Price charts are included in research reports from many of the biggest Wall Street firms. Charts are also readily available on many web sites. Although charts are easy to find, it’s not easy to find a clear explanation of how to use them to generate a profit. Books on charting often describe dozens of patterns but almost always leave out details about whether or not the patterns work. This report takes the opposite approach – we detail just five patterns that have been shown to consistently make money for investors. To do this, we update the work of technical analysts who identified in the early years of the twentieth century with newer research from economists studying behavioral finance. We found that there isn’t any value in most chart patterns but there are few that work. After reading this special report you will know exactly what to look for in a chart and even more importantly, how to profit from a chart.

Do Charts Work?

Before reviewing specific patterns, we need to ask the most important question related to any investment technique, “Does this work?”

The answer is that there are some patterns that work despite the fact that many investors have been led to believe charts have absolutely no value. Billionaire investor Warren Buffett is included in this group. Buffett once said, “I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer."1 Buffett is joined in his disdain for charts by Nobel Prize winning economist Burton Malkiel who concluded in his 1973 book A Random Walk Down Wall Street, “under scientific scrutiny, chart-reading must share a pedestal with alchemy.”

Buffett and Malkiel are certainly two of the greatest minds on Wall Street and it seems impossible to believe they can be wrong about charts. But the truth is charts can be useful although it really does depend on how the chart is used. Skilled analysts can find profitable patterns in some charts but most of the time, a chart will not show a clear and usable pattern.

1Quotedin“TechnicalAnalysisDragsDownPerformance”byRickFerriathttp://www.forbes.com/sites/rickferri/2014/06/02/technical-analysis-drags-down-performance/

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It’s important to emphasize that last point – most of the time, charts will not show a clear and usable pattern. This is different than the claims made by chart enthusiasts. There are analysts who claim they can look at any chart and forecast the future trend of the underlying chart without knowing anything about the company. These analysts are most likely overpromising because there are only a few patterns that indicate what a stock is likely to do in the future. Most of the time a chart will tell us nothing because there won’t be clear buy or sell signals.

Rather than viewing periods of silence on a chart as a reason to avoid charts, this characteristic actually argues in favor of charts. Markets only make large moves, up or down, occasionally. We want to spot these moves as they are beginning. Chart patterns offer a tool to do that and when charts tell us nothing, they are merely telling us there is a better trading opportunity elsewhere. That is valuable information to have.

Another objection to charts that Malkiel makes is the fact that chart patterns can be found in random data series. In experiments, he found technical analysts couldn’t distinguish between charts generated by market action and charts produced by random number generators. He concluded this made charts worthless.

Researchers at the Massachusetts Institute of Technology took a different view of this experiment.2 They asked analysts to make forecasts from charts built with random data. They found analysts could learn to spot patterns in the random data and concluded some patterns have value.

One final objection to charts we’ll cover is that if you draw enough lines on a chart you are bound to hit one of them so you can claim your forecast was correct. The chart below is an example of this problem.

22IsItReal,orIsItRandomized?:AFinancialTuringTestbyJasminaHasanhodzic,AndrewW.Lo,andEmanueleViolaavailableathttp://arxiv.org/pdf/1002.4592.pdf

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Figure 1: This chart presents an example of a chart pattern that doesn't work but uses a technique that is rather common.

Figure 1 includes a charting tool called the geometric polygon. It simply draws lines at various angles based on phi and other mystical sounding concepts. There are a number of tools like this and they are popular among chartists. There is no proof geometric polygons work but their widespread use is one reason investors don’t trust charts. Rational investors can see these charts clearly aren’t grounded in logic. So Buffett and Malkiel are correct that charts are useless much of the time but based on more recent research by respected finance professionals there are a few patterns that work in the hands of a skilled market watcher.

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Charting 101 Charts have been used to track prices in markets since the ancient Babylonians recorded wheat prices around 2000 BC. Speculators in seventeenth-century Japan created a charting technique to track prices on the Dojima Rice Exchange. By the 1830s, economists in England were producing detailed charts of financial markets and selling them to stock brokers. In the 1880s, Charles H. Dow was using charts on the floor of the New York Stock Exchange. Realizing the value of charts, Dow partnered with another floor trader, Edward D. Jones, to create the Dow Jones and Company news service in 1889. Traders and investors still rely on the ideas that flowed from this company, including the Dow Jones Industrial Average and other major market averages created more than a century ago. As traders studied charts over the course of nearly 4,000 years, they recognized some patterns seemed to appear frequently. These patterns were well known among traders and were first documented for the general public by Forbes Magazine editor Richard Schabacker in his 1932 book, Technical Analysis and Stock Market Profits: A Course in Forecasting. Schabacker passed away in 1935 but his son-in-law Robert Edwards teamed up with John Magee to publish Technical Analysis of Stock Trends in 1948 which detailed 37 distinct patterns. This book became popular among individual investors and has been continuously in print ever since. Over the past sixty years, charts have become the cornerstone of technical analysis. Technical analysis is the study of market data to forecast future trends in prices. Technical analysis can be combined with fundamental analysis. The combination of the two disciplines works well and is simple to implement. Practitioners who combine the two disciplines often say “fundamentals tell us what to buy, technicals tell us when.” For example, fundamental analysis can be used to find undervalued stocks. Since value stocks can remain undervalued for years at a time, technical analysis can be used to determine when the stock should be bought. By avoiding periods of time when undervalued stocks remains

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undervalued or even decline in price to become more undervalued, investors combining fundamentals and technicals get the best of both worlds. This strategy is an effort to buy good companies based on financial statements when they are good stocks based on charts. That is important distinction to remember – charts tell us what the stock is doing but tell us nothing about the underlying company. Often we find technicals and fundamentals agree but there is no reason they have to. It’s possible the chart will display a bullish pattern for a company that is losing money. Pure chartists who ignore fundamentals are likely to suffer losses when the stock eventually sells off. Pure fundamentalists will also suffer losses by ignoring the sell signals on a chart. The combination of charts and fundamental analysis could be one of the most successful trading strategies. There are a number of different types of charts traders have developed to help them study the markets. Line and Bar Charts Line charts are the simplest form of charts. These charts plot closing prices on the vertical axis of a chart relative to time which is shown in the horizontal axis. Figure 2 is an example of a line chart.

Figure 2: A line chart is simple but trends and some price patterns are still visible in the chart.

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This chart uses weekly data but any timeframe can be used to create a chart. Daily charts are popular but weekly or monthly charts can provide a longer-term perspective. Hourly or even shorter timeframes are popular with day traders. Chart patterns can appear in any timeframe so there is no “best” timeframe to use. The best charts are the one that provide useful information to you. We will cover timeframes in detail as we review each pattern. Bar charts add another level of detail to the analysis of a chart. In this type of chart, a vertical line is drawn from the highest price reached in the day to the lowest price. A small horizontal line is added to the left of the vertical line to indicate the opening price. The closing price is represented by a small horizontal line drawn to the right.

Figure 3: Constructing a bar chart is a clear-cut process.

With a bar chart, we now have four pieces of information for each day. Figure 4 is a bar chart using the same data that was used in Figure 2. By adding the highs and lows to the chart we can see how volatile the price action was in any given week. Longer bars are an indication of higher volatile relative to shorter bars.

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Figure 4: This chart covers the same time period as the line chart in Figure 2.

