10 Year Reliability Study (200,000 Charts)
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In this video we look at popular chart patterns and determine which are the best chart patterns to trade, supported by a pattern reliability study.
A chart pattern is defined by the price action of a stock price over a specified period, for example, if you were looking at the price action of a daily chart you might spot numerous chart patterns, the trader hopes that such chart patterns offer some predictability of future price in the short term, whereas a trader looking further out at the same patterns, perhaps on a monthly chart, would hope to gain some insight into longer term price moves. Regardless of the time frame, the theory and principle of how chart patterns form, remain the same.
Chart patterns are often placed into a bullish or bearish category, for example, an ascending triangle or a cup and handle pattern would be deemed as bullish continuation patterns, meaning that price was in a prior uptrend before its formation.
A double top pattern would be classed as a bearish reversal pattern, often recognised for price reaching a resistance point on two occasions before making a move downward.
A descending triangle would be classed as a bearish continuation, meaning that price was in a prior downtrend before its formation.
A falling wedge could be deemed as a continuation or a reversal depending on the trend prior to its formation.
The popular head and shoulder pattern could be deemed as bullish or bearish depending on its rotation, in this example of an inverted pattern it is deemed as a bullish reversal. The pattern is complete when two shoulders and a head are established, followed by a break of the neckline.
A pennant or flag pattern is classed as a bullish continuation sign, whereas the less popular Bump and Run pattern can often be seen at the end of bullish trend before it reverses, making it a bearish pattern.
One thing you may notice with all these patterns is that they all form varying lines of support and resistance, followed by a breakout in either direction.
There are many theories as to why certain chart patterns appear with a degree of regularity, and each have their own explanation. In this example we see a price increase, shortly followed by some profit taking, we then see a battle between buyers and sellers, buyers forming points of support, and sellers forming points of resistance. Notice how during this process price volatility contracts through each battle, this eventually moves to an area of equilibrium or a squeeze between bulls and bears. In this example the bulls took control and price broke through resistance, often exaggerated by what is known as a ‘short squeeze’ where sellers must become buyers to close their short positions.
Before we look at the probabilities of success for some of the most popular patterns, lets first understand how the patterns themselves only form part of the trading equation and should not be traded blindly.
In its purest form a pattern is made up of numerous price candles and each candle has its own story. For example, if we are looking for a breakout trade, we would expect the breakout candle to be of a bullish nature, full bodied and perhaps with a small underside wick, we would not however want to see a large wick to the upside of the candle, such a wick would suggest significant resistance from sellers further ahead. They could of course get exhausted, and price could continue up, but trading is all about probabilities and seeing such resistance through a large wick is not ideal.
So, number one could be the chart pattern itself, number two could be the bullish price action of the breakout candle.
Depending on the pattern, we also want price action to be in favour of the pattern prior to its formation.
Volume within the pattern would also need to be considered, with increased volume at the break (showing conviction) being of particular importance.
Price being on the right side or even supported by a longer-term moving average should also be considered. I personally add a shorter-term momentum indicator too.
Look at the market indices. Look at the individual sector performance. Check the fundamentals of the company. Determine the stop loss placement, position size, and how you plan to exit the trade.
The point is, despite the chart pattern rankings we are about to see, chart patterns alone are just a small fraction of a viable trading strategy, they are by no means the holy grail of trading. The holy grail, if there is one, is by gaining an edge and being able to apply it with enough frequency for the edge to materialise, just like a casino, which we covered in a previous video.
Imagine if we gained just half of a percent edge for each of the areas we just covered and traded them as a strategy repeatedly with perfect discipline. That is the key, therefore a pattern ‘alone’ is not the answer.
Next we look at some of the best patterns to include within a strategy, and as always if you do find value, please click the like button and consider subscribing.
This study was completed by the Samurai Trading Academy in which they tested more than 200,000 patterns over a ten-year period. They gave 7 of the best patterns based on reliability, whilst also giving a dishonourable mention to a popular but poor performing pattern.
The pattern with the relatively poor performance was the bullish and bearish pennant. The bullish pennant success rate was 54.87%, whilst the bearish pennant was successful 55.19% of the time. The success of the pattern was determined by the length of the trend prior to the pattern formation and confirmed if the trend from the breakout achieved the same distance.
Ranked number 7 of the most reliable patterns came the Bull and Bear flags. The bull flag had a success rate of 67.13% whilst the bear flag was successful 67.72% of the time. Again the same measure to determine success was used. The flag is like the pennant other than the pennant shows a contraction at the breakout point, whereas the flag only consolidates throughout the pattern, a small visual difference but a significant change in reliability.
In sixth place we have the Ascending and Descending triangle patterns. The ascending triangle has a success rate of 72.77% whereas the descending triangle is successful 72.93% of the time. The success of these patterns was determined by the width of the triangle at its widest point against the equivalent distance achieved from the breakout.
Slightly better in fifth place we have another continuation pattern, the Ascending and Descending channel. The ascending channel was successful just over 73% of the time, whereas the bearish descending formation was successful just under 73% of the time. These were classed as successful by the initial trend length, equal to the eventual breakout ascendency.
Next, in fourth place we have the first reversal pattern, the double top and double bottom. The double top was successful just over 75% of the time whereas the double bottom was successful 78.55% of the time. Success was determined by the depth of consolidation, against the length of the eventual breakout.
It’s worth pointing out at this stage that although the study does provide a gauge of success for each pattern, it does not disclose the eventual distance achieved from the breakout points. This aspect would be crucial in determining the risk reward ratio for each of the patterns, arguably one of the most important factors.
In third place, we have the triple top and triple bottom formation, again a sign of price reversal. The triple top was successful 77.59% of the time whereas the triple bottom was successful a credible 79.33% of the time. Very often the more points you have making the support and resistance lines, the more meaningful those lines become.
In second place, we have the Bullish and bearish rectangle pattern. The bullish rectangle is the pattern I personally specialise in, using the weekly charts. The bullish pattern was successful 78.23% of the time and the bearish pattern was successful 79.51% of the time. Although I provide my strategy in a PDF detailing the set up I use, one of the reasons I personally like the lateral consolidation (which we see here in the price channel) can be seen when we compare it against some of the other popular patterns, for example, if we look the Ascending channel we can see that there are numerous near term resistance points created within the pattern, whereas the lateral channel does not have any near term resistance, other than the breakout point itself.
Members in our group have access to my bespoke breakout scanner, which ensures that I do not miss any of these channel breakout opportunities. I’m able to determine minimum channel length, maximum channel width, and the size of the breakout candle, amongst other parameters. Feel free to access it using the links below if you think you could benefit.
The final chart pattern taking top spot is the head and shoulder pattern. These are classed as reversal patterns and provide very credible success rates of more than 83%, making them the most reliable patterns statistically according to the study.
These patterns are classed as successful when the breakout exceeds the distance from the head to the neckline.
So there we have it, some of the most reliable chart patterns to trade, and I have no doubt that by adding other variables around a pattern, the reliability can be improved further.
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