Six Tips to Assess the Significance of Price Patterns

Oct 24, 2007: 2:18 AM CST

While there may be an unlimited number of potential price patterns in the market, most popular price patterns fall into two broad categories in relation to trends:  Reversal Patterns or Continuation Patterns.  Knowing more about specific patterns may help you determine which resolution in price is likely to occur.

Without delving too deep into the topic, popular reversal patterns include the “head and shoulders,” broadening formations, and rounding formations, while popular continuation patterns include rectangles, triangles, and flags/pennants.

Any of these patterns can turn into the other pattern (a reliably consistent reversal pattern may resolve to be a continuation pattern) at any given time and without warning.

Are there hard and fast rules you can apply quickly to assess the probabilities of resolution, or the significance of a given price pattern?

While these suggestions will not work all the time when you feel you have identified a pattern, they just might help you preserve capital or temper your expectations.

1.  The longer the pattern forms, the more likely it is to be a reversal pattern. 

2.  The shorter the pattern, the more likely it is to fail to conform to expectations. 

3.  The deeper (greater price fluctuation) the pattern, the more significant the likely price ejection from the pattern (due in part to the ‘measuring rule’ inherent in some patterns).

4.   The more accurately the expected volume pattern unfolds, the more reliable the pattern (examples:  Volume should contract during a triangle, flag, or pennant pattern.  Volume should be heavier on the left shoulder than the right shoulder.  Volume should confirm a pattern break-out.  etc)

5.  The longer (and more steep the angle) a trend has endured, the more likely a pattern is to be a reversal pattern.

6.  The more “perfect” (textbook) the pattern, the more likely it is to fail to conform to everyone’s expectations. 

Each pattern has its own set of expectations and rules, but these generally encompass most resolutions of price patterns.  There are a plethora of books or websites that can give you more information on specific patterns and the rules associated with them, but always keep in mind suggestion #6.  If everyone sees the same pattern and expects the same thing, the pattern will most likely fail due to the often sinister resolution of mass-expectations in the market.

Remember, patterns are expected to reflect psychological patterns of human participants, and observed patterns have been categorized, classified, and tested through the years.

While no pattern is 100% accurate, they can help add a new level of trade selection or analysis to your growing toolbox of trading ideas and tactics.

4 Comments

4 Responses to “Six Tips to Assess the Significance of Price Patterns”

  1. Lauriston Says:

    Excellent stuff, as usual. Very revealing and extremely useful!!! I always stops by your site each and everyday, vacation or not!

  2. Corey Rosenbloom Says:

    Thank you!

    I’ve been busier than normal lately getting everything prepared for the Chicago trip and the Chartered Market Technician Exam Level 1 this Saturday. I will resume educational posts in greater frequency in addition to the market observation posts.

    Thank you for stopping by!

  3. greg Says:

    Hi, #4 and #6 seem to conflict.
    4. The more accurately the volume unfolds, the more reliable
    6. The more “perfect” (textbook) the pattern, the more likely it is to fail to conform to everyone’s expectations.

    The accurate volume pattern would be part of the ‘perfection’ or textbook-ish-ness. But in that case it doesn’t add to reliability? Or does it only add to the reliability of the reversal or direction (as opposed to strength) – thanks

  4. Corey Rosenbloom Says:

    Greg,

    Excellent observation. I wrote point #6 to cover the “fade the majority” principle, as the more times I have observed a ‘perfect’ pattern and tried to trade it, the less accurate my results and the greater my frustration. This seems to be true in terms of the notion “If it seems too good to be true, it probably is.”

    In my observation, most retail traders who react to an pattern do so in the obvious and expected way and expect the pattern to work without fail. They place their orders in and place their stops at the ‘proper’ levels which creates an enormous pool of liquidity of literally ‘low hanging fruit’ for professionals and ‘fade-traders’ to exploit, and if they can drive the price to those pools of liquidity (where the price should NOT go), then the stops will be triggered, and a false break will occur, or a pattern that was seeming to work will suddenly fail.

    This, combined with the sense that if everyone sees something, the more nimble traders will exploit it before the mass public can take advantage of it, and thus ‘destroy’ a pattern before it can complete perfectly.

    There is sort of a disconnect that should be noted when actually trading patterns, as opposed to visually inspecting patterns that occurred in the past. In other words, it helps to be objective and inherently suspect when ‘everything lines up’ perfectly.

    Now, regarding volume, not all patterns have volume characteristics, but the examples I mentioned do.

    The inherent patterns – especially the ones developed by Shabacker and Edwards & Magee – were more likely to ‘work’ because there weren’t mass computer programs exploiting volatility and order flow over 50 years ago. The volume was literally created by psychological reasons and supply and demand.
    The head and shoulders example is classic in that the left shoulder represents optimism of the ‘unsophisticated’ traders and the start of ‘distribution’ by the sophisticated ones. The ‘head’ rally further confirms the enthusiasm of the public against the distribution tactics of the insiders, and the rally occurs on lower volume, and the final right shoulder rally – should it occur on lower volume – means the pattern now has high odds of working (in other words, we can count on a break of the neckline to produce a minimum price objective and we can trade this pattern and place stops appropriately.

    However, now, with speed of execution and algorithmic trading, as well as a much higher level of sophistication of the professionals, if they anticipate a price break downwards, they may begin shorting before the proper ‘neckline break’ and thus ‘bust’ the pattern before it completes, or alternatively, if a huge proportion of stops are placed once the neckline breaks downwards (the stops would be placed above the neckline break), then if the downward move stalls and price creeps upwards seeking the liquidity pool of those stops, then should the market get there, shorts would cover and price would rally, busting the pattern. The eventual resolution may be to the downside, but not before that pool of liquidity – those massive pocket of live orders – are filled.

    I suppose my main point is nothing is perfect. A pattern is likely to fail if volume characteristics are radically different than what is expected (if price rallies and then pulls back creating a flag, we would expect volume to be lighter during the flag, or else the flag becomes suspect. Further, we would expect price to eject upwards in a bull flag.)

    I hope that helps.

    Thanks! Corey