Computers and Pattern Recognition in Technical Analysis

Analysts began recognizing chart patterns in the days when prices were plotted daily by hand. Aside from trend lines, patterns were the beginning of technical analysis, and for this reason, many nontechnicians mistakenly believe that patterns are all that technicians study. Floor traders and market makers still plot intraday charts of prices for their use in trading short periods, but the computer has changed technical analysis considerably. On a computer screen, charts of minute-to-minute, even tick-to-tick prices can now be displayed, and from them, various patterns can be recognized. This has led to impersonal contact with prices, different from the days when each bar was plotted individually and the “feel” for price action was more easily learned. In addition, the time horizon for traders off the floor has become shorter. The ability to see almost instantly a change in price behavior combined with lower commission costs and less slippage, all due to the introduction of computers, has led traders to speculate on shorter-term trends and patterns.

The computer did not make the study of patterns any easier, however. Patterns change and adjust to new markets. Some of the old patterns do not seem to work very well anymore, and others have taken their place. Patterns are also subjectively determined, and in many cases they are perhaps invalid. Tests are being made currently on their validity—a difficult enterprise because patterns are more visually based than mathematically based. They are peculiar to humans in that, like recognizing a friend’s face out of a collage of faces, a particular chart pattern must be recognized out of a series of patterns in prices. Like quantifying your friend’s face, quantifying a chart pattern is not easily accomplished. Only through practice, many mistakes, and many correct interpretations that go wrong is the technical analyst consistently able to recognize patterns. This is how the art of technical analysis developed before the computer, and although the computer is now taking over both in plotting and in analyzing, the chart patterns still exist and are used by many practitioners. Recent authors of books on technical chart methods will attest to the longevity of certain patterns and their fractal nature. The analysis of price patterns remains, although less emphasis is placed on it.

The analyst using a computer is able to compute more quickly various ratios, averages, spreads, and so on. Computer usage also has the advantage of giving the technician the ability to test these new calculations as well as the old ones for accuracy and statistical significance. The old-time technical analyst had to rely on many years of experience to determine the reliability of formations and indicators and often, for example, stayed up late at night with a hand-crank adding machine calculating indicators and oscillators. As we know from studies of behavior, anecdotal experience can be deceiving, but with the advent of the computer, we can now objectively study many oscillators, averages, and other methods that before were impractical to study. The computer has “cleaned” up a lot of the folklore about patterns and trends and eliminated those that have little or no validity. It has made technical analysis more of a science than an art. Remarkably, although understandable from the previous discussion of human behavior, many of these old inaccurate methods are still used.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.

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