What is Pattern Recognition?

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What is Pattern Recognition?


The following article was published in Business Week. The article explores the result by academics at the MIT, that chart patterns are are reliable indicators of the future path of stock prices.

This Alchemy May Yield Real Gold

Technical analysts--the Street's soothsayers--get a vote of confidence from MIT rocket scientists

Technical analysts don't get no respect. Academic economists consider their game--predicting stock prices by studying charts--on a par with examining the entrails of a freshly slaughtered goat. Conventional economic wisdom says that stock prices already reflect all relevant information, so past movements are no clue to future ones. Even if stock prices are a little predictable, say most economists, you won't get anywhere by poring over charts for such technical-analyst arcana as ''rising bottoms,'' ''double tops,'' and ''head-and-shoulders formations.'' Burton G. Malkiel, author of A Random Walk Down Wall Street, writes that ''under scientific scrutiny, chart reading must share a pedestal with alchemy.''

But technical analysts--also known as chartists--may yet get the last laugh. A paper written by three authors from the Massachusetts Institute of Technology, and recently published by the prestigious National Bureau of Economic Research, concludes that ''certain technical patterns do provide incremental information, especially for Nasdaq stocks.'' In language that's bold for academics, the paper goes on to say that ''while this does not necessarily imply that technical analysis can be used to generate 'excess' trading profits, it does raise the possibility that technical analysis can add value to the investment process.''

Technical analysis might actually add value? Predictably, technical analysts are overjoyed by the partial endorsement. ''I'm, like, flabbergasted,'' says Ralph J. Acampora, the director of technical research at Prudential Securities Inc. The chartists are particularly pleased that Andrew W. Lo, director of MIT’s Laboratory for Financial Engineering, who taught many of the finance rocket scientists now working on Wall Street, led the project. Says Acampora: ''This gives the field an awful lot of credibility.''

The paper, by Lo, graduate student Harry Mamaysky, and finance professor Jiang Wang (http://www.nber.org/papers/w7613), is tough slogging unless you happen to be on intimate terms with kernel regression estimators and the Kolmogorov-Smirnov test. But its basic strategy is simple. First, the authors wrote a computer program that automated the process of finding 10 of the chartists' favourite patterns. Then they turned the program loose on daily stock returns for hundreds of companies on the New York Stock Exchange, American Stock Exchange, and Nasdaq from 1962 to 1996. Out of more than 800,000 observations of raw data, the program turned up about 2,500 head-and-shoulders patterns (three peaks, the middle one being the highest), about 2,100 triangle tops (a pattern with progressively lower peaks and rising bottoms), and so on.

STARTLING RESULTS. The next step was to see how stocks performed in the period after a pattern was completed. If technical analysis were hogwash, the authors should have spotted no regularities at all--just-random ups and downs.

The results were startling. The most bullish signal, the inverse head-and-shoulders pattern, produced an average 4% increase in the price of a stock on the third day after the pattern's completion. The most bearish signal, broadening bottoms, produced an average 6.2% decrease (charts). The authors also looked at other statistical measures such as standard deviation and skew and found that they also were significantly different from those of a randomly chosen day in the market.

The reason for waiting until the third day after a pattern's completion to peek at the stock performance was that in practice, it sometimes takes a day or so to recognize that a pattern has formed and to act on it. Plus, the authors figured it would be more impressive to sceptics if a stock was still moving as long as three days after a pattern's completion. While the paper reports only the one-day change, Lo says the authors got similarly impressive results when they looked at five- and 10-day returns.

INTUITIVE INPUT. So, is this bankable? The authors don't offer an opinion. The problem is that there's no agreed-upon definition of what it means to ''beat the market,'' because of the trade-off between risks and rewards. If you earn an above-average return, but take on above-average risks in doing so, doubters will argue that your risk-adjusted return was no better than average. For instance, if a chartist-trading strategy were highly correlated with movements in the overall market, it would expose an investor to extra market risk. Rather than get into a protracted debate about what constitutes beating the market, the MIT group decided to focus on what they could clearly prove. The paper demonstrates that technical patterns do contain genuine information about what is going to happen next in the market.

To be sure, real-life technical analysis isn't as pure as the MIT research. Flesh-and-blood chartists operate heavily on intuition. They often don't agree on whether a particular pattern exists or even what it signals if it does exist. They'll frequently walk both sides of the street, predicting that stocks will fall in the short term but rise in the long term, or vice versa, without precisely defining long or short. ''You scratch three technical analysts, you'll get four opinions,'' says Mike Epstein, the Boston-based director of quantitative trading for NDB Capital Markets.

There is, for example, no consensus among technical analysts about where today's gyrating stock market is headed in the coming days. In the middle of the Nasdaq Composite Index's roller-coaster ride on Apr. 4, Acampora said, ''I don't think it's over for the Nasdaq necessarily,'' but added that ''if they can blow out some more of these stocks, you'll get to the capitulation phase,'' in which stocks touch bottom and rebound. Epstein said, ''I'm looking for a trading rally very shortly, maybe even right here,'' but warned that he might well change his mind the next minute.

