According to Thomas Bulkowski, a popular and highly probable stock chart pattern used by many traders, has lost much of its profit potential. In the most recent issue of TECHNICAL ANALYSIS OF STOCKS & COMMODITIES (MAY 2009) on newsstands now, Bulkowski discusses the BREAK OUT PATTERN and comes to some very interesting and eye opening conclusions.
Mr. Bulkowski is best known for his statistical analysis of stock patterns which he covers in great detail in his many books, specifically Encyclopedia of Chart Patterns. His most recent book is entitled Encyclopedia of Candlestick Charts. He also has an excellent website dedicated to his research with over 400 pages of free price pattern research. I suggest you take a look (thepatternsite).
In his article entitled, “Do Chart Patterns Still Work: Has the Failure Rate of Chart Patterns Increased in Recent Years?” Mr Bulkowski uses the following parameters for his investigation:
I used 13,932 chart patterns spread over the years from 1991 to 2008. I did not use all of the chart pattern types in my analysis but concentrated on 23 of the most common and popular. They are: diamond tops and bottoms; double tops and bottoms (eight types of Adam and Eve combinations); triple tops and bottoms; rising and falling wedges; head & shoulders tops and bottoms (four types of simple and complex); ascending, descending, and symmetrical triangles; and rectangle tops and bottoms (48).
Mr. Bulkowski breaks down the investigation into upward and downward breakouts and concludes that the failure rate for these patterns have increased. I will leave it up to you to read the details on your own but suffice it to say the figures are not promising for those who trade upside or downside break outs at the exclusion of other factors.
Here are just some of the factors that should be considered before entering an upward or downward trading pattern:
1. Is there a known news event (such as earnings) that could affect whether or not the stock confirms its breakout? A stock could have a perfect breakout from a recent high/low the day before earnings and then gap way up/down the next morning depending on the sentiment of traders.
2. Could the chart pattern of the general market affect the success rate of the individual stock? Since most stocks will move with the general market, an analysis of the NASDAQ, S&P, DOW, etc. could be beneficial in determining the success or failure of the individual stock’s next move. Is the NASDAQ breaking out along with your AAPL trade? Is the DOW breaking out with your GE trade?
3. Are there any points of resistance/support on the major indices and/or individual stocks that could stall or reverse the breakout? These resistance/support areas could be in the form of major moving averages such as the 200, 50, 21 SMA (TANKS) and are used by traders as buy/sell signals. Or they could be in the form of recent recent high/lows in a channel that have refused to be broken in past attempts.
4. Do other indicators you use contradict the break out? In other words, are you showing MACD bearish divergence with an upward breakout? Or bullish MACD divergence with a breakdown? Or does the breakout day show a reversal candlestick? There could be a clue here that the breakout pattern is false. If you do not use other indicators (without analysis paralysis!) to confirm patterns then you may be missing an important piece of the puzzle.
Below is a chart of the S&P 500 from May 2008. Even though there was a recent breakout in price, my CROSSHAIRS indicators, along with 200 TANKS as resistance, bearish divergence, and a DOJI candlestick pattern did not confirm the breakout pattern and thus began a long move down in the market.
If you look at your charts from May 2008 I am sure you will find many examples of individual stocks that failed to breakout along with the general market, thus confirming the need for multiple factors when considering a trade decision.
Mr. Bulkowski’s research is to be commended, here and elsewhere. However, I am sure that Mr. Bulkowski would agree that pattern trading alone should not be used for trading decisions and that other factors should be taken in consideration before entering a trade. The failure rate would be much less and would vary greatly from one trader to the next.
