The other day a friend and I were chewing the cud about what makes a good trader. Sure, we talked about the usual things:

•    Risk management,
•    Having a strategy with an edge, and
•    Consistently applying our risk management and trading rules.

But the conversation also threw up this rather interesting idea – that all trading is a function of pattern recognition. What was even more fascinating was that this idea applies not only to technical traders but to all types of traders; be it Warren Buffett or Paul Tudor Jones or John Henry.

In this article, I shall examine what I mean by:

•    "Pattern recognition",
•    The relationship between pattern recognition and perception,
•    What distorts perception and
•    How traders use pattern recognition for profit.

In the process, I’ll briefly examine the role of computers in pattern recognition.

So, what do we mean when we talk about pattern recognition?

It's just this: a pattern emerges when we take a set of observations and classify them based on perceived similarity.

With pattern recognition we can immediately comprehend vast amounts of information, make decisions, and take action. It has been said, "Discerning patterns is essential to the higher order of human brain function, reasoning, and behavior"- Elaine Knuth.

If we take a moment to reflect, we’ll see that reasoned perception is a critical element to pattern recognition.  The adjective ‘reasoned’ is an important distinction. We have the unique ability to take our perception of reality (data), interpret it and extrapolate the data to make new associations. An even more powerful factor is this: discoveries in neurology show that the brain seeks to make sense of the world through pattern discovery – it’s a pattern seeking and pattern creating machine.

And therein lies the problem…..

The brain, because of its predisposition to pattern seeking and discovery, makes connections where none exist. We can add to this ‘flaw’, three other well-known barriers to objective perception:


1.    If our flight or fight reaction is engaged, we’ll tend to see what we want to see.
2.    We tend to see what we expect to see and finally
3.    What I call "expert blindness". This is tied to (2).  Because we see what we expect to see (i.e. what we expect reality to be), the more confident we are because of past success that we are ‘right’, the less we see that ‘this time it’s different’. This explains why so many experts are continually caught by Black Swan events in the market: because they cannot foresee it, they assume it cannot happen. A great example of this is the Long-Term Capital fiasco in 1998 when a group of experienced traders and Nobel prizewinners succeed in losing over $8 billion.

So, can we do anything about our perception blindness? “Yes” and again Neurology comes to the rescue.

The first thing we can do, rather than focus on the detail of the pattern, is to isolate and focus on the key elements: history tends to rhyme rather than repeat. By isolating the key elements, we formulate a more robust and more useful hypothesis about how the pattern forms.

As an example of what I mean, let’s consider a bullish Wolfe Wave (Figure 1).


FIGURE 1: Bullish Wolfe Wave

When I see what appears to be a pattern, the first question I’ll ask myself is:

How can I distinguish between the times a pattern ‘makes money’ and the times when it ‘loses money’? Is there any non-random occurrence that tells me the difference?

The next question is: what do all ‘bullish Wolf Waves’ have in common?

Finally, I ask: why?

For example, in my Bullish Wolf Wave we see a series of low momentum lows; what could be causing this? In Wyckoff terms:

This shortening of the thrust at ‘3’ and ‘5 ‘in Figure 1 shows that:

•    either the buyers are stepping in and holding up the market and/or
•    selling pressure is waning.

The answers to the questions provide me with the key elements of the pattern. And while I expect the details of the pattern will change, I also expect the key elements to be always in place.

(By the way, for the answers to the questions above, see http://tradingsuccess.com/blog/wolfe-waves-2067.html

Once you have a robust pattern a key to avoid ‘pattern blindness’, is preparation.

I prepare by creating competing scenarios and through rituals and routines.

Scenarios

•    I start with a scenario that in my view has the least probability of occurrence.
•    I then proceed to the scenario which I think will most likely occur.
•    I then map a response to each of the scenarios.

The good thing about trading is the fact that there are only three main scenarios that are possible – up or down or sideways. So the numbers of scenarios I have to create are limited.

The scenarios take the form: “If X happens, I’ll do Y”.

Once I have scenarios, I visualize my response. By creating the ‘ritual of visualization’, I prepare my mind for the event: by vividly imagining my responses, I find that I execute more consistently when the event occurs.

Rituals and Habits

The rituals and habits I have formed center around scenario building to ensure that I am not focusing on ‘what I expect or want to see’.

Some questions I ask myself are:

1.    How do I feel about this piece of information?
2.    Is the information supporting or attacking my view of reality? Is it supporting my view of reality, and am I using it to reinforce my decisions? If it is attacking my view of reality, am I giving full weight to its probability of occurrence and consequences?
3.    Am I hopping from tool to tool looking for one that will fit by preconceived notions?
4.    Should I exit the trade because the reason for entry is no longer there?
5.    What new information will cause me to change my plan?  
6.    Have I blocked out information that is contrary to my beliefs?

Scenario building, visualization, questioning all help me prepare – they work for me. You may find that they don’t work for you. No probs, go and find some preparation that does work for you. It is by adapting and adopting preparation tools that we are able to discern reality and use that discernment to trade profitably.

What I am saying boils down to this:

We traders seek to make money from change. If we understand ourselves and especially how we respond to changing market conditions, we will have an edge in the markets.

Patterns are no more than a reflection of fear, greed, anxiety because of uncertainty and aversion to loss. These are reflected in price action. By understanding ourselves and understanding the basis of the patterns, we create a structure that gives us an edge.

The question then arises: is it really that easy? Identify pattern, interpret, and then take decisive action. If so, why can't computers take the decision-making process off our shoulders?

Ah, if only all we had to do is a press a key on a keyboard to be a trading success. The fact is right now, humans have a capability that no computer can match. For example, the computer may recognize the face, but can it recognize the subtle differences – Is it a teenager or adult? Is it human or is it a doll?

These are questions that humans automatically answer in the blink of an eye. We have context and that context gives us a wealth of information. And it is this context that also allows us to make new associations. This power, no computer can match; only humans can reason in this way.

That is not to say that computers cannot assist us in our quest to find robust patterns.  Computers can help us find valid relationships of static patterns – computers measure the statistical relationships of static patterns. They are valid only until there is a change in the environment observed.  As long as we remember that despite periods (sometimes long periods) of stability, trading is in a constant state of change and as a result trading is never predictable. Many quants learnt this to the detriment of their bottom line during the sub-prime.

So, the reasons behind the pattern are as important as the patterns themselves. We can use computers to assist but, at least for now, we cannot substitute computers for human judgement.

Pattern recognition has been used in trading from at least the 18th century when the rice traders of Osaka created candlestick charting. Then in the 1920s and 1940s, extensive work was done on general price patterns of equities. From this work, we have our head and shoulders, double tops and double bottoms, triple tops and triple bottoms, etc. To the body of knowledge, you can add to that the Elliott Wave Theory, Fibonacci ratios, Gann theory and so on. Finally, you have qualitative studies using computer technology in power to discern patterns in what appears to be a chaotic process.

Our success as traders depends not only on finding robust patterns; our success hinges much more on how we manage our risk and how consistently we execute our trades. That said, the best risk management, and greatest winning psychology will not help a jot if we don’t have a strategy with an edge. In seeking that strategy, robust pattern has a significant role to play.

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