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February 16, 2006

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The Power of Price Patterns – for Reliability and Structured trading

Name: Valdi Thorkelsson & Ron Schoemmell

Company: RS of Houston

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The Power of Price Patterns for Reliability and Structured trading

The focus of today’s article is on price patterns. We will explain the benefits we perceive of relying on chart patterns over other forms of analysis and why we prefer them to the myriad of indicators and oscillators available. We certainly hope you find the following discussion beneficial and will consider adding structured chart patterns to your trading arsenal as they have the potential to dramatically improve your trading results .

PRICE PATTERNS PROVIDE RELIABILITY AND LEND STRUCTURE TO TRADING

In our view chart patterns are the purest form of Technical Analysis as they are created through the process of price discovery itself. They are the “footprints” left on the chart by commercials and large institutional players that control the markets and tell you the direction they are headed. You simply can’t get any more current or closer to the market than the latest tick and the bar that just formed. That last tick is formed by the “auction” process and reflects ALL the latest information and news (both public and private) available to market participants at that point in time, eliminating the need to follow news and pore over the annual reports of companies.

Contrast this type of analysis with the myriad of indicators and oscillators available in most software packages and widely used by traders. Such tools are derived from price and must therefore by definition be lagging. Most indicators and oscillators rely on smoothing techniques over several price bars (anywhere from a couple of bars to 20, 30 bars) and therefore reflect information that is several bars old. By the time one gets a change in direction, or a cross-over of a multi-line indicator the trade is already gone (or at least it is under way to the extent that one can no longer get on board with low risk).

When using multiple indicators and/or oscillators one frequently runs into situations where they provide conflicting information (i.e. one “says” Buy, while the other “says” Sell or fails to provide confirmation). This introduces indecision and undermines the trader’s confidence in his analysis and the signal provided.

We’ve also found that using indicators and oscillators removes the user from focusing on price and what the price action is telling him. We frequently hear from traders who are having trouble in their trading. They will send us a snapshot of their trading screen and the reason becomes evident: They’ve got so many indicators (RSI, Stochastics, MACD, ADX etc.) absorbing valuable screen real-estate (all pointing in different directions) that they can barely see the price bars! How can you trade the market when you can’t see what it’s currently doing?

Using patterns in your trading allows you to eliminate the clutter, reclaim that valuable screen real-estate wasted by indicators/oscillators, and puts the focus back where it belongs, on price.

If you haven’t guessed it already, chart patterns are at the core of our trading methodology, they are extremely powerful tools and highly reliable when used properly. It is important to note that when we talk about chart patterns we are NOT referring to the standard patterns taught in many technical analysis books (i.e. “Head and Shoulders”, “Cup with a Handle”, “Rising Wedge” etc.).

Most of those patterns are only evident after the fact and are highly subjective. They contain too many price bars and require too much interpretation to discern. They also fail the acid test of being tradeable from the hard-right edge of the screen, as they are often hard to spot until several bars have passed and they’ve moved to the middle of your trading screen. By that time, of course it’s too late to take advantage of them. It’s like looking at the clouds trying to see a picture of an animal or some object. One person might see it and the other says I don’t.....

This subjectivity is what has given patterns a bad name in the trading community in the past. Through our research we have found a series of patterns and categorized them based on the context in which they appear. By imposing a pre-defined structure with a one bar trigger on the patterns we are able to identify them as they set up at the hard-right edge of the screen where the trading decision is made. In a recent TraderSavvy article, August 24 th ’05, we shared the details of one of our patterns with readers, the “1-2-3/TrendChange” pattern. These patterns prove to repeat over and over again and offer a structured way of trading for entry, trade management and stop loss and that is what makes them highly reliable trading tools.

The hallmark of a good trading strategy is that it works on any market, in any timeframe. If it does, it tells you that the strategy in question is not over-optimized or curve-fitted to a specific market or set of data. The patterns we’ve identified work on all time frames and markets. For instance, while the focus of our work is on short-term and day-trading (primarily on 5 minute charts) we recognize that a number of our students prefer to trade a longer timeframe. We therefore initiated a daily chart signal service for our students covering a range of 10 different markets in the 2 nd half of 2004. Since that time we’ve identified numerous great trading opportunities for subscribers based on our patterns (not to mention several trade recommendations we’ve published in different articles and sent to our entire mailing list).

Following are but a few examples of trade recommendations we’ve put out in different markets from recent weeks:

09/01/05 - Sell T-Bonds below 09/01/05 low (117^18)
=> 12 trading days later Bonds had traded as low as 114^00, and ultimately moved under 110^ 16 by 11/04/05

10/03/05 – Sell S&P500 Futures below 10/03/05 Low (1229.75)
=> 8 trading days later S&P's bottomed out over 50.00 pts lower in the 1172.00 area!

11/30/05 - Buy Crude Oil (light) above 11/30/05 High (57.40)
=> 9 trading days later Crude Oil had traded as high as 61.90

12/14/05 – Buy Coffee Futures above 12/14/05 High (97.00)
=> 14 trading days later Coffee had moved above 110.00, and ultimately moved above 125.00 within 6 weeks!

01/12/06 – Sell S&P500 Futures below 01/12/06 Low (1290.50)
=> 9 trading days later S&P's traded as low as 1262.25

01/19/06 – Buy Wheat Futures above 01/19/06 High (3.28)
=> 6 trading days later Wheat had moved to 3.50, and ultimately topped out at 3.65 by last week!

01/30/06 – Sell S&P500 Futures below 01/30/06 Low (1286.75)
=> 6 trading days later S&P's traded as low as 1256.00

01/31/06 – Sell Crude Oil (light ) below 01/31/06 Low (67.35)
=> 10 trading days later Crude Oil has traded as low as 57.50 !

Besides demonstrating the effectiveness of our patterns and their applicability to different markets and longer timeframes it is interesting to note that most of the above moves identified by these patterns took place in less than 10 trading days (i.e. 2 calendar weeks).

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