2023 – Technical Analysis of
Financial Markets
Module 3: Pattern Recognition and
Financial Statistics
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Course Plan
Module Titles
Module 1 – Introduction to Technical Analysis, Charting Techniques, and Arithmetic
Scale vs. Ratio Scale
Module 2 – Dow Theory and Trend Analysis
Current Focus: Module 3 – Pattern Recognition and Financial Statistics
Module 4 – Quantitative Indicators I
Module 5 – Quantitative Indicators II
Module 6 – Lightning Round, Candlestick Chart Analysis, and Point and Figure
Chart Analysis
Module 7 – Breadth Analysis, Volume Analysis, Sentiment Analysis, Sector
Analysis, and Sensitivity Analysis
Module 8 – Performance Measurement, Risk Management Strategies, and Money
Management Techniques
Module 9 – Lessons Learned from Trading Exercises and Special Topics: Ichimoku
Charts and Financial Psychology 2
Topics for this Module
• 3.1 Trading Execution Basics
• 3.2 Reversal Pattern Recognition
• 3.3 Continuation Pattern Recognition
• 3.4 Financial Statistics and Their Trading
Application
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Quote of the week
“Diversification is a protection against
ignorance. It makes very little sense for
those who know what they’re doing.”
– Warren Buffett
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Module 3 – Section 1
Trading Execution Basics
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Trading Execution Basics #1: Market Order vs.
Limit Order
• Market Order
– A market order is a buy or sell order to be executed by the broker
immediately at current market prices.
• Limit Order
– A limit order is an order to buy a security at no more or sell at no
less) than a specific price.
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Example of the Market
Bid is highest price buyer willing to pay Ask lowest price sellers are willling to accept
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Questions
1. Can you describe the “market” briefly?
2. If you put in a market order to buy 100 shares of SST, how
much will the order cost you?
3. What would happen if you place a limit order to buy 50000
shares at $1.24?
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Trading Execution Basics #2: Stop Order
• Stop Order
– A stop order is an order to buy (or sell) a security once the price of
the security has climbed above (or dropped below) a specified stop
price. When the specified stop price is reached, the stop order will
become a market order.
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Trading Execution Basics #3: Trailing Stop Order
• Trailing Stop Order
– entered with a stop parameter that creates a moving or
trailing activation price
– This parameter is entered as a percentage change or
actual specific amount of rise (or fall) in the security price
– Key advantage of setting a trailing stop sell orders are
used to maximize and protect profit as a stock's price
rises and limit losses when it's price falls
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Questions
• Assume that you hold shares of SST with a stop sell order
at $1.20. What needs to happen to trigger the order?
• Can you explain how a trailing stop loss at $0.20 can be
used to protect your profit and limit your downside risk for
SST?
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Module 3 – Section 2
Reversal Pattern Recognition
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Intro to Pattern Recognition
• Certain chart patterns provide additional information about
the behaviour of the market action
• Researchers (Lo, Mamaysky and Wang) found that
– Several patterns such as head-and-shoulders
tops/bottoms occurred with much greater frequency in
actual price data than did in the randomly generated
price series
– Returns following certain patterns’ presence were also
significant – specifically, declines following the head-and-
shoulders top, and rallies that followed the head and
shoulders bottom.
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Encyclopedia of Chart Patterns and Trading
Classic Patterns (Thomas Bulowski)
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Significance of Price Patterns
• Important changes in trend usually require a transition
period.
• These transition periods are characterized by unique price
patterns.
• Recognition of price patterns helps determine the pending
direction of the market.
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Reversal vs. Continuation Patterns
Two Types of Pattern:
1. Reversal pattern (i.e. reversal in trend is pending)
• Head-and-shoulders tops and bottoms
• Double tops and bottoms
• Rounded/saucer tops and bottoms
• Key reversal day
• Island reversal day
2. Continuation pattern (i.e. market is pausing for consolidation
and then the existing trend will resume)
• Triangles
• Wedges
• Flags and Pennants
• Broadening Tops
• Rectangles
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Pattern Formation and Its Trading Application
The trading application consists of:
• Classification of reversal vs. continuation pattern
• Determination of bullishness or bearishness
• Confirmation of pattern and breakout
• Measurement of minimum price objectives
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Head-and-Shoulders Top Formation
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Head-and-Shoulders Top Formation
Key Characteristics of a “Typical” H&S Top
Formation
• Usually observed at the end of bullish trend
• LS and RS usually are similar in height and length
• Volume declines from LS to H to RS for typical H&S
top formation and expands on the breakout of the
neckline
• NL is usually slightly positive
• 3% below the NL is a breakout
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Differences between tops and bottoms
• The bottom formation usually takes longer to form.
• Volume confirmations are generally more important for
bottom formation.
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Group Exercise 1
• Stock A completes a head-and-shoulder bottom formation
with a neckline at $20 and head at $15. What should be
your minimum price target once the neckline is broken?