In Figure 4, the lows stand out in several bars. We can see the lows in several weeks were far from the rest of the price action. Technical analysts call this price action a “spike low” since prices spike lower and then quickly rebounds. In hindsight we can recognize this as short-term panic selling. A single bar can thus provide important information to traders. Panic selling is just one feature that stands out to experienced chartists. Each bar tells a story in some way. At other times we can see spike highs which are often a short-term overreaction to news events. A relatively small bar, where the distance between the high and low is small compared to nearby bars, is often a sign that traders have become complacent. This is in contrast to traders becoming exuberant or despondent when the range is relatively large. In this way, short-term traders can use the length of a bar as a clue to the short-term sentiment of other traders. Skilled chart readers can also gain insights into market sentiment from the open and close. Floor traders believe opening prices are set by individual investors, whose orders accumulate overnight and are executed in a matter of seconds when the market opens in the morning. An open above the previous close

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shows individual investors are anxious to own stocks. Opens below the previous close show individual investors want out of a stock. Closing prices are for the most part set by market professionals who trade throughout the day. By reviewing where the close is relative to the high and low we can determine what professionals think about the prospects of a stock. We know the high of each bar represents the maximum power of bulls during the day. The low of each bar marks the maximum power of the bears. The closing price represents the outcome of the battle between the bulls and the bears. A close near the high indicates the bulls are stronger than the bears while a close near the low shows the bears are in control of the market in the short term. When viewed on a daily chart, the battle between bulls and bears offers information to short-term traders. Long-term investors can conduct this analysis on monthly charts and look for trends. If stocks are in an uptrend but the monthly close is near the low for several months, it’s likely the trend will reverse. This information is just one way charts can be used and is an analytical technique usually used only by professionals. The more common way to analyze charts is to identify patterns like the ones discussed later but identifying where the close is relative to the high and spotting divergences as they develop can allow individual investors to avoid many of the steepest market declines. Candlestick Charts Another popular charting style represents each day as a candlestick. Candlestick charts were first used by rice traders in Japanese futures markets in the 1700s. They were introduced to traders outside of Japan in 1991 when “Japanese Candlestick Charting Techniques” was published by Steve Nison. This charting technique immediately gained widespread acceptance among traders. Candlestick charts are available on many web sites and this chart style is an option in every major trading software package. Candlesticks offer

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more information at a glance than traditional bar charts. Experienced traders can quickly spot patterns in the candlesticks and many patterns are formed with only one to three bars. The speed with which candlestick patterns is formed is one of the reasons many traders like these charts. Patterns on bar charts usually take several weeks or months to form. Candlesticks can be applied to any market and over any time frame. Each candle is drawn using the same information used to draw a bar chart. Candlesticks show the difference between the open and close as a rectangle which is called the body of the candle. The body can be filled in when the close is lower than the open signifying that price action in that time period was heavy and the price was pulled down by the weight of the selling. Traditionally, the body was left unfilled when the close was above the open. The white body of an up close can be thought of as prices floating higher and the lighter candlestick symbolizes that. Many charting web sites and programs now use colors for all candles. When the close is higher than the open the body is colored green. When the close is lower than the open, the body is colored red. This follows the protocol used with many indicators where green lines or bars are considered bullish while red is used to denote bearish conditions. Whether the body is in black and white or red or green, these visual cues help a trader quickly assess the market condition. To complete the candlestick, vertical lines known as wicks are drawn from the top of the rectangle to the level of the day’s high. The day’s low is also marked by a vertical line extending below the rectangle.

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Figure 5: Candlestick charts include a body and wicks.

Figure 6 shows the same time period and price action we saw in the line chart and bar chart. Some analysts prefer candlesticks to bar charts because the colors add additional information. In the chart below, the uptrend on the left consists mostly of green candles indicating the close was higher than the open, a condition that’s bullish. Near the topping action seen at the right of the chart, we don’t see a consistent trend and we have a mix of red and green candlesticks. While some analysts do find this feature of candlestick charts to be useful others view it as extraneous information.

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Figure 6: Compared to bar charts, candlesticks add another layer of information that can be used in analysis.

Line charts, bar charts and candlestick charts are the most popular chart styles. There are a number of other chart styles that analysts use including point and figure charts and ichi-moku cloud charts. These charts can be seen in the next two figures.

Figure 7: A point and figure chart uses Xs and Os to depict price changes. Rising prices are drawn with Xs and falling prices are marked with Os on the chart. This chart emphasizes the direction of the price moves by drawing Xs in green and Os in red, adopting the standard applied to candlestick charts in the previous section.

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You will notice chart patterns are identifiable in the point and figure chart just as they are in line charts. There is a trend evident in Figure 7 along with a consolidation period at the top and a rapid reversal to the downside before an equally rapid reversal to the upside develops. Proponents of point and figure charts claim they display patterns in more detail than other chart styles. Critics of the style note there is less detail in the patterns and signals, although clear, are more often than not incorrect which results in rapid whipsaw trades. In Figure 8 we have an ichi-moku chart which is also based on the work of analysts in Japan. Clouds, the shaded green and red areas in the chart, are formed by the interaction of two moving averages. Additional moving averages are drawn as lines on the chart and are considered to be an integral part of the interpretation of the chart. Candlesticks are also a part of the ichi-moku chart.

Figure 8: Ichi-moku clouds use a series of moving averages to forecast the future trend.

Ichi-moku clouds do show trends and patterns but the price action is in some ways hidden by the clouds, moving averages and other elements of the chart. Despite these drawbacks the charting style is becoming increasingly popular as traders continue their never-ending search for new techniques. This search often involves adding complexity as we can see in icji-moku charts. As you’ll read later in this report, we have discovered complexity isn’t needed to consistently generate profits from charts. In fact, simple patterns work quite well.

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Experienced traders know any chart style can be used to generate profits in the hands of a skilled analyst. Patterns that provide useful information for trading will be visible on any type of chart as long as you know what to look for. Why Charts Should Work “Prepare for the unknown by studying how others in the past have coped with the unforeseeable and the unpredictable.”

― attributed to General George S. Patton Patton was, of course, a great American general. He was also an inspiration to at least one great trader. Paul Tudor Jones was prepared to profit for the 1987 crash based on a pattern he identified earlier in the year. This pattern paid off handsomely and in 1987, he earned 125.9% after fees for his investors. When a similar pattern played out in Japan in 1990, Jones delivered gains of 87.4% and he made 48.1% when internet stocks crashed in 2000.3 Jones has averaged gains of 19.5% over almost 30 years of trading and is still actively managing funds. Jones wrote the foreword to George Soros’ 1994 book The Alchemy of Finance and explained what he learned from the movie Patton:

In Patton, my favorite scene is when U.S. General George S. Patton has just spent weeks studying the writing of his German adversary Field Marshall Erwin Rommel and is crushing him in an epic tank battle in Tunisia. Patton, sensing victory as he peers onto the battle field from his command post, growls, “Rommel, you magnificent bastard, I read your book!”4

For traders, charts are in a way similar to Rommel’s book. Charts offer a visual history of a stock’s price action. From the history printed on the chart, investors can quickly see whether prices are trending up or down or moving sideways. A glance at the chart can also reveal whether

3“AfteraDazzlingEarlyCareer,aStarTraderSettlesDown”byRandallSmith,TheNewYorkTimes,March5,2015,http://dealbook.nytimes.com/2014/03/05/after-a-dazzling-early-career-a-star-trader-settles-down/?_r=04Soros,George.TheAlchemyofFinance(1987)Wiley.

