Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Trade What You See: How to Profit From Pattern Recognition
07/01/2009 11:20 am EST
After the sharp stock market decline in the summer of 2007, I had the privilege of listening to many analysts discuss the drop and what, if any, long-term significance it might have. Only one, Larry Pesavento, was firm in his view that the severity of the decline, from a cyclical view, made the worst bear market since the Great Depression a real possibility. Even though I had known Larry for many years, his strong stance on the market at this pivotal time had me looking forward to reading his new book, Trade What You See, which he co-authored with Leslie Jouflas.
The book is divided into three sections with a total of 14 chapters. In the first section, there is a good introduction to understanding pattern recognition and some of the basic tenets of trading, including a comprehensive list of reasons why most traders succeed or fail. As part of this introduction, the geometry of price patterns is discussed, as are the Fibonacci numbers, and the concept that individual markets have their own unique harmonic numbers. I had never heard of this concept, but found it quite intriguing and a potential area for study.
In the second section, the authors start off by discussing one of the most common patterns: AB=CD, which was first discussed in the 1930's by H.M. Gartley in his book, Profits in the Stock Market. Now, some of you may not be familiar with the Gartley name, but most recognize that most continuation patterns take this same form. The authors' discussion of the topic is quite thorough, as it includes the psychology of this pattern, suggestions on how best to trade it, and insights on how to tell when the CD leg is likely to be a Fibonacci extension of AB.
The discussion of the "222" pattern in the next chapter was one that I did not find as easy to understand. This formation adds what is referred to as an "anchor leg" (X), which is then followed by an AB=CD pattern. For example, in an up-trending market, a sharp rally (X) is then followed by an AB=CD, which corrects the uptrend. The market actions that invalidate this formation are clearly stated. The butterfly pattern discussed in the next chapter is an extension pattern "that attempts to trade the highs and lows at market reversal points." Later in the chapter, the authors point out that while it can be one of the most rewarding patterns, the risk can be also be high. Several trade examples are provided, which include the placement of the stop and management of the trade.
While I have seen these formations over the years, I have never categorized them and it would take some serious work before I could actually trade them. I believe that the addition of more charts and examples would have made it easier to understand both the "222" and butterfly patterns. Several other patterns are included in the second section, including a chapter on trading traditional technical patterns. For those of you who trade the E-mini market, Chapter 10, "Learning to Recognize Trend Days" will be an invaluable guide, as the authors discuss in a clear manner how to identify and trade trend days in the stock index futures.
The final part of the book is titled "Essential Elements of Trading," and while this sets a high standard, I think that the authors actually do succeed. Almost every book on trading has a similarly titled section, and I feel this is one of the most comprehensive. The highlights of this section include thinking in terms of probabilities, calculating a position size, using options with the Fibonacci ratios and patterns, and the three components of a trading plan. In the past two years, position size has been a focus of many traders and is a key strategy used by many of the successful hedge fund managers. The appendix contains an extensive list of books and additional resources, and the authors advise that beginning traders should allocate enough funds to explore different trading methodologies until they find one that best suits their personality. For either the beginner or the advanced trader, this book should be a part of the educational process. Its approach to the markets is unique and is likely to change the perspective of many traders.
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