You don’t have to spend countless hours any more looking at stock charts in order to identify profitable patterns.
After years of research I have developed systems to detect some popular chart formations mechanically.
When it comes to trading, however, nothing is certain. Identifying a specific chart pattern, doesn’t guarantee any profits because there is a high probability that the stock will fail to perform as expected.
A friend of mine purchased a metastock patttern recognition system plug-in and before using it to trade with real money he had the foresight to test it. To his dismay the test results were disastrous: The profit factor was <1.0 and profitable trades <50%.
Unlike similar systems which only identify specific chart pattern, my systems use also a number of money flow indicators and conditions to filter out stocks with a high probability of failing to complete the pattern successfully.
Identifying a pattern and entering a trade, however, is only the first step. Knowing when to exit is equally important. To calculate the profit target for some of these formations, traders have relied on the traditional measuring formula introduced for the first time in Edwards & Magee’s Technical Analysis of Stock Trends, in 1948 which states that the breakout will duplicate the formation height.
My research has revealed, however, that this rather simple method tends to overestimate breakouts from flags and conversely underestimate rectangle breakouts. This is probably because the flag pole height is, by nature, more than double the rectangle height.
I have therefore derived new, more realistic, measuring formulas, more appropriate for current market conditions, based on my original research, for trading these formations efficiently. You can find more information about chart formations and profit targets in my articles in Technical Analysis of STOCKS & COMMODITIES.
My work on chart patterns, includes systems and explorations (scans) in order to detect the following popular formations. You can find the system performance during the last 10 years (until September 2018) at the bottom of the page. You can purchase these systems for the Amibroker and Metastock platform by clicking on the appropriate tabs at the left.
DOUBLE BOTTOM & DOUBLE TOP.
Just as the name implies, the price action pattern involves the formation of two bottoms at a critical support level and looks like the letter “W”. The idea that the price was supported at this level not once, but twice, is an indication that the level is likely to hold. The double top system is the exact opposite and it involves the formation of two highs (tops) at a critical resistance level. A double top is only confirmed once the price closes below the support level (neckline).
HEAD & SHOULDERS.
The Head and Shoulders top is a popular and well known system. It is a reversal (bearish) pattern most often seen in uptrends. As one might imagine from the name it looks like a head with two shoulders.
The Head and Shoulders bottom or inverse head-and-shoulders is a reversal pattern often seen at the end of a downtrend. It is the exact opposite of the Head & Shoulder Top and it involves the formation of three bottoms with the middle one (head) lower and the two outside bottoms higher. Ideally the two outside bottoms should be at about the same level. The highs at the middle of the pattern can be connected to form the resistance line or neckline (see diagram at the right) .
CUP with HANDLE.
The Cup with handle formation was popularized by William O’ Neil in his book How to make money in Stocks first published in 1988.
As its name implies, there are two parts to the pattern: the cup and the handle.
The cup looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side, and the handle is formed. My system was designed to detect the pattern and initiate trades when price broke out from the handle above the right hand cup lip.
Flags and pennants are quite common continuation pattern. They are typically seen right after a steep, quick move and consist of lower tops and lower bottoms bounded by two parallel trendlines, with the pattern slanting against the prevailing trend.
To design the system code I used my statistical research published in the April 2005 issue of Technical Analysis of Stocks & Commodities for Bullish flags and in the May 2006 article for Bear flags.
Rectangles consist of a sideways price action or congestion area bounded by two horizontal or nearly horizontal parallel trendlines at top and bottom. At least two points are required to define each line but three points are more common.
This system detects stocks breaking out from the top trendline of a rectangle formation.
To design the system code I used my statistical research published in the June 2007 issue of Technical Analysis of Stocks & Commodities. The rectangle system performed better when tested on high capitalization stocks like the Russel 3000 component stocks.
All systems are available for the Amibroker and Metastock platforms. You can purchase each system separately or the complete chart formation bundle by clicking on the appropriate menu tab on the left.The best performing long systems, when tested during the last ten year period until September 2018 on the Russell 3000 component stocks were the Double Top and Head & Shoulders bottom.
The only short (bearish) formation that performed reasonably well during this period was the Double Top system and therefore I withdrew the rest of the formation short systems. This was probably because of extremely bullish market conditions and the buy the dips mentality during the last 8 years. The performance of the Sperandeo short systems and Overbought in a downtrend were also quite good considering the bullish test period.
LONG SYSTEM PERFORMANCE
You can see below the performance of all chart formation systems tested on the S&P 500 or the Russell 3000 constituent stocks. To produce the results I used Amibroker with the following test parameters:
Initial trading capital = $150,000
No margin or compounding.
Max. Open positions: 10-15
Commissions: $0.01 per share
Volume filter: Limit position to 10% of trading volume
Entry & Exit next day at the open