Reliable and repeatable patterns present excellent profit opportunities, says Larry Pesavento, but focusing on risk, not potential reward, is the "secret" to pattern recognition trading.
I’m here with Larry Pesavento, and Larry, let’s talk a little bit about pattern recognition as a broad trading tool. How do you use it and how do you approach that?
As you know, I’ve been studying markets for 50 years, and the thing that I migrated to 40 years ago was pattern recognition. But it wasn’t really until 2000 when Andrew Lo came out with his book, A Non-Random Walk Down Wall Street, that pattern recognition became really popular, because people realized it had a scientific background.
Since that time, it’s become a lot easier to convince people that these patterns are real, they repeat, and they do have predictability.
Is this something you can use on any time frame or do you have to specialize on a particular one?
It works on any time frame, from a tick chart all the way through monthly charts. Frankly, I’m more interested in risk control, and so I migrate to 15-minute and hourly charts, and I primarily trade forex, crude oil, Treasury bonds, and gold.
Those are the three things from the futures and twelve cross rates that we trade at the hedge fund.
Everybody’s always looking for a pattern that is great and works 90% of the time. When looking for one that is reliable, what’s realistic?
The best pattern that I found has been the Gartley pattern, and that was on page 222 of H.M. Gartley’s book, Profits in the Stock Market, from 1935; that book was $1500 in 1935.
That’s been the best one, but it doesn’t approach 90%. You don’t have to achieve 90% to make a lot of money in this business. If you can be 60% or 65% profitable, you can make a great deal of money.
The trick is to lose less money than you make. You want to make at least 1.5 times what you risk each time, and that’s the real secret to it: risk control. It’s not how much money you make.
Does your repertoire have patterns? Do you have four or five that you use all the time, or do you have a bigger universe?
I have seven buys, seven sells. That’s what I use, and that’s all I use. I primarily focus on Gartley’s butterflies and the A-B-C-D, and then you’ll see the “three drive” pattern once or twice a week on an hourly chart.
You’ll see double bottoms and double tops occasionally, but not nearly as often as people think they occur. They work, but they have certain characteristics that you have to follow to get them to work.
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If somebody’s just starting out, is the Gartley the one that they should start with and get good at recognizing that pattern?
If you can do the Gartley pattern, I think that’s the best thing, because Gartley spent three full pages discussing that in his book. At no other time in the book did he spend more than a few paragraphs, so if he spent three pages on something back in 1935, it’s worth our effort.
We’ve tested tens of thousands of these and they stand the test of time. Patterns do work.