Pattern recognition forms the basis for most trading systems. Patterns are most obvious in traditional charting, which is primarily the identification of common formations; even moving averages attempt to isolate, using mathematical methods, what has been visually determined to be a trend. Traders have always looked for patterns in price movement. Because the earliest technicians were not equipped with computers, their conclusions are considered market lore rather than fact, and are handed down from generation to generation as proverbs, such as “Up on Monday, down on Tuesday,” “Locals even-up on Fridays,” and “Watch for key reversals.” Because these three sayings have endured, they are candidates for analysis later in this chapter. Readers should also note the early work of Arthur Merrill, whose well-known pattern studies are still quoted; these studies are referenced throughout this chapter.1
The earliest technical systems based on patterns were of the form: “If after a sharp rise the market fails to advance for 3 days, then sell.” As computers became more powerful, more complex approaches could be taken. For example, by observing the closing prices starting on an arbitrary day, all patterns of higher and lower closes can be recorded to find their tendency to repeat. A computer is well-equipped to perform this task. First, the 2-day combinations of price changes—up-up, up-down, down-up, and down-down—are tallied to see if there is a greater chance ...