Trading with chart patterns
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Chart patterns are the basis for technical analysis. They are chart forms linking high and low points on price histories. They are used to define entry points and set price objectives.There are 2 main families of chart patterns: reversal patterns and continuation patterns. These chart patterns appear regularly on price charts and each form often produces the same effects.
Chart patterns have given rise to numerous statistical studies, the best known and most relevant of which is the one carried out by N. Bulkowski in his book "Encyclopaedia of chart patterns".Here are the main results of his study based on hundreds of cases for each type of chart pattern.
This ranking shows the price breakout direction (bullish or bearish breakout) as soon as the chart pattern has been identified:
With regard to reversal patterns, the HS (head and shoulders), inverted HS, rising and falling wedges are by far the most relevant. These are the ones that are most likely to cause a trend reversal.
Concerning continuation patterns, bullish and bearish flags are the most relevant. These are the ones that are most likely to cause a continuation of the trend.
The least relevant chart patterns are triangles and wedges. However, these charts reflect investor hesitation.It is therefore normal that the breakout direction is variable. It is therefore better if these patterns do not take into account the trend that precedes their formation.
Finally, it can be noted that the double top and triple top are much more effective as a turnaround pattern than the double bottom and triple bottom.
Each chart pattern is used to determine a theoretical target for an increase or decrease in the theoretical price.To evaluate a pattern, it is not enough to evaluate the price breakout direction, you also have to evaluate the percentage of the objectives reached when the breakout is in the right direction. For example, if an HS has led to a reversal, what percentage of the theoretical target has been achieved? This is the object of this second ranking of chart patterns:
Compared to the previous ranking, there are a lot of changes.HS patterns don’t offer such good results.At the top of the rankings are wedge patterns, which reflect gradual increase in volatility. Therefore, it would appear normal that theoretical objectives which are at a distance from the chart pattern, are more regularly achieved on this type of pattern. The breakout often leads to a rally.The same kind of remark can be made about triangles that are price compression zones. At the breakout, all traders are moving in the same direction.
As for the most classic continuation patterns, such as flags and pennants, the objectives are rarely achieved. You therefore have to be cautious with this type of pattern.
Once the breakout of the pattern is completed, prices regularly pullback on one of the chart pattern lines. This phenomenon is common after a support or resistance line breach.On chart patterns, the principle is the same but some of them have a much higher pullback rate than others. Here are the results of the study:
With regard to reversal patterns the double/triple bottom/top very often results in a pullback of the neck line trend. It is therefore better to wait for the pullback to take position on these patterns. In general, turning patterns are more prone to pullback than continuation patterns.Flags and pennants are at the bottom of the ranking.
Chart patterns have an undeniable predictive power. They are based on the study of probabilities, but be aware that high probability does not mean that we have to anticipate the breakout of patterns. A chart pattern is validated only when the neck line or one of the trend lines is broken. This study only serves to show that chart patterns are an indispensable tool for technical analysis. They make it possible to establish scenarios, a prerequisite for taking a position.
Chart patterns have given rise to numerous statistical studies, the best known and most relevant of which is the one carried out by N. Bulkowski in his book "Encyclopaedia of chart patterns".Here are the main results of his study based on hundreds of cases for each type of chart pattern.
Chart patterns ranked by relevance
This ranking shows the price breakout direction (bullish or bearish breakout) as soon as the chart pattern has been identified:
With regard to reversal patterns, the HS (head and shoulders), inverted HS, rising and falling wedges are by far the most relevant. These are the ones that are most likely to cause a trend reversal.
Concerning continuation patterns, bullish and bearish flags are the most relevant. These are the ones that are most likely to cause a continuation of the trend.
The least relevant chart patterns are triangles and wedges. However, these charts reflect investor hesitation.It is therefore normal that the breakout direction is variable. It is therefore better if these patterns do not take into account the trend that precedes their formation.
Finally, it can be noted that the double top and triple top are much more effective as a turnaround pattern than the double bottom and triple bottom.
Chart patterns ranked by objective achieved
Each chart pattern is used to determine a theoretical target for an increase or decrease in the theoretical price.To evaluate a pattern, it is not enough to evaluate the price breakout direction, you also have to evaluate the percentage of the objectives reached when the breakout is in the right direction. For example, if an HS has led to a reversal, what percentage of the theoretical target has been achieved? This is the object of this second ranking of chart patterns:
Compared to the previous ranking, there are a lot of changes.HS patterns don’t offer such good results.At the top of the rankings are wedge patterns, which reflect gradual increase in volatility. Therefore, it would appear normal that theoretical objectives which are at a distance from the chart pattern, are more regularly achieved on this type of pattern. The breakout often leads to a rally.The same kind of remark can be made about triangles that are price compression zones. At the breakout, all traders are moving in the same direction.
As for the most classic continuation patterns, such as flags and pennants, the objectives are rarely achieved. You therefore have to be cautious with this type of pattern.
Chart patterns ranked by pullback
Once the breakout of the pattern is completed, prices regularly pullback on one of the chart pattern lines. This phenomenon is common after a support or resistance line breach.On chart patterns, the principle is the same but some of them have a much higher pullback rate than others. Here are the results of the study:
With regard to reversal patterns the double/triple bottom/top very often results in a pullback of the neck line trend. It is therefore better to wait for the pullback to take position on these patterns. In general, turning patterns are more prone to pullback than continuation patterns.Flags and pennants are at the bottom of the ranking.
Trading with chart patterns
Chart patterns have an undeniable predictive power. They are based on the study of probabilities, but be aware that high probability does not mean that we have to anticipate the breakout of patterns. A chart pattern is validated only when the neck line or one of the trend lines is broken. This study only serves to show that chart patterns are an indispensable tool for technical analysis. They make it possible to establish scenarios, a prerequisite for taking a position.