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volatility is higher or lower than average. From this information, an investor can get a sense of whether or not other investors are bullish or bearish on this particular stock. It’s interesting to note that all traders have access to charts but not every trader uses them. Likewise, in World War II all of the Rommel’s opponents in the field had access to his book but not every opposing commander chose to read the book. In hindsight, that might have been a mistake. In battle, generals should always understand everything they can about their opponent. In the markets investors should also take advantage of any information that is readily available to them. Failing to prepare for either battles or trading can be costly. Obviously the loss of life in battles is more serious than the loss of money in the markets but the same lesson applies to generals and traders – prepare with every tool at your disposal. Charts have been explained in books for decades but books aren’t the only resource available to successful traders. Experience is also important. Over time, traders studying charts will notice that some patterns tend to repeat themselves over and over again. Many patterns will occur for logical reasons. For example we might notice that after several days of relatively dull market action we tend to see a large move in the price of a stock. This pattern might mean that investors were waiting for an earnings announcement which explains the days of dull market action. They buy or sell immediately after the report is released which explains why the sudden price move appears on the chart. Notice how logical this market action is. Let’s consider an example of a volatile stock that displays pattern. The chart below shows Netflix, the streaming video service that’s widely followed by short-term traders because it often makes a big move after announcing earnings. The chart combined with an understanding of what is actually happening in the market, is a visual display of this earnings-related trading pattern. Once we understand what’s happening we can see the earnings reports in the price action.

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Figure 9: NFLX has a tendency to make a large price move within a week after earnings announcements.

The question for traders is “could you make money from this pattern?” Based on this pattern, you should be able to consistently buy NFLX about a week before it reports earnings and generate a profit. Because the stock is so volatile you could limit risk by buying call options which have a predefined amount of dollar risk. By using an advanced options strategies like a straddle you could possibly even make money if the stock falls instead of rises. These trades are possible because the chart is really telling you to expect volatility after the earnings announcement. Recently the volatility has been to the up side but there’s no guarantee it will always be that way. A straddle, a trade involving a combination of call and put options, benefits from volatility and could be the most conservative strategy to benefit from this chart. This example illustrates the correct way to study a chart. Notice how we don’t necessarily obtain new information from each candlestick as it forms. We do obtain general information that we can use to trade occasionally. But 90% of the time we are not seeing a trade signal in this chart. The only signals in this chart are generated by the calendar which tells us when the next earnings announcement is due.

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Using a logical premise isn’t the way many traders analyze charts. An investor using the Edwards and Magee chart pattern taxonomy would be looking for the possible completion of 37 different patterns every day. This would lead to disappointment because if patterns actually have value, they should occur relatively infrequently. Think about that idea for a moment and you’ll realize that big moves in stocks are relatively rare. Therefore, a strategy to identify those big moves in advance should only provide trade signals occasionally. In practice, this insight means you will need to review a large number of charts to uncover just a few stocks that are worth buying or selling at any particular time. This is what market professionals like Stanley Druckenmiller do. Druckenmiller worked with the legendary speculator George Soros. Together they managed the trade that broke the Bank of England. These two individuals managed to change history by forcing the Bank of England out of the euro price mechanism and earned $1 billion shorting the British pound in 1992. Druckenmiller later ran Duquesne Capital Management, a hedge fund that he converted to a family office in 2010. Druckenmiller’s trading success is apparent from his net worth which was recently estimated to be $4.4 billion by Forbes.5 In an interview with Wall Street Week, we learned Druckenmiller found stocks to trade by looking at charts.6 He noted he could review 3,000 charts in an hour but couldn’t guess how much time he would need to review 3,000 annual reports. He was looking for specific, high probability chart patterns like the ones we will discuss shortly. Druckenmiller is not the only hedge fund manager who uses charts. In fact, many of the most successful managers use charts according to a recent study. In “Sentiment and the Effectiveness of Technical Analysis7,” researchers found hedge funds that leaned on technical analysis beat

5http://www.forbes.com/profile/stanley-druckenmiller/6WallStreetWeekinterviewwithByronWienavailableathttp://wallstreetweek.com/read/episode-12-preview-byron-wien-amy-butte-michael-cahill/7ByDavidSmith,EdwardZychowiczandNaWang.Upcoming in JournalofFinancialandQuantitativeAnalysis.

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their peers by an average of 5.3% per year with the outperformance coming when investor sentiment was at an extreme. Sentiment is a measure of how investors feel about the market. When they are unusually optimistic they buy and when investors are deeply pessimistic they sell. You might personally be guilty of following this pattern. At least some readers probably bought internet stocks in 2000 as the market was about to crash or sold stocks in early-2009 as the market was forming an important long-term bottom. This is a behavioral pattern reinforced by analysts and media outlets that are telling us now is the time to buy when markets are topping and warning of more down side risks when we are near a bottom. It’s difficult to ignore the media but relying on charts helps successful hedge fund managers move against the crowd and make money for their investors. You can put those same patterns to work in your personal accounts. The 5 Chart Patterns That Consistently Make Money For Investors Through our research, we have found five simple patterns that investors should consider using in their personal trading. We reviewed dozens of patterns and found many patterns are not reliable. These five patterns can deliver consistent profits and reduce risk for traders.

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1. Head and Shoulders

Classical chart patterns are named after their appearance. In this case, a head and shoulders (H&S) looks like a person’s head and shoulders sitting atop an uptrend. In theory, the H&S should have the appearance of the market action depicted in Figure 10.

Figure 10: This is the textbook appearance of a head and shoulders pattern. In practice, they will only have this general appearance.

In reality, complex chart patterns such as the H&S are rarely, if ever, as clear as they appear to be in this figure. The next figure (Figure 11) shows a more typical H&S pattern. The H&S is marked as an overlay pattern on the right side of the figure. It is important to remember that to profit from patterns you need to be able to see the pattern through the noise of the market action.

Figure 11: In the market, patterns will never perfectly match their textbook description.

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In general terms:

• The H&S pattern consists of three peaks in price at the end of the uptrend, with the center peak (the head) being higher than the other two.

• The two “side” peaks (the shoulders) should be about equal in height.

The three peaks give the pattern its name, with the center being the head and the right and left shoulder forming on either side of the head. Connecting the bottom of the peaks, the neckline forms. The pattern is completed when prices fall below the neckline. At that point, we have a signal the uptrend has concluded and a new downtrend is beginning. The neckline is shown in Figure 12. Perhaps the most important point about an H&S is that the pattern must occur at the end of an uptrend. This is a reversal pattern which means there must be a clear trend to reverse. As a rule of thumb, you should not look for an H&S until the stock, ETF or index has gained at least 10% from its most recent low. The time to begin looking for a H&S to trade is after the head has formed. This idea is illustrated in the chart below which shows the H&S marking the top before the beginning of the deepest bear market since the Great Depression. This is a chart of SPY, the trading symbol of the SPDR S&P 500 ETF. SPY is one of the largest ETFs in terms of assets and is also among the most actively traded assets. Its large size and liquidity make it relatively inexpensive to trade. SPY is a popular trading vehicle for traders with an opinion on the direction of the broad stock market. This chart provides an example of how traders could have decided it was time to sell SPY and reduce their exposure to other stocks in the market. Figure 12 is an example of how you can make money using charts. Imagine how your wealth would have grown if you had spotted this sell signal and avoided most of the losses in the bear market. We consistently see bearish patterns like the H&S develop in SPY at important market tops.

