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The Candlestick Trading Bible

Candlestick Trading for Maximum Profits

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By design, 3-point chart patterns are useful for determining trend reversals. However, 3-point chart patterns of the continuation type also can provide valuable information.

Chart patterns are among the most important investment tools available. They express investor behavior and provide a rare consistent element in the analysis of structures in price data.

Valid chart patterns do not occur too often, and traders have to look for them. It takes great patience to work with 3-point chart patterns. On the other hand, traders have to act instantly on most breakouts, and executing trades based on 3-point chart patterns requires considerable experience.

A few results of empirical research may be helpful in understanding chart patterns. We are grateful for the efforts of Thomas Bulkowski in sorting chart patterns according to statistical criteria. Readers of his works will find a statistics summary that includes performance statistics for all of the chart patterns discussed in his encyclopedia (Bulkowski, pp. 654-657). In the following paragraphs, we refer to the findings of Bulkowski for the 3-point chart patterns we have tackled (and some of the candlestick patterns discussed earlier).

Before showing the statistics in tabular form, we need to state Bulkowski's criteria.

Bulkowski defines a failure rate, which is the percentage of formations that do not work as expected, including 5 percent failures. The numbers apply to formations once they stage a breakout (confirming the formation).

Bulkowski also distinguishes between reversal or consolidation. The letter "R" appears if the majority of formations act as reversals of the price trend, and the letter "C" appears for consolidations (or continuations, as we call them). If both R and C appear in an entry, then the chart pattern has no overriding majority of either type.

Furthermore, Bulkowski separates throwbacks from pullbacks. A throwback is an upside breakout that returns prices to the top of the formation or trend line boundary. A pullback is a downside breakout that returns prices to the bottom of the formation or trend line boundary. Both occur after a breakout and return within 30 days. The percentages for throwbacks apply to formations with upside breakouts only; pullback percentages apply to downside breakouts only.

In addition, Bulkowski provides a measure for average rise or decline. He typically measures the average rise or decline from the price on the breakout day (using the daily high or low) that is closest to the formation. The ultimate high or low is the highest or lowest point before a significant change in trend (typically a 20 percent price change, which is measured high to low).

From these figures, Bulkowski computes a value for likely rise or decline and tabulates a frequency distribution of the results. The most likely rise or decline is the range with the highest frequency and usually excludes the rightmost column.

Most important to our readership is Bulkowski's rank by score. He separates the table entries into bullish (1 to 35) and bearish (1 to 32) formations and then ranks them by their score. The score is the average rise or decline times the most likely rise or decline divided by the failure rate. The best rank is 1. Bulkowski used bull market data for the five years beginning in mid 1991.

Table 4.11 lists the relevant (in the context of this book) 3-point chart patterns—and related candlestick patterns—in alphabetical order.

Table 4.11 Summary of Statistics for 3-Point Chart Patterns (and Candlestick Patterns)

Failure

Rev.

Rank

Rate

and/or

by

Formation

(%)

Cont.

Score

Broadening wedge, ascending

6

R

13

Broadening wedge, descending, down

41

R

25

Broadening wedge, descending, up

41

R

25

Double bottom

3

R

4

Double top

17

R

21

Hanging man, down breakout

22

C

27

Hanging man, up breakout

67

R

33

Head & shoulder, bottom

5

R

9

Head & shoulder, top

7

R

11

Key-reversal day, bottom

17

R

29

Key-reversal day, top

24

R

26

Rectangle bottom, down breakout

4

C

8

Rectangle bottom, up breakout

0

R

32

Rectangle top, down breakout

0

R

31

Rectangle top, up breakout

2

C

1

Triangle, ascending

2

C

3

Triangle, descending

4

C

6

Triangle, symmetrical, bottom, down

2

C

2

Triangle, symmetrical, bottom, up

3

R

5

Triangle, symmetrical, top, down

6

R

10

Triangle, symmetrical, top, up

5

C

11

Source: Trading Classic Chart Patterns, by Thomas N. Bulkowski (New York: Wiley, 2002), pp. 655-657. Reprinted by permission of the author.

Source: Trading Classic Chart Patterns, by Thomas N. Bulkowski (New York: Wiley, 2002), pp. 655-657. Reprinted by permission of the author.

The table indicates that some of the chart patterns we have stressed do well and prove reliable in practical trading, at least according to Bulkowski's rank by score.

The greatest advantage of working with chart patterns is that skilled traders can execute them without elaborate computer programs. Although the 3-point chart patterns may look somewhat old-fashioned, they are powerful trading tools.

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