that the price direction has probably changed and tell us how far we can, as a minimum distance, expect the price to go.

Continuation patterns predict whether the current price direction will continue and give us a predetermined target for the price to reach. Continuation patterns are also known as ‘mid-move consolidations’ and represent a consolidation, not a retracement, of which more will be covered below.

Directional change patterns

There are many directional changes patterns written about: four of the most common were detailed above. While there are others, we will deal primarily with the first two patterns as these are the ones I have been able to identify, confirm and use with a high degree of probability. I have not yet been able to make the ‘Vs’ or ‘Roundings’ work with the same probability.  The reason for this may be as simple as my inability to find a reliable confirmation technique to use with these patterns to give me the reliability I need to use them.

I need to be able to get a reliability factor of at least 75% from any technique I use to make sure that it provides me with a better outcome than I was previously getting, before I will adopt and incorporate it as part of my overall strategy. 

Directional change patterns have proven to be unreliable, as a trading pattern, when trading the break of the pattern. Their use is that they can confirm the directional change and give us a target to which we can aim for the price to achieve; we can then make other determinations on how we use this information.

An example of this is that the pattern largely overrides previous resistance/support levels, which may otherwise have kept us out of a continuation entry under our risk management guidelines.

Double top & double bottom patterns

A double top is commonly called an ‘M’ pattern and a double bottom is commonly referred to as a ‘W’; the associated graphs illustrate the reason for this naming.

These patterns are directional change confirmations and are used in the following circumstances:

• Double Top confirms upward directional change to a downward one and is therefore used in short transactions.

• Double Bottom confirms downward directional change to an upward one and is therefore used in long transactions.

The identification of these patterns is relatively straight forward and very reliable.

A double top needs to have a trend coming into its first peak, followed by a retracement, to form a low.  This is followed by a rally to form another peak, with a valley between the two peaks, followed by a fall in price action to below the low in the middle of the valley.

Conjecture surrounds the relationship between the two peaks and the maximum variation in price as an acceptable difference.  3 – 5% variation between the two prices seems to be where the major consensus lies; I have found 5% variation to be acceptable.

As an example, if the first peak is at $10.00, the second peak needs to be between $9.50 and $10.50.  Once the variation becomes larger than 5%, the reliability of these patterns falls away.

A horizontal line drawn from the low point in the valley, between the two peaks forms the ‘neckline’ of the pattern; this is the critical element in the confirmation of a double top pattern.

The confirmation which seems to be the most reliable is a close below the neckline.  Patterns of this type which do not work tend to have a price penetration, but no close, below the neckline.  I believe that the close below the neckline gives a much higher reliability to the pattern, and therefore higher probability in its overall use.  These conclusions have been drawn from work I have collaborated on with Rob Lennox (trader and Dean of Studies, Australian College of Financial Education and Leon Wilson (trader and author, The Business of Share Trading and Next Step in Breakthrough Trading)

A similar interpretation can be applied to a double bottom, the reverse of a double top. Here price action falls, rallying to give a high point, retracing to give a second low (within 5% of the price of the previous low), then rallying again.  We then need to see a close above the neckline formed from the ridge between the two lows.

There are many trend change techniques that help identify entry signals for either long or short positions and which occur earlier than any signal given by the pattern and its confirmation.  However, the double top/bottom pair of patterns seems to be unreliable for a trade entry from the pattern itself.

Their real strength is to confirm a continuation entry, which occurs after this confirmation, because the reliability of the pattern reaching its target is higher than the probable support/resistance levels exhibited by previous low or high turning points.

We can use the target price of the pattern to give a stronger support/resistance level, and therefore calculate our risk management and reward-to-risk ratios on this level, rather than on intervening levels.  This enables us to enter transactions which we would otherwise have been kept out of, based upon these intervening levels.  

This is Coles Myer Limited in January 2000.  We have a clear trend coming into the peak of the week ending 0502-1999, followed by a low week ending 23-04-1999, followed by a peak week ending 13-08-1999.

We can also see three penetrations and one touch of the neckline prior to the last week, and here we can clearly see there is a close below the neckline of the week ending 21-01-2000.  It is this close below the neckline which confirms the pattern and gives it the reliability.

To calculate the price target for a double top, draw a line across the two peaks of price, then measure the distance from this line to the neckline of the pattern and project this distance down from the neckline value. 

As we can see in this instance, the target was achieved and penetrated in 17 weeks and the target overrode the previous support/resistance levels from October 1998.

A double bottom is merely the reverse of this procedure.

We will finish Double Tops and move to Head & shoulders in the next article.

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