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Figure 12: Spotting this H&S in 2007 would have helped you avoid the worst bear market since the Great Depression.

Let’s look at this chart in detail. An uptrend is defined as a series of higher highs and higher lows. In the chart we see a series of higher highs and higher lows culminating in the formation of the head (marked as H in the chart). The left shoulder (LS in the chart) is merely the high before the ultimate high in the trend. The head forms after prices fall back to form the neckline, the vertical blue line labeled NL in the chart. Prices then rally but quickly turn lower. At the top of the rally, the right shoulder (RS in the chart) is completed. The sell signal is given once the price falls below the neckline. Necklines are an example of support lines. In late 2007, investors were optimistic. SPY had reached an all-time high near $133 in October and pulled back to about $122. In a bull market, investors are looking to buy dips and this appeared to be a normal dip. With prices where they had been three months ago it looked like it was time to buy that dip. Buyers did enter the market at support and pushed prices up to what would become the right shoulder (RS). This rally only lasted a few weeks before prices turned down again. Once the price fell below the neckline, the selling accelerated. An increase in selling pressure is expected after support is violated. SPY quickly fell to about $111, the target price projected by the H&S.

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Price targets for an H&S, and almost any other chart pattern, are based on the idea of symmetry. We expect the price to move down below support a distance equal to the amount it moved above the support line. This is also illustrated in the chart of SPY. A line is drawn from the neckline to the top of the head. Using whole numbers, in the chart this line is about $11 in height (the distance from the head at $133 to the neckline at $122). After a break of the neckline we expect prices to fall at least $11 which is near $111 in this chart. Price targets are an important concept to consider when trading and price patterns are the only technical tool that allows traders to project the size of a potential price move. With a price target, we can determine whether or not the potential profit is worth trading. In Figure 12, we had a price target of $11 or about 9% of SPY’s price at that point. This is a significant move and many traders will find it worthwhile to avoid a potential decline of 9% or more. But if the price target indicated the down move would be smaller, maybe 3-5%, it might have been best to pass on the trade. For long-term investors avoiding a 5% pullback wouldn’t be a concern. Short-term traders, on the other hand, might be happy to target moves as small as 3%. The decision about what size price move is worth trading for is up to you. Price patterns are the tool that allows you to determine whether or not a trade is worth taking. To trade an H&S, follow these rules:

- H&S patterns are reversal patterns and there must be a trend to reverse. Always be sure prices have been in a significant up trend before identifying a potential H&S.

- After ensuring an uptrend exists, look for the peaks of the head and shoulders. Do not apply rigid rules. It’s not necessary for the shoulders to be exactly equal.

- Identify the neckline. Again, don’t apply rigid rules. Pullbacks that define the neckline will not always end at the exact same price. Allow a variance of at least 2-3% for the pullbacks that occur after

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the left shoulder and head. It’s also possible the neckline will be a slanted line rather than a horizontal line as shown in Figure 12. Allowing for variations like this will increase your likelihood of successfully identifying patterns.

- Place a sell order just below the neckline. How far below the neckline should be determined by your risk tolerance. If you are extremely risk averse, place the sell order just a few cents below the neckline. If you can accept a fair amount of risk, sell several percent below the neckline. An order 2-3% below the neckline will help avoid many false signals.

As implied in that last point, there will be some false signals. A false signal occurs when prices move below the neckline but quickly reverse to the upside. This is known as a whipsaw trade because the price actions is similar to the back and forth actions lumberjacks make when operating a whipsaw. In the case of the H&S pattern, prices whipsaw lower and then higher. In trading, no tool will ever be perfect and there will be some whipsaw trades or signals that result in a loss with any tool. The question traders need to answer is how often the tool they use is likely to be correct. Does the Head and Shoulders Pattern Work? About sixty years after Schabacker explained how to make money with the H&S pattern, researchers were finally able to objectively program the H&S pattern. A computer makes it possible to test signals which can be taken by any trader. Prior to computerized testing, tests were done by asking traders to identify patterns on price charts. The answers depended upon the skill and biases of the trader. This was a subjective test since the answers were subject to the opinions of the test subjects. Objective tests are preferred since the results will be reproducible. The first published objective study of the H&S pattern was produced by one of the most reliable and unbiased organizations conducting financial research, the Federal Reserve. In 1995, researchers with the Federal

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Reserve Bank of New York reported their results in "Head And Shoulders: Not Just A Flaky Pattern.”8 Based on extensive test data, they concluded that the H&S pattern could be used to trade a basket of six currencies and the resulting "profits would have been both statistically and economically significant." That phrase is taken directly from the paper and highlights one of the differences between traders and academics – these two groups just don't speak the same language. A trader would simply say something like "you can consistently make money trading the H&S pattern." Dr. Andrew Lo, a finance professor at the Massachusetts Institute of Technology, also studied the H&S pattern from an academic perspective. In "Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, And Empirical Implementation,"9 working with Harry Mamaysky and Jiang Wang, he found that the H&S pattern, along with several other indicators, does "provide incremental information and may have some practical value." In another example of the language differences between the academic community and the trader, Lo described the H&S pattern as

a price pattern where the magnitudes and decay pattern of the first twelve autocorrelations and the statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns.

Fortunately we can make money without calculating the Box-Peirce Q-statistic. We merely need to look for an uptrend that is reversing and then place a trade when the neckline is broken.

8ThispaperwaswrittenbyCarolL.Osler,nowwithBrandeisUniversity,andP.H.KevinChang,nowatCreditSuisseFirstBoston.Itisavailableathttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=993938.9Lo,AndrewW.,HarryMamayskyandJiangWang."FoundationsOfTechnicalAnalysis:ComputationalAlgorithms,StatisticalInference,AndEmpiricalImplementation,"JournalofFinance,2000,v55(4,Aug),1705-1765.

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Figure 13: This chart provides another example of the H&S pattern.

The H&S pattern indicates a downtrend is likely to develop in the market. Many traders and investors focus solely on the long side of the market and make money only when prices rise. The H&S can be a signal to trade on the short side to benefit from a potential decline. A short trade is one where you sell a security you don’t own. Your broker facilitates this trade by lending you the shares you need to sell. You will pay that loan back when you close the short trade by buying the stock at a later time. Short trades invert the normal sequence of a trade. In a long trade, you buy first and sell to close the trade. With a short trade, your first order is a sell and you close the position with a buy order. If the share price is lower when you buy to close a short trade, you generate a profit on the trade. If the price of the stock has gone up, you will face a loss. Stocks can rise to any level which means the potential loss on a short trade is potentially unlimited. The potential profits of a short trade are capped at the price you receive when you enter the trade. Many investors avoid short trades because of the large potential risks associated with the trade. To limit the risks on a short trade, you can use inverse ETFs or put options. These instruments can be used to profit from a downside break of the neckline with limited and predefined risk.

