What Is a Pattern in Technical Analysis?

In the literature and usage of technical analysis, the terms pattern and formation are used interchangeably. We will do the same. A pattern is simply a configuration of price action that is bounded, above and below, by some form of either a line or a curve.

The lines that bind price movement in a pattern can be trend lines or support/resistance lines. In this chapter, we apply the concepts and terminology that we studied in Chapter 12, “Trends—The Basics,” regarding these lines. When studying patterns, we add a new concept—prices being bound by a curve instead of a straight line. A curve is a less definite arc drawn with either a “smiley face” for a bottom curve or a “frown” for the top curve. The lowest level in a bottom curve is a support level, and the highest level in a top curve is a resistance level. Curves simply define a support or resistance level with curved rather than straight lines. A pattern can be bounded by any combination of curves or lines as long as the upper and lower bounds are defined well enough for a breakout level to be established.

1. Common Pattern Characteristics

The focus of this chapter is bar chart price configurations. Thomas N. Bulkowski has accomplished the most comprehensive modern study of bar chart patterns in his twin books Encyclopedia of Chart Patterns, 2nd edition (2005) and Trading Classic Chart Patterns (2002). Bulkowski observed more than 700 stocks over ten years on a daily basis and cataloged their results under varying conditions. In total, over two market periods he found and analyzed 12,385 chart patterns. Although his analysis of patterns was, of course, subject to his potential bias, it was consistent and included a significantly large number of examples. Much of the material—specifically the statistics—in this chapter relies on Bulkowski’s work. Bulkowski has a Web site (www.thepatternsite.com) that explains in significant detail all the patterns we discuss and more. Before we begin discussing some of the particular patterns, however, we need to explain some vocabulary related to the general characteristics of bar chart patterns.

2. Entry and Exit

All patterns have a combination of an entry and an exit. The entry describes the trend preceding the formation, and the exit is usually the signal for action. A pattern can occur after a decline, in which case, the entry is from above, or after an advance, in which case, the entry is from below. The exit, of course, can also be downward or upward. Figure 15.1, a double bottom, shows an entry from above and an upward breakout. On the other hand, a top formation has an entry from below and an exit downward. A consolidation in a larger uptrend has an entry from below and an exit upward. Thus, all patterns are described with these four variables: entry from above, entry from below, downward exit, and upward exit. These variables are important because statistically, in each pattern type, some of these characteristics are more reliable, occur more frequently, or are more profitable than others.

3. Fractal

The bars in a bar chart can be any period: weekly, daily, minute, and so on. Bar chart patterns are fractal. This means they can occur in any bar chart, regardless of the bar period. A triangle formation, for example, can occur in hourly bars or weekly bars. The pattern is always the same type and will always have the same general characteristics. This is odd but true. Indeed, looking at a bar chart pattern without a specified time horizon, a technical analyst who is experienced in pattern recognition cannot tell the periods of the bars.

2. Pullbacks and Throwbacks

Pullbacks occur when prices break out downward and then “pull back” to their breakout level. Throwbacks occur when prices break out upward and then “throw back” to their breakout level (Edwards and Magee, revised 2007). Figure 15.1 shows an example of a pullback. Neither a pullback nor a throwback is easily or precisely defined, but you know one when you see it. The interesting aspect of this price behavior is that invariably a pullback or throwback will decrease the extent of the eventual move in the direction of the breakout. Thus, although each may provide a second opportunity for action at the breakout level, the subsequent rise or fall generally will be less than if there were no pullback or throwback. Tactically, this implies that a breakout should be acted upon immediately; waiting for the retracement will diminish profitability, and you may very likely miss the entire price move.

Pullbacks seem to occur more frequently on downward breakouts with less-than- average volume, and throwbacks occur more frequently with upward breakouts on above-average volume. Because pullbacks and throwbacks seem to undermine performance, the ideal situation, as a rule, is that on an upward breakout, less volume is preferred, and on a downward breakout, more volume is preferred.

3. Failures

All breakouts can fail in any of the formations—some more than others. Remember that a breakout is a signal that prices are beginning to trend, either upward or downward. This is particularly frustrating to the beginner who desires perfection. As we have seen, however, perfection is not in the lexicon of technical analysis. It is favorable odds, or an “edge,” for which we are looking. Bulkowski’s definition of a failure, which we use, is when a breakout occurs and the price fails to move at least 5% in the direction of the breakout.

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