How Profitable Are Patterns?

Studies of chart performance and reliability are scarce. The problem, of course, is the difficulty in defining a chart pattern on a computer. In 1970, one of the authors of this book and Robert Levy (1971) devised a method to identify patterns by recording the sequence of reversal points relative to their immediate past reversal points. This sounds complex, perhaps, but using only five reversal points, almost all simple chart patterns can be identified and their results recorded. Arthur Merrill (1997) took this study method and with some variation tested it on the Dow Jones Industrial Average. In both studies, the results showed that chart patterns as defined had little predictive ability. Several patterns showed some statistical reliability, but not enough to prove the case for technical price patterns in general.

In a 1988 study by Lo and MacKinlay, more sophisticated statistical methods were used to see if patterns existed in individual prices. The study had mixed results. Although it did not negate the possibility of patterns, neither did it prove that patterns existed.

The most comprehensive study to date is that of Bulkowski (2005). Many of the statistics mentioned in each pattern section later in the chapter are taken from his more recent work on trading classic patterns (2002). The intriguing nature of Bulkowski’s studies is that many of the old observations seen in the classic literature are turning out to be questionable, especially for maximum performance. As examples, volume trend within a pattern, slope of trends, and breakout volume may not be as relevant as others had originally thought.

Remember also that Bulkowski’s observations are in retrospect. We can easily identify many chart patterns after they have occurred and when we have observed the results. The real talent comes in identifying a chart pattern while it is evolving in real time and profiting from its completion. For this ability, only study, practice, and experience will suffice.

Finally, the results from Bulkowski’s observations are relative only. They cannot be assumed to be profitable in the future, as they appeared to be during the trial period. The value of his study is not in determining the value of chart pattern analysis itself but in determining which of the classic patterns are more

profitable with less risk. From Bulkowski’s studies, it appears that pattern analysis outperforms the market (S&P 500) on average in every instance. This might or might not be true, but for our purposes, we are more interested in which patterns to study as being the most likely to profit over others.

Box 15.2 Using Breakout Price to Set Price Targets

Bar charts can project price targets once a formation completes with the breakout. Most targets are measured from the breakout price. Targets are infrequently used because most technicians are satisfied with just being on the right side of the trend, want only to ride that trend, and believe that targets are generally inaccurate. In many patterns, however, this is not so. Generally, the target is calculated by taking the height of the pattern and adding it to the breakout price. In each of the following trading boxes, we describe the target peculiarities for each pattern and the success percentages.

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