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An inverse ETF is one that goes up in value when the price of the underlying security declines. Leveraged ETFs are also available. All ETFs rebalance their holdings daily to meet their objective. An inverse ETF on the S&P 500 index will set its holdings to gain 1% in value if the index declines by 1%. This can be done with futures, options and other derivatives. A leveraged ETF will set its holdings to move 2 or 3 times as much as the index. If the S&P 500 decline 1%, a 2x inverse ETF should gain 2%. A 3x inverse ETF should gain 3% if the index falls 1%.10 A put option is an option that gives the buyer the right, but not the obligation, to sell 100 shares of a stock or ETF at a predetermined price before a predetermined date. Puts can also benefit from a market decline. There are various factors that determine the price of an option and there is no certainty that a 1% move in the underlying security will result in a 1% move in the option. The option could move more or less than the underlying security. One advantage of inverse ETFs and put options is that they have limited risk. When it comes to risk, these securities act the same as stocks in that you can never lose more than invest in these securities. Of course you can always close a trade before you lose 100% of your investment. With proper risk management, inverse ETFs and put options could be valuable additions to your portfolio. When you spot an H&S, you could short the security, buy an inverse ETF or put option to benefit from the downside, or simply sell the security of you already own it to avoid the potential decline. The right choice for you depends upon your risk tolerance. Selling a security and moving to cash is the most conservative choice. Shorting the security is the most aggressive trading decision. While the choice of how to trade is up to you, the H&S is the tool that will help you determine when to initiate the trade.

2. Rectangles

10Technically,leveragedandinverseexchangetradedproductsareETNs,orExchangeTradedNotes,ratherthanETFs,orExchangeTradedFunds.ETFsholdstockswhileETNsholdderivativesandcarryadditionalrisksrelatedtothefinancialhealthofthecounterpartytothederivativestrade.Inpractice,leveragedandinverseETNsarefrequentlycalledETFsandthattermisusedheretocomplywithstandardpractice.

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The second important pattern to recognize is the rectangle. This pattern develops as prices move back and forth to consolidate recent gains or losses. Technical analysts explain the significance of this pattern by saying that consolidations serve as a resting period for a stock. This pattern provides a base from which the stock eventually emerges. A popular saying among old chartists is “the bigger the base, the bigger the bounce.” Consolidation patterns like the rectangle recognize the third type of trending behavior a stock can exhibit. This third trend is probably the least well known trend among individual investors. Prices are almost always moving in a trend. They are either or in up trend, a down trend, or a sideways trend. The sideways trend is the most common form of price action and is the basis of the rectangle pattern. This pattern gets its name from the appearance of the chart. As the rectangle develops, almost all of the price action will fit within a rectangle that can be drawn on the chart. You’ll remember from our discussion of head and shoulders patterns that it’s important to interpret charts without rigid rules. Although a rectangle is precisely defined in mathematical terms as

a plane figure with four straight sides and four right angles, especially one with unequal adjacent sides, in contrast to a square

when we look for a rectangle on a chart we are simply looking for an extended period of time where prices move sideways. Figure 14 offers an example.

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Figure 14: A rectangle developed in SPY during the spring and summer of 2015. This was a setup for a large price move that would occur when the rectangle was completed.

This chart uses daily data but as with all patterns, you can use weekly or monthly data if you are a long-term investor or intraday data if you are a short-term trader. You can see in that chart how prices transitioned from an uptrend to a sideways trend. It’s the sideways trend that forms the rectangle pattern. Sideways price action is referred to by many names. This can be called a basing pattern, a trading range, a consolidation or a rectangle. The name is not important because all of the descriptions are referring to the same sideways price action. For clarity we will use the term “rectangle” but you will hear analysts call this pattern by other names at times. Rectangles combine the ideas of support and resistance into a single chart pattern. Support is a price level where we expect to see buyers come into the market to stop a price decline and support the price of the security by buying. This definition can be confusing but an example will help make it clear. Sometimes, prices will fall back to a price they traded at in the past and then bounce higher. This bounce and fall can occur several times and the level that prices bounce higher from is called support. For example, a

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stock might rise to $12 and then decline to $10 before turning up again. Another price dip follows and pushes the price back down to $10 where buyers come into the market again. This can happen several times. Each dip to $10 brings in more buyers and higher prices follow, making $10 a support level. When we see this happen, we are probably observing the behavior of investors who believe that prices are cheap at $10 and they buy based on that opinion. Some investors will look at a stock that has moved higher and wish they had bought it at a lower price. Many will say something like, “If ABC falls back to $10 a share, I will buy it so that I don’t miss out on it again.” On a chart, we can see this behavior form support levels. When prices reach a support level, they are said to test that price. If the stock moves higher, it is a successful test and a move below the support level is sometimes called a failure to hold support. It is common to see prices fail to hold support briefly and then reverse higher. This can be called a false breakout and often comes right before prices move higher. It’s also called a whipsaw trade, a term we first encountered when discussing the head and shoulders pattern. You’re seeing that whipsaw trades are an inevitable part of trading. Fortunately, whipsaw losses will almost always be small and the trader who suffers through them will eventually be rewarded for their patience with large gains. Resistance is the opposite of support. When prices encounter a resistance level, they often fall. For example, it’s common to see price increases stop at the same price that served as a high in previous market action. This is resistance, a price level that seems to stops prices from moving higher. It could be caused by investors wanting to sell at a price they think is too high. Resistance might form for a variety of reasons. If a company experiences slow earnings growth, many investors will believe it is overvalued at a certain price. They will sell when it hits that price and that can cause resistance to form. There are also psychological levels that lead to resistance in some securities. For example, advances in the price of oil are often stopped, at least temporarily, when the price nears a multiple of $10 a barrel, prices like $40, $50, $60, etc. This price level seems to

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make traders pause and sell-offs often start when the price is near multiples of $10. When the price breaks through resistance and moves above those round numbers, the price usually continues moving higher and delivers quick gains to traders. This might also be seen in stocks trading near multiples of $100 a share where resistance is encountered at round numbers. Support often marks a short-term bottom while resistance often marks a short-term top. In a rectangle pattern, prices move between support and resistance for some time. It is a consolidation pattern and is often seen after a sharp price move. Rectangles can mark tops or bottoms because the price of a stock can move higher or lower once it 4breaks out of the rectangle. Let’s look at how the rectangle shown in Figure 13 resolved.

Figure 15: Prices broke to the downside when that rectangle was resolved in August 2015.

This rectangle ended when prices fell below support. As with all classical chart patterns, we can develop a price target from the pattern based on the expectation that prices make symmetrical moves. To find the downside price target of a rectangle, subtract the support level from the resistance level to find the depth of the pattern. Subtract the depth of the pattern from the support level to determine the price target. It’s best to use approximate numbers since the actual price move

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will rarely meet the exact calculated value. The approximate size of the move will tell you whether or not the pattern is worth trading based on your risk tolerance and other factors. To calculate the price target of the rectangle in Figure 15, calculate the distance between the support and resistance levels identified by the pattern. In this case, support was near $203 and resistance formed at about $212. The distance between those two prices is $9 and after the breakout to the downside we expect a decline of about $9 from the support level, pushing the price to about $194. If prices had broken through resistance, we would also have also expected a move of $9. In this case we would add the depth of the rectangle to the resistance level to find the upside price target. We never know in advance which direction a rectangle will breakout. It’s best to be prepared for an upside and downside breakout so you can profit no matter which way prices move. Figure 16 shows an example of a rectangle that broke out to the up side. When this happens, the rectangles serves as a bottom instead of a top as it did in Figure 1.

