Background
I created this indicator in mid 2007 to help determine the best time to invest.
The theory behind the chart pattern indicator is simple: bullish chart patterns appear
near market bottoms and are sparse near market tops. For example, you rarely find double
bottoms when price makes a new high but you will find double tops instead.
The chart pattern indicator is the ratio of a count of bullish patterns to total
patterns (bullish and bearish), expressed as a percentage from 0 to 100. If the indicator
is below 50, then more bearish patterns appear so the trend is bearish. When the indicator
is above 50, that is bullish because of the plethora of bullish patterns.
The indicator can use many different chart or candlestick patterns or it can use just
one. The buy and sell thresholds can vary, too, as well as the number of stocks involved
in the test and the time period tested.
Patternz, which has the chart pattern indicator built into
the program, makes finding and charting the indicator easy. All you have to do is throw
a bunch of stocks at it and select the appropriate chart patterns or candlesticks to test.
Results
The above chart show the S&P 500 index from April 4, 2007 to February 15, 2008. Below
the bar chart is the chart pattern indicator (squiggly blue line that probably looks black). Bullish and bearish thresholds
are optimized by the Patternz program to give the best performance, but I turn that off. In this example,
the buy threshold (green line) is 65 and the sell threshold
(red line) is 35. I used the NR7 indicator (narrow
range 7) in the test with the breakout method. The NR7 pattern occurs when the intraday
(high-low) price range is narrower than the preceding 6 days. I used 548 stocks from my
database (click here for details about the
stock list) on the daily scale. The breakout method waits for price to close either
above the top or below the bottom of the chart pattern to determine whether to score the
pattern as bullish or bearish, respectively. In this case, price has to close higher than
the 7 days in the pattern to be bullish and below the 7 days to be bearish.
This is the same chart as the prior one but the buy and sell signal bars are overlayed
on the chart. This shows how well the indicator is at predicting market turns,
at least for the period shown.
On this chart, only the first signal of one color appears and not every signal. As a trader, I
am interested only when we get a signal change from bullish to bearish or the reverse, so I told the
program to only show those polarity changes. You could, if you wanted, see every signal. In that case,
you would see many green bars followed by red bars. Some of the bars would be clear where the indicator
is neutral.
Warnings
The following is a series of warnings on what you may discover in the indicator
and why.
For the NR7 indicator, I use the breakout method, one of two methods offered by the Patternz
program. In the breakout method, I wait for a close either above the top or below the bottom of
the NR7 to signal a bullish or bearish pattern. If an NR7 completes today, it will not
be counted as bullish or bearish until sometime in the future (when the breakout actually occurs).
Thus, the current pattern count is expected to be 0 or very low because few or no breakouts have occurred. As each trading day is tallied,
the counts will change as more NR7s stage breakouts. In my analysis, I have seen the delay vary
from 6 days to much longer until the numbers stabilize. It all depends on how long it takes a stock to move up or down enough
to create a breakout. To fix this problem, I configured the program to only count breakouts that
occur within 7 days of the NR7. If price has not broken out by then, then it is discarded.
As securities are added to the list or removed from the list scanned, the indicator may change because
the counts may change. Thus, a chart from today compared to one a year ago may appear slightly different
because the stocks were added to or removed from the database. This assumes the program is configured in
the same manner, of course.
Much of the following applies to Patternz and the results from that program.
If you do not use enough securities, you will not get an accurate picture of the indicator.
How many is enough? I think at least 125 securities will give good results but it depends on how many
price patterns are found. The more patterns found, the better the result will be.
If you change data, then you are going to see a different result. The Patternz program makes
it easy to fall into the trap of expecting the same results regardless of what data you throw at it.
You see the same stock or index plotted and yet you get different results.
Why?
Think of it this way. Imagine you plot the RSI or MACD indicator against a stock. Now, pick another
stock and plot the same RSI or MACD indicator. Would you expect to see exactly the same result? No. Why then
do you expect to see the same result when you change the data presented to the chart pattern indicator?
The chart pattern indicator counts chart patterns. If you change the data, the count totals will be different,
sometimes dramatically so but sometimes not.
The indicator is only as good as the chart pattern recognition system. If Patternz keeps finding
bogus rectangles, for example, then the indicator results will be flawed. I chose the NR7 because it
does not have pattern recognition flaws and it tested well.
When the data starts also determines what the indicator looks like. Oddly, a shorter begin and end
date period may create MORE chart patterns than dates farther apart. Why? Because the trend
leading to patterns may be unknown. Thus, for shorter dates, a triple bottom may exist because
Patternz cannot tell if the prior trend is up or down leading to the start of the chart pattern.
For an earlier begin date, the trend is clear and a triple bottom may not be a "bottom" at all,
because the price trend is moving up into the chart pattern. Thus, changing the dates may
change the results you see. This should not affect how NR7 works because it does not depend on the price
trend leading to the chart formation like some other chart patterns do.
Since the results vary with the markets under test, the number of securities used
in the test, and the price patterns selected, you will have to configure and test the
indicator for your situation. If you see a horizontal blue line (the CPI line) at 50, then no patterns
were found during that time. Additional securities may be needed to plug the hole.
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