Chart Pattern Trading Strategy — What Is It? (Backtest)
Last Updated on May 29, 2023
As a technical trader, you must have encountered some chart patterns. They are an integral aspect of technical analysis, especially for discretionary traders. But what is a chart pattern trading strategy?
A chart pattern strategy is based on recognizable shapes on the price chart created by price movements. They can be identified with the help of trend lines, horizontal lines, and curves. In technical analysis, chart patterns represent a period of consolidation, which can signal a continuation of the prevailing trend or a transition from one trend to another.
In this post, we take a look at chart patterns and how to use them in trading. At the end of the article, we provide you with some data-driven statistics.
What is a chart pattern?
Chart patterns are recognizable shapes on the price chart created by price movements. They can be identified with the help of trend lines, horizontal lines, and curves. They are distinctive formations created by past and current movements of a security’s price on the chart. A pattern can be identified by a line that connects common price points, such as closing prices or highs or lows.
Chart patterns are created by price bars clustered around the same level over several trading sessions. They can indicate how the price will likely move in the near future, as they are created by the action of traders and investors as they are buying and selling their positions in different timeframes. These patterns can be as simple as two trendlines showing a triangle and as complex as double head-and-shoulders formations.
Price patterns are the basis of technical analysis. Many trading patterns are formed as price consolidations after a trend in one direction, so they may either signal a continuation of the prevailing trend or a transition from one trend to another. In chart pattern analysis, technical analysts and chartists (technical analysts who study naked price actions on charts) seek to identify patterns as a way to anticipate the future direction of a security’s price.
What is chart pattern analysis?
Chart pattern analysis is a form of technical analysis that studies the price charts to identify chart patterns and use the patterns to analyze the current price movements so as to predict how the market is likely to move in the future. The shape of the chart formation and the nature of the price movement preceding it help analysts to forecast what the price might likely do next.
These patterns can be identified in any type of chart — candlestick chart, bar chart, and even line chart — but they are better appreciated on the candlestick chart. By analyzing chart patterns, traders can spot tradable opportunities. While some of the patterns signal a change in trend, others indicate that the trend may continue in its current direction.
Traders and analysts use trendlines to delineate the chart patterns, even though the shapes of the chart patterns may be recognizable without the help of trendlines. This not only helps the chartist to properly see the shape but also marks the boundaries of the pattern for easy identification of a breakout. In fact, the essence of chart pattern analysis is to know how to trade the pattern, and in most cases, it is by trading breakouts. If you understand how to read those patterns, you can spot profitable trade setups that show how institutional traders play their game.
Are chart patterns profitable?
There is no yes or no answer to this question. Chart patterns may be subjective, and they tend to appear in hindsight — you tend to identify them after the price has moved from the pattern. They are difficult to spot as they are being formed. So, even if they work, you’ll not be able to profit from it. That is to say, by the time the chart pattern is confirmed, the price has moved away, and a good part of the profit has already been realized by those who cause the patterns in the first place.
This is why we are a bit skeptical about chart patterns. We are not saying that chart patterns don’t work. We believe most traders are better off trading with strategies that can be quantified, and chart patterns are not easy to quantify or trade. For most people who trade it discretionarily, the pattern may be combined with other conditions that are not dependent on the pattern. Whichever, it is difficult to say whether chart patterns work or not.
The most successful chart patterns
There are many chart patterns, but these are the most popular ones:
Head and shoulders
The head and shoulders pattern is considered a potent reversal pattern that may signal the end of an uptrend and the beginning of a downtrend. It consists of three price swing highs and two intervening price swing lows, with the middle swing high (the head) being higher than the other two swing highs (the shoulders).
Being on the left side of the head, the first swing high is called the left shoulder, while the third swing high is called the right shoulder because it lies to the right of the head. A line connecting the two swing lows is known as the neckline. This line serves as a support level that must be broken for the pattern to be completed.
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Backtested trading strategies
Most people take a short position when the price breaks below the support level, but some aggressive price action traders may enter a trade earlier when the right shoulder is formed if there is a bearish reversal candlestick pattern, such as the shooting star, bearish engulfing, and inside bar.
Regardless of the entry method, the profit target is estimated by measuring the height of the head from the neckline and projecting it downwards from the neckline. The stop loss can be kept above the right shoulder for a breakout entry or above the head if the trade entry is at the right shoulder. See the chart below:
The double bottom is another common reversal chart pattern. It can be seen at the end of a downtrend and signals a potential reversal from a downtrend to an uptrend. The pattern consists of two swing lows and a swing high in-between. The two swing lows end around the same level, which indicates that level is likely an established support level. The line connecting the swing high with the preceding swing high is known as the neckline, which is a resistance the price must break to start an uptrend.
The pattern is considered completed only after the price has broken above the neckline. When that happens, it shows that the price is about to turn and start heading upward. Those who trade this pattern take long positions when the price breaks above the neckline. The profit target is estimated by measuring the size of the pattern and projecting it upward from the neckline. The stop loss order can be placed in the middle of the pattern, which offers a 2:1 reward/risk ratio, or below the pattern, which is a bit safer but offers poor reward/risk. See the chart below:
The triangle pattern
The triangle pattern is considered a continuation chart pattern. When it forms, traders anticipate a breakout in the direction of the preceding trend which signals the continuation of that trend. The pattern is shaped like a triangle, which can be of three types: symmetrical, ascending, or descending triangle.
For example, the symmetrical type is formed by a series of descending swing highs and ascending swing lows. So, you delineate the pattern by attaching a descending trend line along the swing highs and an ascending trend line across the swing lows to show its descending resistance level and an ascending support level.
The pattern is completed when the price breaks out of the pattern. The price can break out from any side, irrespective of the direction of the trend before the pattern occurred, but it is more likely to break out in the direction of the pre-existing trend. The target is estimated by the base of the triangle. The chart below shows a symmetrical triangle, with the price breaking out above the upper trend line.
Pennants and flags
These are another set of continuation chart patterns. They form as small price consolidations after a swift price movement. A pennant is a small triangular price consolidation following a swift move, while a flag is a small horizontal or slanting consolidation channel following a fast price movement.
Both patterns can be bullish or bearish. When form in an uptrend, they are bullish pennants or flags, and when they form in a downtrend, they are bearish pennants or flags. The chart below shows a bearing flag in the Brent Crude Oil price chart.
Can you backtest chart patterns?
Yes, you can backtest chart patterns manually as a discretionary trader, but manual backtesting is not usually reliable. The results are often subjective and heavily influenced by the trader’s experience and preferences. Any chart pattern strategy requires strict trading rules, signals, and settings – something which is pretty difficult to quantify for most chart patterns.
No matter what many people think, discretionary trading is extremely difficult to be profitable in today’s world. So, any manual backtesting that claims chart patterns are profitable or not is likely biased. We recommend that you quantify all your strategies and backtest them. Most traders don’t have an edge in the first place and they don’t know it because it’s an untested strategy.
So, we are a bit skeptical about using chart pattern strategies. We like data-driven strategies with proven historical performance.
Thomas Bulkowski wrote a pretty long and detailed book called The Encyclopedia of Chart Patterns (published in the year 2000). He made a decent try when he manually looked at chart pattern formations over a five-year period for 500 different stocks. He compiled the results into tables with failure rates, success rates, most likely gain, most likely loss, and several others.
The results are interesting, but unfortunately, the results are not based on 100% quantified rules. Thus, we wouldn’t base any trading strategy on those results.
All in all, a chart pattern strategy is most likely not based on any quantification at all. Thus, how do you know you have a profitable trading strategy? (Unless you have a long and detailed trading log or journal.)