Figure 16: After a selloff in 2011, a rectangle formed that served as the base of a powerful up move.

In this example, it took some time for the price target to be reached but patient traders were rewarded for recognizing the rectangle.

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This chart confirms the principle that prices rarely move in a straight line. After the initial breakout, prices pulled back towards the resistance level and actually fell below resistance for a few days. This is not uncommon and is called a “throwback” because prices are being thrown back under the critical price level. Many traders will panic and sell at this point. A better plan is to sell only if prices retrace half of the depth of the pattern. In this example, resistance formed at about $112 and support was at $102 for a depth of $10. Half of that is $5, an amount that can be subtracted from the resistance level to identify a stop-loss for the trade after the upside breakout. If prices close below $107, it’s safe to assume the up move has failed and the long trade is unlikely to work. This is a strategy that can be applied to all chart patterns that use symmetry to develop a price target. A retracement equal to one-half the depth of the pattern can be used as a stop-loss level. By applying this rule, we have both a profit target to help us handle winning trades and a stop level to address losing trades. As noted earlier, rectangles can be seen on daily charts, as in the previous examples, or on weekly or monthly charts. Figure 17 shows a monthly chart of SPDR Gold Trust which is an ETF that tracks the price of gold and trades under the symbol GLD. This rectangle would also be visible on weekly or daily chart.

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Figure 17: This rectangle served as the base for a bull market in gold that took prices to a new all-time high in 2011.

Notice how after GLD broke out of the rectangle it moved higher for a time before pulling back. The pullback ended at the top of the rectangle. This chart illustrates an important point about resistance -- after prices break through resistance that resistance level becomes an important support level. If you had missed the breakout of the rectangle you would have been able to enter the trade with little risk as prices tested support. Your stop-loss would be equal to half the width of the rectangle pattern. The next chart uses intraday data with each candlestick representing 15 minutes of the trading day. One rectangle ends when prices break out to the upside and the price briefly reaches its target before falling back. The other rectangle breaks out to the downside and also briefly meets its target before prices reverse.

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Figure 18: Rectangles also appear in intraday data as this chart of the PowerShares QQQ Trust ETF demonstrates.

With intraday data, it is important to quickly take profits when they are available rather than holding the position with the hope of additional gains. Intraday trading requires a great deal more attention than longer term trading and requires different tactics for success. These charts illustrate the rules for trading a rectangle:

- You can spot a rectangle on a chart when you see prices moving within a relatively narrow range. There are no rules for the size of the range. The difference between the highs and lows of the pattern could be just 1% apart or as much as 10% or more. The wider the range, the more powerful the breakout should be.

- The price objective for the move that follows the completion of the pattern is a move equal to the depth of the pattern (the difference between the approximate high and low.)

- A valid rectangle pattern requires prices to touch the support and resistance lines at least two times each.

- After spotting a rectangle, you can place an order to buy just above

the upper limit of the trading range.

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- If you own a stock that enters a rectangle, you can place a sell order just below the lower range of the pattern to lock in a profit.

- You can also short the stock or use leveraged ETFs or put options to benefit from a downside break of the pattern. This strategy was discussed in detail in the section on head and shoulder patterns.

Test Results Rectangle bottoms are among the most consistently profitable patterns. One study found that rectangle bottoms meet their price objectives 85% of the time. These are rectangles that develop after downtrends. Rectangles at tops, those that serve as sell signals, are less reliable and meet their objective just 63% of the time. This is still a high percentage signal. If you own a stock that breaks to the downside after forming a rectangle, approximately two-thirds of the time you should expect the price will continue lower. While rectangle tops are less reliable, they can still be useful for conservative traders.

3. Flag A flag is a more complex pattern than a head and shoulders or a rectangle. Flags occur after a trend develops and mark a short-term period of consolidation. Although they form quickly, flags can still signal powerful price moves. Traders say the “flag flies at half mast” which means we expect the previous trend to continue and we have a price objective that is equal to the length of the move prior to the formation of the flag. Flags offer a relatively low risk entry point for traders who missed the original breakout signal. Flags are among the most reliable patterns and met their price objective 90% of the time in one test. To understand the flag pattern, let’s start with a notional example of what the pattern looks like.

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Figure 19: Flags occur after a trend is established and are continuation patterns indicating that prices should continue to move in the direction of the original trend.

Flags can occur in up or down trends. They are similar to rectangles in that they are both consolidation patterns. The best performing flags are actually small rectangles that form shortly after a trend begins. The difference is that flags are a short-term pattern that generally forms over just one to three weeks. Because they are a short-term pattern, it’s best to use daily charts to trade them. On a weekly chart, the flag will form in just one to three bars and will be difficult to identify. Flags can take the form of a short-term rectangle as shown in Figure 20. This is a common pattern and is easily explained. The initial downtrend results in a feeling of disbelief among investors who had been expecting the earlier uptrend to continue. They buy after selling creates what they believe is a bargain and form a flag pattern which is highlighted in blue in Figure 20. After a short time when buyers stabilize prices, the downtrend resumes as smart money continues selling the stock. In this example the downtrend was quickly exhausted and a new uptrend in AAPL began.

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Figure 20: A flag formed in Apple (AAPL) as it fell during a broad market selloff in August 2015.

This pattern met its price objective quickly. This will often be the case for flags which are generally found only on short-term charts. These charts illustrate the rules for trading a flag:

- Look for a flag to form after a relatively quick price move unfolds after a breakout. The move can be up or down but should always be an almost uninterrupted trend. No matter how long the initial price move lasts, the majority of days should close in the direction of the primary trend.

- The flag should also form quickly, taking no more than two weeks to develop on the chart.

- After you notice the consolidation forming, you can enter an order to benefit from the continuation of the primary trend. If the move is down, you could enter an order to sell any open positions after the flag is completed. This would allow you to exit a long a long position if the downtrend resumes as expected. You could also buy a put option after the flag is completed to benefit from the downtrend.

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If the flag forms during an uptrend, you can enter a buy order just above the top of the pattern. This allows you enter at a relatively low-risk entry point.

- The price target of a flag is equal to the size of the price move that preceded the development of the flag. If the initial move was down, subtract the size of the preceding move from the bottom of the flag. If the initial move was up, add the size of the preceding move to the top of the flag.

- A flag is negated if prices break out of the short-term consolidation in the opposite direction of the original price move. If you believe a flag is forming after a down move, if prices rise then the flag pattern is invalidated. Likewise, a down move negates the flag pattern if the initial move that preceded the flag was up.

The Test Results In one test, the flag was found to be the best performing pattern of 23 patterns that were included in the test. As noted earlier, flags have met their profit objective 90% of the time.

4. Islands Islands are easy to spot on a chart – they are areas where a small piece of the price action stranded from the rest and the chart appears to show an island. This pattern can be seen at either tops or bottoms, in any market and in any timeframe. Like the other patterns mentioned so far, this pattern can be seen on candlestick charts or traditional bar charts Islands start and end with a gap. Gaps occur on a chart when the opening price is significantly above or below the previous close. The gap appears as blank space between the two bars as shown in Figure 21. There are two up gaps highlighted on the left of the chart. Up gaps form when the open is above the previous high and the day’s low remains above the previous day’s high. As a formula, these conditions can be written as

Open > Yesterday’s high AND Low > Yesterday’s high

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A gap down is also highlighted in the chart. Down gaps form when the open is less than yesterday’s low and the day’s high remains above the previous day’s low. As a formula, these conditions can be written as

Open < Yesterday’s low AND High < Yesterday’s low

Figure 21: Gaps and an island pattern are easy to spot on this chart of Apple (AAPL).

