An Introduction to Price Patterns
Figure 1 shows an example of the type of price patterns Price Action Lab discovers in historical price data. The pattern shown in the figure is an inside day
breakout, presented here for illustration purposes only. It is just one possible formation out of literally hundreds of thousands of formations Price Action Lab can identify in price data to satisfy
user-defined performance criteria and risk/reward objectives. The price pattern in Figure 1 has three bars in its formation but Price Action Lab looks for patterns that are formed by a maximum of six bars,
excluding any added delay. These price patterns are solely based on the Open, High, Low and Close of the bars. Price Action Lab does not look for traditional chart patterns although some price patterns
resemble some popular chart formations, such as double bottoms, pennants, triangles, etc. Also, Price Action Lab does not take into consideration volume and other indicators, just pure price action.The
three chart bars labeled 0, 1 and 2 and shown in Figure 1 form this particular price pattern. The most recent bar in the price pattern formation, bar 0, is referred to as "today". Bar 1 is referred
to as "yesterday" and bar 2 is referred to as "2 days ago", and so on. Bar 1 is "inside" bar 2 and hence the cutesy name "inside day". Figure 1. An example of a simple 3-bar price pattern - long entry
Each bar in the formation in Figure 1 has a high, a low and a close price. It may be seen that the close of the last bar, or today's close, is
higher than the high of bar 2 (the high of 2 days ago). This relationship can be expressed mathematically as follows: Close of today > High of 2 days ago
By the same reasoning as above, it is clear from Figure 1 that: Close of 2 days ago > Close of yesterday
The complete description of the price pattern shown in Figure 1 can be obtained by following the same reasoning: High of today > Close of today AND
High of 2 days ago > High of yesterday AND
Close of today > High of 2 days ago AND
High of yesterday > Low of today AND
Low of today > Close of 2 days ago AND
Close of yesterday > Low of yesterday AND
Close of 2 days ago > Close of yesterday AND
Low of yesterday > Low of 2 days ago
The above 8 inequalities uniquely describe the price pattern formation shown in Figure 1. These inequalities (referred to as the "pattern logic")
can be combined with appropriate money management, trade entry point and trading time frame into a complete system. For instance, if the
trade entry is on the open of the day following the price pattern formation, the profit-target is T and the stop-loss is S, both expressed as a
percentage of the entry price, a trading system model for long positions can take the following form: {Time frame: daily}
If {long pattern logic} then
Buy tomorrow on the open with
Profit target price at Entry Price x (1+T/100)
Stop-loss price at Entry Price x (1 – S/100)
By following a similar methodology, every simple price pattern formation can be incorporated into a complete trading system model and used
in back-testing or in generating trading signals. For example, Figure 2 shows a 3-bar pattern for short positions. 
Figure 2. An example of a simple 3-bar price pattern - short entry
The complete description of the price pattern shown in Figure 2 can be obtained by following the same reasoning: High of today > Close of yesterday AND
High of 2 days ago > High of yesterday AND
Close of today > Low of today AND
High of yesterday > close of two days ago AND
Low of two days ago > Close of today AND
Close of yesterday > Low of yesterday AND
Close of 2 days ago > high of today AND
Low of yesterday > Low of 2 days ago
The above 8 inequalities uniquely describe the price pattern formation shown in Figure 2. These inequalities (referred to as the "pattern logic")
can be combined with appropriate money management, trade entry point and trading time frame into a complete system. For instance, if the
trade entry is on the open of the day following the price pattern formation, the profit-target is T and the stop-loss is S, both expressed as a
percentage of the entry price, a trading system model for short positions can take the following form: {Time frame: daily}
If {short pattern logic} then
Sell tomorrow on the open with
Profit target price at Entry Price x (1-T/100)
Stop-loss price at Entry Price x (1 + S/100)
Delay Patterns
Definition: The number of bars to delay placing a trade after a price pattern is formed is called the
delay and the associated pattern a delay pattern. Figure 3. An example of a delay pattern
In figure 3 above, bars 3,4 and 5 forrm the price pattern and bars 2 and 1 are the delay. Adding a delay of 2 bars, produces a signal at the open of bar 0.
The logic of the price pattern with the delay added is then:
High of 3 day ago > Close of 3 days ago AND
High of 5 days ago > Close of 5 days ago AND
Open of 3 days ago > Low of 3 days ago AND
Close of 3 days ago > High of 5 days ago AND
High of 4 days ago > Open of 4 days ago AND
Low of 3 days ago > Open of 5 days ago AND
Open of 5 days ago > Low of 5 days ago AND
Close of 4 days ago > Low of 4 days ago AND
Open of 4 days ago > Open of 3 days ago AND
Close of 5 days ago > High of 4 days ago AND
Low of 5 days ago > Close of 4 days ago
In certain situations, the presence of a delay can turn a losing trade into a winning one. In the example in figure 3, if the trade were to be
placed immediately following the formation of the price pattern (bars 3, 4 and 5) and at the open of the next bar (bar 2), it would turn into a
open position loss by the close of bar 1, even hitting a stop-loss, depending on the price levels. Placing the trade at the open of bar 0, instead
of bar 3, filters out the price correction and results in a better (lower) price for the long signal. Of course, the opposite could happen, i.e. the
price could increase resulting in a worse (higher) price for a long position signal at the time the trade is executed. Therefore, any application of
delay trade input must be done carefully and after a detailed analysis of the parameters involved. Price Action Lab determines the best value for the delay for the patterns discovered by it.
It may be seen from the examples in Figures 1, 2 and 3, as well as, from the logic of the patterns, that there are no parameters to adjust in
order to affect the timing of the entry signals generated by such trading system models. This is true unless additional logic is introduced,
which will alter the basic structure of the trading system models. What can be changed though is the timing of the exit signals, by changing
the profit target and stop-loss levels, T and S. Such change may eventually affect trading system performance by turning some entry signals
into winners or losers depending on the exit price levels and may result in some kind of optimization of the exit part. However, regardless of
any optimization made to the exits, the entry part of such trading system model cannot be affected. Thus, one can claim that while most
indicator based systems are subject to full optimization (i.e. optimization of their entry and exit part), price pattern systems can only be
half-optimized (i.e. in the exit part). A stronger version of this statement is that price patterns that exhibit a robust performance for a wide range
of exit parameters do not belong to the class of optimized or fitted systems. |
