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Thomas Bulkowski’s successful investment activities allowed him to retire at age 36. He is an internationally known author and trader with 30+ years of stock market experience and widely regarded as a leading expert on chart patterns. He may be reached at

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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information.

This article discusses chart pattern confirmation, what it means, and the probabilities of success if you decide to trade before confirmation.

 

Results Summary

Confirmation means waiting for price to close outside of a chart pattern trendline or above the top/below the bottom of a chart pattern, depending on the type of pattern.

If you decide to trade after the chart pattern forms (such that many can recognize the twin peaks of a double top, for example) but before confirmation, your probability of price actually confirming the pattern is 35% to 37% in a bull market for chart pattern tops and 56% to 57% for bottoms.

That means you should not try to short a stock before confirmation, but the risk is nearly random for long trades.

What is Confirmation?

Picture of Apple Computer (AAPL) on the daily scale.

I show a picture of Apple Computer (AAPL) on the daily scale. Is AB an Adam & Adam double bottom chart pattern?

No.

Why not? Because it doesn't confirm. What does that mean?

Before squiggles on a chart become an actual chart pattern, price has to confirm the chart pattern. In this example, price has to close above the top of the peak between the two bottoms. That is point C in the figure.

As the red line shows (drawn horizontally at the price of C), price does not close above the line even though it does pierce the red line.

Price closes below the lowest spike at D, invalidating the potential double bottom.

Pattern AB represents squiggles on the chart. It's not a double bottom.

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Why is Confirmation Important?

Picture of Apple Computer (AAPL) on the daily scale.

David wants to own Apple and sees the potential double bottom at AB (see chart). He waits for price to climb so that he knows the trend has changed from down to up. A breakaway gap appears at E and that is the signal he has been waiting for. He buys on the black candle just after E. The next day, another gap appears but this could be a continuation gap. Continuation gaps follow breakaway gaps. He continues to hold.

However, two days later, price stalls at the price of the old high at C. The continuation gap is really an exhaustion gap. He now expects a retrace, but since the position is profitable, he doesn't worry.

The stock moves horizontally and he holds onto his position. He expects an upward breakout from this "handle" and is confident of a move up.

Price breaks out downward instead. This shocks him. He holds on, not knowing what to do. Then price bottoms in late May and begins another move up. "Whew!" he says, but the up move is short. Going into June, the stock plummets and at D, when price closes below the bottom of the unconfirmed double bottom, he sells. Of course the stock recovers after that.

Why is confirmation important? Because it prevents a trader from losing money like David did.

How often does buying or selling short before confirmation lead to an unconfirmed pattern like the one shown above?

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How Often Do Unconfirmed Chart Patterns Fail?

To answer that question, I used my database of over 1,000 stocks covering the 1970s to 2011. Few stocks covered the entire range. I programmed my computer to automatically find the potential chart patterns listed in the below table. Then I counted how often price closed above the top of the chart pattern (buy long), below the bottom of it (short sale), or when it closed above/below the right armpit (for head-and-shoulders patterns).

The table shows the confirmation failure rate (the rate at which chart patterns fail to confirm). Before I discuss the results, let me issue this warning. The results were found using automated pattern recognition tools, not manually viewing patterns and cataloging them. The most reliable results are for double tops and bottoms (which are easiest to spot automatically) then triples and followed in last place by head-and-shoulders.

As to the results, I found that 53% of chart patterns in two bear markets since year 2000 resulted in unconfirmed patterns. That means if you shorted the stock after the second peak formed but before price had closed below the valley between the two peaks, you would have lost money 53% of the time.

How Often Do Patterns Fail to Confirm?


Chart
Pattern
Bear
Markets
Failure
Rate
Bull
Markets
Failure
Rate
Reliability
Double tops53%63%Most reliable
Triple tops56%65% 
Head-and-shoulders tops33%38%Least reliable
 
Double bottoms50%44%Most reliable
Triple bottoms55%43% 
Head-and-shoulders bottoms31%24%Least reliable

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For bull markets, 63% of double tops failed to confirm.

Since price has a tendency to rise over time, going short in a bull market means increasing the chances of failing. Trying it with a double top means you'll be wrong and lose money 63% of the time if you short before confirmation.

Bottom patterns, which are shown in the lower half of the table, tend to have lower failure rates. Why? Because price tends to rise over time anyway (look at a picture of the Dow industrials from the 1920s until now) and buying into an unconfirmed pattern means a higher chance of success when trading with the market tide.

Notice how double and triple top/bottom failure rates are close together. I attribute that to the software finding valid patterns (as opposed to finding bogus patterns that few would recognize as valid). Head-and-shoulders are either more reliable patterns, or are more difficult to find valid ones (few good samples).

For example, my software found 2,387 double bottoms in a bear market (since 2000) compared to 994 head-and-shoulders bottoms. In bull markets, the samples were 3,039 and 1,176 respectively.

If the head-and-shoulders numbers are reliable, then they are the pattern to trade before confirmation (a close above or below the right armpit for bottoms and tops, respectively).

-- Thomas Bulkowski

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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. A well-adjusted person is one who makes the same mistake twice without getting nervous.