The always hot and new question that analysts and traders ask themselves is when price moves come to an end and change direction.
There are many ways to approach this problem with technical analysis. Traders have identified hundreds of chart patterns and formations. In this section, we concentrate on the ones that have at least three peaks or valleys on one side of the chart pattern. This restriction eliminates many of the popular formations, but it reduces the number of trades and makes it much easier to identify chart patterns.
Our approach comes very close to the wave count from Elliott. In contrast to Elliott, however, who counted three impulse waves and two corrective waves in an uptrend or downtrend for a complete price move, we focus on the total number of five waves. It makes little difference whether the market moves up, down, or sideways. After 5 waves, the market price often changes its direction, no matter whether it is a trending pattern or a sideways pattern. The only difference is the profit potential. As long as traders rely on precalculated profit targets, a buy or sell signal at the end of a sideways pattern might even be safer than at the end of a 5-wave uptrend or downtrend.
Even more important is that we can combine the 3-point chart patterns with Fibonacci trading tools or candlestick chart patterns. This combination separates our approach from many other strategies available in this field.
Most knowledgeable books on the topic of pattern recognition were written decades ago. However, Thomas N. Bulkowski has written two books* that go far beyond the content of competing books. The
* Thomas N. Bulkowski, Encyclopedia of Chart Patterns (New York: John Wiley & Sons, 2000). Further references will cite Bulkowski; Thomas N. Bulkowski, Trading Classic Chart Patterns (New York: John Wiley & Sons, 2002).
Encyclopedia of Chart Patterns and Trading Classic Chart Patterns provide detailed computer studies for many chart patterns that were tested on 500 stocks and backward for five years. Bulkowski writes:
To knowledgeable investors, chart patterns are not squiggles on a price chart; they are footprints of the smart money. The footprints are all they need to follow as they line their pockets with greater and greater riches. They are the one making the footprints. They are the smart money that is setting the rules of the game—a game anyone can play. It is called investing. (Bulkowski, p. 3)
We recommend this book to anyone who is interested in chart patterns. In the following discussion of selected patterns, we refer to Bulkowski's key studies.
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