Figure 21 includes an island which is formed after prices gap down and then gap up a short time later. An island is a reversal pattern and the chart shows AAPL moved higher after the island was completed. Islands can also form at tops as shown in Figure 22.

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Figure 22: Best Buy (BBY) formed an island top at the beginning of January 2014.

Islands usually mark significant trend reversals. In the case of BBY, it took a year for the price to recover.

Figure 23: BBY eventually recovered to reach its old highs a year after the island top formed.

In Figure 23, the island top is not visible because it is a weekly chart. The gaps that set the island apart from the price action are only visible on daily charts. Figure 23 also demonstrates how resistance forms. Notice that BBY sold off in 2015 after reaching its old highs set in 2013. This was most likely due to investors who viewed the return to old highs as a

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chance to break even on the trade after suffering a steep loss the year before. Many charts will include several technical features and should be studied in context. Islands can also form as continuation patterns although this is rare. In the daily chart of Google below, an island forms based on two up gaps. These gaps were three months apart and were the result of quarterly earnings reports. This is an example of the news-driven pattern highlighted in Figure 9 which showed that earnings announcements often resulted in large moves for Netflix (NFLX). In Figure 24 we see that quarterly earnings announcements are a frequent source of price moves in popular stocks.

Figure 24: This island pattern marked a continuation in the primary trend rather than a reversal as seen in the previous examples.

Figure 24 also reinforces the point that real world patterns will often differ from text book examples. In August, the price of GOOGL dipped briefly into the area that formed the gap that was the starting point of the pattern. This was a one-day selloff and in hindsight was insignificant. A chartist who applies strict rules would then argue the the subsequent gap that formed in October couldn’t be part of an island pattern. The purist would have missed the 10% move in GOOGL that unfolded over the next five weeks. After the island forms, traders can easily spot the pattern and then anticipate the general direction of the trend. The island will stand out on

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the chart and traders can look for prices to move away from the island. Islands can form over several weeks or in as little as four trading days. While islands can theoretically develop in any timeframe, they are most commonly found on daily charts. Gaps are relatively rare on weekly and monthly charts which make islands even rarer. Their rarity is simply due to the way weekly and monthly charts are constructed. To form a gap on a weekly chart, prices need to open sharply lower or higher on the first trading of the week, usually Monday, and continue trading in the direction of the open. On a daily chart the gap can occur on any day. On a monthly chart, the gap must occur on the first trading day of the month. Daily gaps occur on just 1% of trading days for an average stock.11 Statistically, weekly gaps would be expected to occur on just 0.2% of trading days and monthly gaps on only 0.05% of trading days. An island would require a second statistically rare event to occur in close proximity to the first. Searching for islands on weekly and monthly charts is not likely to be a good use of a trader’s limited time but if you notice one in your normal market review it could be worth trading the pattern. On intraday charts, gaps are also relatively rare in liquid stocks. Market makers and high frequency trading firms maintain continuous quotes in these stocks. After the opening price is established, subsequent trading tends to be an orderly and continuous process throughout the day. Again, it might not be the best use of time to search for gaps on intraday charts but if one is observed it could be a profitable trade. The charts above illustrate the general rules for trading an island:

- You cannot anticipate the formation of an island. This pattern can only be spotted after it forms.

- The pattern consists of two gaps that occur in relatively close proximity to each other. The pattern can be completed in as little as four days but usually requires several weeks to form.

- Once you spot the pattern, you should expect the trade to unfold in the direction of the second gap. If prices gapped up, a long trade is

11AnalyzingGapsforProfitableTradingStrategiesyJulieR.Dahlquist,Ph.D.,CMTandRichardJ.Bauer,Jr.,Ph.D.,CFA,CMT,http://docs.mta.org/pdfs/2011-dowaward.pdf

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set up. On a down gap, you should sell any long positions or buy a put to benefit from the expected down trend.

- Islands do not offer any technique to find a price target. The trades should be held as long as the trend continues. Momentum indicators like the relative strength index (RSI) or MACD can be used to spot the end of the trend.

- An island should be considered negated when prices close below the bottom of the island pattern for a long trade or above the top of an island for a short trade.

The Test Results Testing shows islands tend to provide an average gain of about 20% within several weeks after a breakout. This large potential gain makes them appealing to traders. These patterns are easy to identify and because they offer a high potential profit in many cases, they should be a part of every trader’s toolbox. Islands are similar, in many ways, to the abandoned baby candlestick patterns. Candlesticks are short-term patterns that consist of just one to three bars. The abandoned baby consists of a single doji candlestick with windows on either side of the doji. Traders can spot a number of patterns using candlestick charts to identify times when the trend of the market is likely to change. One of the simplest patterns is the doji which forms when the body is very small, indicating the open and close were very close to each other and price was almost unchanged. Traders believe that dojis represent a period of indecision in the market and the battle between the bulls and bears has resulted in a draw without a clear winner. These times when buying and selling pressures are relatively balanced usually don’t last long and the doji often signals a large price move is coming. Dojis are single candlesticks where the open and close are the same or very close together. This price action makes the body of the candle look

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like a horizontal line. The length of the wicks will vary and that can offer a clue as to whether a doji pattern is expected to be bullish or bearish. Although there are many variations, three common dojis are shown in Figure 25. If the open and close are near the middle of the price action, the doji is sometimes called a Rickshaw Man. This is believed to show a market

where the forces of demand and supply are relatively in balance. The Rickshaw doji on its own doesn’t offer any clues about the future direction of prices but this type of doji is often thought of forecasting that a big move is likely. Gravestone dojis occur when the open and close are near the low of

the day. It is named a ‘gravestone’ because it looks a gravestone with its base buried in the ground and its length extending above the ground. It

is a bearish signal since it shows that prices could not hold on to the gains they achieved during the day and fell all the way back to the day’s low which was near the open. A Dragonfly doji is formed when the open and close are both near the high. Although prices moved lower as the dragonfly formed, buyers appeared near the lows and pushed prices back up towards the high by the end of the day. This is considered bullish because it shows buyers are waiting to act when prices reach a bargain level. The abandoned baby is a rickshaw doji with a gap on both the day before and the day after the doji forms. In candlestick charting, a gap is called a “window.” Abandoned babies are relatively rare patterns because the requirements for the pattern are so precise with two gaps required to form along with a specific pattern for the open and close on the day the doji appears.

Figure25:Dojiscantakevariousformsbasedontherelationshipoftheopenandclosetotheday’shighandlow.

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There are dozens of other candlestick patterns that have been identified by traders. Many software programs and web sites can scan for candlestick patterns and help traders find possible buys and sells. Testing shows that one pattern is the most reliable and that is the fifth pattern that you can use to consistently make money.