PROFITABLE PATTERNS. Despite the theatrics surrounding technical analysis, Lo thinks it works because it provides insight into some of the key forces that determine prices, such as the warring forces of fear and greed. Since markets are made up of real people, not economic automatons, psychological concepts used by technical analysts such as ''resistance levels,'' ''support levels,'' ''overbought,'' ''oversold,'' and ''momentum'' can have real meaning. Lo says that technical analysts ''have been doing informally and intuitively what academic economists do''--namely, measuring the forces of supply and demand.

Ultimately, Lo hopes to use computers to detect new patterns that are better indicators of the stock market than the ones handed down from generation to generation of technical analysts. He acknowledges that any pattern will eventually be arbitraged away, but believes that ''the arbitrage itself can create new ones....There might be two heads and three shoulders--some pretty bizarre Quasimodo figures.'' As Lo sees it, the trick is to develop tools that find exploitable patterns before others do.

Lo says he and his co-authors have been approached about commercialising their work, but they aren't looking to go into technical analysis full-time. ''We actually like being academics a lot,'' he says. On the other hand, Lo isn't completely immune to the lure of money. He said he's still curious about whether technical analysis really can beat the market after adjusting for risk--a question that his latest paper doesn't attempt to answer. If he and his colleagues discover that it can, he says, ‘‘we might never publish that paper.'' Now, there's a professor with a good head on his shoulders.

By Peter Coy in New York

Market Pattern Forecast

We trade the Market Pattern Forecast alongside, in conjunction with technical analysis or what we call our quantitative models. Short term cycles and patterns are never to be traded on a "standalone" basis by themselves, ever.
Just like quantitative models should never be used by themselves.
The more tools that you have in your arsenal, the better.

Has anyone ever seen an indicator that flashes a buy or a sell signal, and then bought or sold, only to see the market keep going in the same direction, without turning?  It is our hypothesis that what is occurring at these points, even with the best mathematical/statistical models in the world- is that a pattern formation is in play, being traded, and it is over-riding even the best of the the best  technical indicator sets.

Our computers analyze the formations, or patterns from the past several days: You cannot see them with the naked eye, because, as mentioned in the above article on pattern recognition,  you cannot see where one begins and ends.  Some traders (and computers) see or detect and act on them earlier than others. The program that we have written does that for us. It gives us the highest probability pattern; turning points, angles of ascent/descent along with the relational amplitude of the Y axis which should occur over the next 6 to 8 hours. We publish our trading tool in the form of a 5 minute bar chart which is posted to the site before the open each day. 

The Future:  

Can anyone 'predict" the future?  Is it random chaos? We don't think so, because we have several large firms and multi-million dollar traders that subscribe to our service- many rarely have one losing week per year.  Why have they been subscribers to our service for many, many years?

The software program works on any stock, commodity or index.  We use it in-house on certain equities that we trade.
In the past few years the "research" section on many brokerage websites publish opinions on what should happen to certain stocks. They read: "Our pattern recognition program is issuing a buysignal, or a sellsignal on XYZ stock".  There are two camps of analysts:  fundamental analysts, and  "technical" or quantitative analysts.  The technical / quantitative analysts "chartists" believe that everything fundamental is contained within the charts. We are firmly rooted in the technical/chartist camp and believe that everything fundamental is contained within the most recent formations. This is not to say that we do not look at fundamentals, we do when we select equities to trade.  But for daytrading- Our quantitative measurements and analysis of the current pattern that has been developing over the past several hours determines for us what we should expect to occur over the next 6-8 hours.

This field is the future, and it sits on the cutting edge of methodologies employed for extracting profits from the world's bourses.  Quantitative models- technical analysis systems analize price action and indicators will issue signals. Throw in  sets of data with a head and shoulders formation.  The models issue the same signals  traders take, over and over again; buying or selling  when it issues those signals; when those highs and lows are taking place. This human "patterned behaviour"  affects the direction of markets, and are predictable behaviour
s which present us with very high probability trading opportunities. Traders should use a good set of technical indicators in conjunction with our predictive modeling. The quantitative model we use in house detects the actual accumulation or distribution that is occurring at each of the turning points defined within each Market Pattern Forecast: Looking at both models side by side: the scientific math/stat quantitative model and our projected formation of the next 6 to 8 hours- when they confirm, trading opportunities may present themselves, if they are not confirming, we will stand on the sideline and wait for confirmation.

Subscribers can see our projections for the indices/currencies each day for only US$ 99 a month.

The Quantitative Model:

We are very lucky to have a good math/stat model.  We apply it to multiple time frames: tick charts through monthly charts and everything in-between.  We could not be successful traders without it. It identifies for us whether the market is moving into a low or a high on the cycle turning points depicted each day on our maps; it helps us to determine when the cycle inverts, as is with all cycles; you cannot always tell if it is a high or a low. So forgive me for repeating myself-  It is required that users of our service apply a good set of technical analysis indicators, ie; a good math/stat quantitative model which will allow you to do the same: confirm whether or not the cycle point is a high or a low, with a higher degree of probability. See the tutorial section on inversions: here.  

Below are some types of patterns that occur in all markets. Our service provides you with a timing tool to use in conjunction with technical analysis :  The Market Pattern Forecast.
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