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Double Bottoms Formation
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Double Bottoms Formation
Key Characteristics of a “Typical” Double Bottom Formation
• The pattern is complete or confirmed when prices increases
over the previous peak
• Increasing in volume to confirm the breakout is more
important for double bottoms relative to double tops.
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Double Bottoms Formation
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Rounded Bottom Formation
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Rounded Bottom Formation
Key Characteristics of a “Typical” Rounded Bottom (also
known saucer) Formation
• Usually takes a long time to develop
• Creates a strong support
• Very difficult to tell exactly when the formation is complete
• No measured move
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Key Reversal
Top Reversal Day Bottom Reversal Day
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Key Reversal
Key Characteristics:
• Typically occur at the third phase of a primary trend
• Heavy volume on the reversal day
• Do not occur frequently but when it occurs, it is very strong
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Group Exercise 2:
• Draw the candlesticks for the top reversal day and the
previous day.
• Come up with a name for this two-period candlestick
pattern.
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Reading Assignment
• Read P. 174 to 184 on different types of “gaps” and
answer the following questions:
1. What are the causes for gaps?
2. What are the four different types of gaps?
3. How do we use these gaps in trading?
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Island Reversal
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Island Reversal (cont’d)
Key Characteristics:
• Occur at the end of an intermediate or even a major move
and form part of an overall price pattern.
• Usually a 1-day phenomena
• Is usually not signaling a major reversal
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Example: [Link]
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Example: [Link] (cont’d)
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Module 3 – Section 3
Continuation Pattern Recognition
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Continuation vs. Reversal Patterns
• Reversal patterns are usually longer in duration and are
usually involved in the major trend changes.
• Continuation patterns are usually shorter in duration and are
usually involved in the near term and intermediate trend
changes.
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Symmetrical Triangle
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Ascending Triangle
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Triangular Formation
• The pattern usually takes 1 month to 3 months to form.
• Triangles are usually continuation patterns but sometimes
act as a reversal pattern.
• Measuring technique is to project the base of the triangle
from the breakout point.
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Group Exercise 3
• Stock A is showing a breakout of a symmetrical triangle to
the top while Stock B is showing a breakout of an ascending
triangle to the top. All things being the same, which of the
two breakouts shows a stronger change in sentiment?
Explain your answer.
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Wedges
Falling Wedge - Bullish
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Formation of a Descending Triangle
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Reading Assignment
• Read P. 166 to 169 on “Flags and Pennants” and answer
the following questions:
1. What are the key differences between the two patterns?
2. How about similarities?
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Broadening Tops
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Broadening Formations
Key Characteristics:
• Also known as inverted triangle
• Measuring implications are similarly difficult to determine
• Typical patterns found at the top of major bull market cycle
e.g. 1929 and 1987 equity crashes
[Link]
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Rectangle
resistance
support
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VIX and its Importance in Equity Trading
• Ticker or symbol for the Chicago Board Options Exchange
Volatility Index
• Measure of the implied volatility of at-the-money S&P 500
index options with 30-day maturity
• Also known as the fear index
• Remember: volatility is the standard deviation of returns
(not price)
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Historical VIX
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Interpretation of VIX
• Currently, VIX is about 30 or 30% on an annualized basis.
• The market expects the S&P 500 index to move up or down
by 30%/sqrt(12) = 8.7% in the next 30-days with a
probability of 68%. (68-95-99 empirical rule for normal
distributions)
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Module 3 – Section 4
Financial Statistics and Their
Trading Application
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Descriptive Statistics
• Measure of Central Location
– Mean e.g. moving averages, MACD, etc
– Median
– Mode
• Measure of Dispersion
– Range
– Variance/standard deviation e.g. volatility, Bollinger Bands, etc
• Measure of Degree of Asymmetry around its Mean
– Skewness
• Measure of the Relative Peakedness or Flatness (relative to normal
distribution)
– Kurtosis
• Measure of Linear Degree of Association/Relationship
– Covariance and correlation
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Financial Statistics
• Sample Mean
• Financial Interpretation: Expected Return
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Financial Statistics (cont’d)
• Sample Standard Deviation
• Financial Interpretation: Volatility (Risk or Deviation
from the Expectation)
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Financial Statistics (cont’d)
• Sample Skewness
• Financial Interpretation: Biasedness towards
upside potential or downward risk (i.e. positive
skewness = long right tail of the return distribution)
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Financial Statistics (cont’d)
• Sample Kurtosis
• Financial Interpretation: Stability or Surprise Index
(Excess Kurtosis > 0 means that it has more
peakedness than normal distribution)
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Financial Statistics (cont’d)
• Sample Correlation
• Financial Interpretation: Effectiveness of hedge
(e.g. USD index and gold price)
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Formulas and Example
• Calculate all the descriptive statistics mentioned on the
previous page for the following data points:
0 1 2 3 5 5 9
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Excel: Tools => Data Analysis => Descriptive
Statistics
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Example of Positive Skewness
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Group Exercise 4
• Design two trading/investment strategies – one with positive
skew and another with negative skew.
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Any questions?
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