Mathematical definition and detailed statistical analysis allow us to test patterns, giving us a unique view of one particular stage of a market. We refer to the quantified use and study of repetitive price formations as advanced pattern recognition theory (APRT). Let us discuss some key factors found in APRT patterns and then analyze an example of a pattern we have found.
TRADING TECHNIQUES
Combining Statistical And Pattern Analysis
by Walter T. Downs
Patterns are one of the oldest forms of technical analysis. Yet, because patterns can often be subjective, few of us take the time to combine statistical information with this type of market analysis. Before the effectiveness of such technical tools can be judged, the guesswork must be removed -- and here's how.
KEY PATTERN TRAITS
Patterns display repetitive characteristics. They are related to five distinct factors. The first three factors refer to the type of market action to be expected. An expansion factor means that the market can be expected to move rapidly out of the pattern in a specific direction. A contraction factor means price action that has diminished to a small point, and a transition factor is a point of change between contraction and expansion.These three factors were discussed at length in my June 1998 article. The remaining two factors, reversal and continuation, relate to the tendency of a pattern to show a statistical bent for continuing the direction of previous price action, or reversing previous price action. Two examples of this might be a head and shoulders? formation, which would be considered a reversal (transition) pattern, and a flag? formation, which is conducive to the continuation of the current trend (expansion).
All patterns utilize these factors in a common theme: Breakouts from the current price structure result in price action that displays increased momentum and a sharp increase in directional bias. Use of patterns in such a way is how money is made. On occasion, traders will use a pattern that they feel has expanded too far to write option strategies, but in general, this is not the most popular application, so we will not examine that particular methodology here.
Finding logical and mathematical definitions for our five key factors allows us to study the pattern from a statistical point of view. We can define our advantage over the market in finite terms. One such quantified pattern is the SHARK-32 price formation.
SHARK-32
SHARK-32 is a short-term pattern, yet our analysis indicates that it may pack a long-term punch as well. Though generally considered a continuation pattern, it has also displayed some remarkable price reversals.
Excerpted from an article originally published in the October 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.
