POPULAR STOCK PATTERNS WORK…UNTIL THEY DON’T

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If you are a technical trader as I am then you look to exploit historical, high probability  stock patterns that are likely to repeat themselves over and over again.  Indeed, the very definition of technical analysis is the discipline of anticipating the direction of future prices based on historical data.   

On the other hand, you have the fundamental analyst who attempts to take into consideration a wide variety of variables such as interest rates, balance sheets, management and competitive advantages, growth potential, etc. in order to arrive at a projected price at some time in the future.  Just think of an analyst who upgrades or downgrades a stock based on valuation or fundamentals and then gives a price target for the stock.

TWO APPROACHES…SAME RESULT

Now, look at the core belief inherent in both of these market approaches: each analyst, whether fundamental or technical, anticipates future prices based on historical data.  Is there really a difference?  Along the same lines can a fundamental analyst assessment of the future price of a stock be incorrect?  Absolutely!  Can the technical analyst be incorrect about her pattern projecting the future direction of a stock’s price?  Most assuredly!  Which brings me to my current discussion. 

If a  fundamental analyst can get it wrong (and they often do), so can a technical analyst get it wrong with a highly probable stock pattern.  Keep in mind that probability assumes the likelihood that a certain event will occur.  This likelihood is based on historical data that is not 100% correct but shows a high rate of success over a period of time and with a high enough sample size.  In other words, if I based my technical analysis on historical data from the past year that produced three profitable trades and no losers would that give an accurate assessment of the pattern?  I would say no. If, on the other hand, I based the reliability of my stock pattern on 50 trades over the last 10 years of data, then the probability (and the reliability) of this pattern would be much greater. 

CROSSHAIR SOFTWARE

Let’s look at an example from my CROSSHAIR pattern.  Using TradeStation®, I have developed a software program that will alert me when my high probability CROSSHAIR has formed on any of the stocks in my trading arsenal.  The stocks in this arsenal have an average $1 million shares traded a day, are over $15 a share, have at least a 1.5 BETA, and are optionable.  TradeStation® can perform a probability analysis based on historical data which allows me to assess the historical success of this pattern over a given period of time.  In the following reports I use 10 years of historical data (except in the case of ICE or GOOG, neither of which have been public for 10 years) and assume exiting the trade with a 10% profit.  The loss target is based on an aggressive horizontal loss line.  100 shares were purchased with each trade. All of these reports can vary significantly based on a wide array of market conditions and trader mentality.  These are merely imputs.  And, of course, past results are not indicative of future performance. 

GOOG

ICE

RIMM

RTP

GS

 

Notice in the reports how profitable the strategy is over time but also notice that the strategy does not “work” 100% of the time.  Over a period of time with proper money management, emotional control, and consistent application of the strategy, the trader can make money.  My trading strategy is not the holy grail (nothing is!); only a high probability strategy that can consistently make money over time. Why do I choose to show the losses as well as the winners?  Because false expectations can keep a promising trader from becoming a successful one. 

A STOCK PATTERN WORKS UNTIL IT DOESN’T

I have said it before here and I will say it again:  if you read an advertisement or listen to a guru who says he has the way to riches in the market with a system that works 90-100% of the time you better run!  No system or strategy works 100% of the time and never will. 

Following is a recent chart of GG.  Notice there was a signal to buy on 12/2/2009 and then it immediately reversed. 

 

Looked good with a CROSSHAIR and a breakout to new recent highs but it failed.  Even Thomas Bulkowski, the king of stock pattern recognition, will be the first to tell you that no pattern works 100% of the time.  In fact, many work less than 50% of the time but you can still make money trading them.  Get this and you will be on your way to properly understanding how to trade well:  NO PATTERN OR SYSTEM WORKS 100% OF THE TIME.  My software gives alerts almost every day but I always have other criteria to check that raises the probability of its success before I actually pull the trigger (you can check these out under the CROSSHAIRS category).   Get out when it does not work and save your money for the next trade that may be just the one that does work.

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