Why Patterns Don’t Work (Alone and Unsupported)
I recently ran an ad on Facebook which got some interesting responses.
The ad discussed the science behind price patterns in the markets and looked like this:
I provided some helpful information on how patterns can help make a difference in your trading. There are many well-cited academic publications backing up this assertion with plenty of proof.
In fact, one research paper I love to quote interviewed 692 fund managers in five countries, “the vast majority of whom rely on technical analysis.” It was published in 2010 in the Journal of Banking& Finance.
The paper also found that funds which rely heavily on technical analysis are smaller. It becomes very difficult when you get too big. But for individual traders? That limitation doesn’t apply.
More recently in 2018, another research paper was published in the International Journal of Finance & Economics (link at the bottom). They considered 9,555 trading rules and examined the usability of technical analysis.
Here's what they found:
"These pieces of evidence demonstrate that investors who use an appropriate strategy of technical analysis in asset allocation can produce good economic value, a finding that supports the continued use of technical analysis in practice."
They also noted that: “87% of fund managers emphasized the importance of technical analysis, and 18% of them thought that technical analysis revealed information more useful than that provided by other approaches…”
So why did I call this article “Why PatternsDon’t Work”?
Because it’s a bit of a tongue-in-cheek reference to comments like these ones:
By now I hope I’ve demonstrated there’s real value and real proof behind patterns in general.
However, Guy, Ho and Victor do have a point.
Patterns in isolation aren’t very helpful. If you only look at a pattern by itself, it’s about as useful as looking at a single frame of a movie to judge the entire movie.
Yes, a screenshot can give you a helpful snapshot of that movie at a certain point in time. Sometimes they can be very interesting, even iconic screenshots.
But you need to actually watch the movie to have any idea of whether you like it or not.
In the same way, you need to look at the whole market -- not just a pattern -- to be a successful trader.
Patterns are just one part of the equation and you can’t trade based on them alone.
So what else is needed?
You also need to analyze the trend: is there anoticeable uptrend or downtrend?
If so, does it look to be running out of momentum?
Or is the market just sliding sideways?
This is where patterns suddenly become a lot more useful. When you look at patterns in context with the trend, they tell you a lot about where the market might be going next.
Continuation patterns such as triangles, edges and channels can help you decide when a stalled trend is ready to resume.
Reversal patterns such as double tops (or bottoms) and head and shoulders (or their inverted counterparts) can help you decide when a trend has run its course and is ready to move in the opposite direction.
So that’s all well and good. But there’s one more piece to the pattern trading puzzle.
The last part of using patterns consists of price action.
Price action is what confirms the continuation or reversal pattern is actually what you think it is. That’s because we’ve all seen double tops (or bottoms) that turned out to be nothing more than wiggles in an ongoing uptrend (or downtrend), for example.
But price action that breaks the neckline, trendline, or key high/low of a given pattern? Now we’ve just seen something significant. Decisive price action is what confirms the pattern.
And that’s when you can put on a good risk/reward trade:
- You know the trend, including whether it’s continuing or reversing.
- You know the pattern that defines that continuation or reversal.
- You’re seeing price action (and therefore momentum) that supports the continuation or reversal idea.
A good example of how this works came fromVictor’s comment (quoted above) where he feels that a ‘3 Inside Up’ candle combination is actually bearish because whenever he sees it in a downtrend, the price rallies before dumping again.
(The ‘3 Inside Up’ combination is the one shown in the ad, by the way. It’s actually a bullish combination and is composed of a bearish candle, an inside candle, and then a bullish one in sequence. I use bar charts, but the principle is just the same. On my bar charts, a seemingly benign inside bar acts as a reversal/stopping point and is then confirmed by a strong bullish bar.)
Victor has observed that the price rallies temporarily after the ‘3 Inside Up’ pattern appears in a downtrend.
That's an excellent example of a small pattern signalling pretty much what it's supposed to signal (short-term bullish momentum)before the larger downtrend asserts itself.
Context is so important here, because that bullish pattern pointed the way to a potentially great entry point for shorting a downtrend.
But there’s another key point here.
Clearly a “3 Inside Up” combination isn’t enough to reverse the larger trend by itself.
You need something bigger and more complex like a double bottom or an inverse head and shoulders comprised of many bars orcandles to reverse a downtrend.
The analogy here is that oil tankers can’t stop on a dime. A big trend requires a big pattern to reverse it.
But the principle remains the same. Patterns do work once you place them in context and see price action that confirms them.
I could of course go into a lot more detail on this topic!
But I hope this short post has helped you see“the big picture” when it comes to pattern trading. It’s all about context and looking at all the moving parts in the market.
Has this helped improve your understanding of why I find patterns so useful in creating a real edge when trading?
Please reply and let me know.