5. Three crows Bodies of traditional candlestick charts are colored black if the close is lower than the open. In many charting software packages these candles are now red but the traditional black and white candlesticks provided some patterns with their names. Three crows is a pattern consisting of three down bodies and is sometimes called three black crows. Candlesticks have been used for hundreds of years in Japan but were introduced to traders in the United States by Steve Nison in 1991.12 Nison explained black-filled bodies of candlesticks that appear after an uptrend represent “the image of a group of crows sitting ominously in a tall dead tree” and “the three crows have bearish implications.” A perfect three crows pattern is shown in Figure 26. The crows appear at the end of an uptrend. The three candles providing the name for the patter should close at, or close to, the daily lows. Each close must be lower than the day’s open. Each of the candlesticks should open below the open of the previous day.

12Nison,Steve.JapaneseCandlestickChartingTechniques(1991)NewYorkinstituteofFinance.

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Nison provided examples showing the pattern was bearish. This was based on his observations and what he learned from Japanese traders rather than empirical testing. Since Nison’s book was published, it has become a relatively trivial task to program candlestick patterns and objectively test them. Most of the patterns fit Nison’s observations which reflected beliefs candlestick traders had developed over hundreds of years. However, some of the tests have led to surprising results. Three crows, according to test results, is actually a bullish pattern. Most of the time, this pattern is actually a short-term consolidation instead of a reversal pattern. It is a highly reliable pattern when viewed as a consolidation. Traders should expect a sharp up move after they observe three crows. Many of these trading setups deliver gains of 10% or more in a short amount of time. An example of a trade based on this pattern can be seen in Figure 27. After a brief uptrend, three crows appear and a buy is entered for the next trading day. There is no price objective for this pattern so a simple time exit strategy is used in this example. With a time exit, a trade is closed a certain number of days after it is opened. In this case, the trade is closed ten days after it is opened. The sell is not completed at the exact top of the up move but the trade is still profitable.

Figure26:AtextbookrepresentationofthethreecrowspatternasshowninNison'sbookoncandlestickcharting.

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Figure 27: An example of a trade based on the three crows pattern on a daily chart of TAP. Three crows also appear on weekly charts. The next chart shows a signal that occurred during the 2008 bear market. While most stocks were experiencing large losses, IBM gave a three crows buy signal on the weekly chart in November 2008. This chart also shows a simple ten-bar time exit strategy and in this case sells ten weeks after the buy signal.

Figure 28: Three crows are also found on weekly charts. This is an example of a trade in IBM.

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In Figure 28 we see the general pattern appear although it does not meet the textbook definition. The important elements of the pattern are found – the close is lower than the open for three consecutive days and the close is lower than the previous close for each of the three days. The close is not at the low as purists would demand to meet the requirements of the pattern. But, as this chart illustrates, excellent results can be achieved with patterns that meet most of the requirements. Three crows can also be used by intraday traders. Figure 29 is a 15-minute chart of Chipotle Mexican Group which trades under the symbol CMG. The first down candle, identified as 1 in the chart, records a small decline of just $0.06 or 0.2% of the price. But it is a down day and that is all that’s required for a candlestick to count as a crow.

Figure 29: Three crows can also be used by day traders as this chart demonstrates.

This chart uses the same exit strategy applied to the daily and weekly charts, closing the trade 10 bars after the buy signal. These charts again illustrate the general rules for trading the pattern:

- You can begin looking for three crows after you see the first two bars of the pattern appear on a chart. Three crows must appear at the end of an uptrend so look for the pattern only when the price has been moving up for at least two bars.

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- Identify three consecutive bars where the close is lower than the open and the close is lower than the previous close.

- Ideally the low will be near the close but interpret this condition generously to identify the largest number of possible trading opportunities. As long as the low is below the midpoint of the day’s trading action you should consider the pattern requirements to be met. To find the midpoint of the day, take the average of the high and low. As long as the close is below that value, the candlestick should be included in the pattern.

- There are no price objectives for this pattern. Trades can be closed with a time exit or a momentum indicator.

You can obtain excellent trading results combining this pattern with a momentum indicator as explained in the next section. The Test Results Three crows is among the most reliable candlestick patterns. The fact that this pattern can be traded profitably is unusual because most candlestick patterns are not reliable in testing. Trading this as intended in the textbooks, using it as a sell signal rather than as a buy signal, would in fact be unprofitable. It was so unprofitable as a sell signal that testers quickly realized it must have some value as a bullish indicator. Test results demonstrate that three crows often serve as a prelude to a large price gain. This is especially true when the stock or ETF becomes deeply oversold as the pattern develops. Oversold is a condition defined by technical indicators such as RSI. RSI is an oscillator that moves between, or oscillates, between values of 0 and 100 based on the price action. Based on the way RSI is calculated, it moves towards 0 when the stock is selling off and 100 when the stock price is moving higher. Values below 20 are considered oversold and readings above 100 are overbought. Oversold stocks are those which are believed to have moved too far, too fast while overbought means traders have the pushed the price up too much, too fast.

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Just like the three crows pattern, RSI works best when it is applied differently than its developer intended. RSI was introduced to the trading world in 1978 by Welles Wilder.13 Wilder used 14 days to calculate RSI and this became the default value in the calculation. Later, Larry Connors and Cesar Alvarez demonstrated that using just two days in the calculation would offer better results for short-term traders.14 The combination of the 2-period RSI and the three crows pattern can identify winning trades 70 to 80% of the time in testing. This strategy can be easily programmed into trading software to buy after three down days when the 2-period RSI is below 20. Trades can be closed when the 2-period RSI rises above 50. This provides an alternative exit strategy to the time exit described above. An example of this trading strategy is shown in the next chart.

Figure 30: This chart combines the three crows pattern with the 2-period RSI.

In the chart, you can see some patterns will not be traded because they will not be confirmed by the momentum indicator. This is a simple tool to increase the likelihood of a winning trade. The win rate will be higher

13Wilder,J.Welles.NewConceptsinTechnicalTradingSystems(1978).TrendResearch,McLeansville,NorthCarolina.14Connors,LarryandAlvarez,Cesar.ShortTermTradingStrategiesThatWork.TradingMarkets,JerseyCity,NewJersey,2008.

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because you are adding conditions to the trade. Each additional requirement for a buy signal will result in fewer trading opportunities but well-designed conditions should increase the win rate. This particular strategy also results in a short holding period which should lead to a high win rate but a small average gain on winning trades. This strategy is suitable for many traders but may not be right for traders looking for larger gains.

Conclusion

Chart patterns have been used by traders for centuries. Although many patterns are popular, only a few are truly useful for traders seeking consistent profits. The five patterns identified in this report are among the most consistently profitable patterns. Each can be traded using the general rules detailed in this book.

To generate consistent profits, it will be important to trade the patterns consistently. This means trade on a schedule. You never know which week of the year will be the biggest winner. Missing that week is likely to have a significant impact on your trading performance that year. The same is true when trading patterns. If you miss the biggest winners you will have a difficult time beating the markets. If you have the time to review the stock market daily, you should consider trading daily charts. Otherwise you may find weekly charts are the best choice for you.

Once you have a consistent schedule, develop consistent rules. For each pattern, we have included a section defining general trading rules in a bullet format. This style choice was deliberate. We encourage you to use those bullets as the starting point for creating your personal trading checklist.

After you have a checklist, stick with it in bull and bear markets. The key to consistent profits is disciplined trading. High probability chart patterns like the ones detailed here are profitable only when they are traded consistently.

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