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1. SECTION VI
Classical Methods

2. CHAPTER 24
Pattern Recognition

3. Learning Objective
▪ Learning Objective Statements
▪ Analyze potential patterns in price data and describe why they
may be valid as a trading signal
▪ Analyze potential trading opportunities based on gaps in price
data
▪ Distinguish those signals based on gaps that are likely to be
worthwhile trading signals from those which are not likely to be
worthwhile
3

4. Projecting Daily Highs and Lows
▪ Statisticians claim that the best forecast of tomorrow‘s price is today‘s
price; for longer-term projections, the best forecast is the mean.
▪ Pivot Points
▪ The simplest approach to projecting tomorrow‘s highs and lows is to
base those figures on the average price of today plus or minus a value
that somehow relates to the current trading range, or volatility. One
technique, based on a pivot point,2 projects two levels of support and
resistance:
4

5. Demarks Projected Ranges
▪ Tom DeMark, has based his projections on the positioning of today‘s opening
price relative to yesterday‘s closing price, which gives him added timely
information.
▪ If today‘s open is higher than the previous close, the projections are biased
upwards; if lower than the close, they are biased downwards.
▪ If today‘s close is below today‘s open, then
▪ Tomorrow‘s projected high = (H + C + 2 × L)/2 − L
▪ Tomorrow‘s projected low = (H + C + 2 × L)/2 − H
▪ If today‘s close is above today‘s open, then
▪ Tomorrow‘s projected high = (2 × H + L + C)/2 − L
▪ Tomorrow‘s projected low = (2 × H + L + C)/2 − H
▪ If today‘s close is the same as today‘s open then
▪ Tomorrow‘s projected high = (H + L + 2 × C)/2 − L
▪ Tomorrow‘s projected low = (H + L + 2 × C)/2 − H
5

6. Comparing The Two Methods
▪ For example, if the Swiss franc had a high, low, and close of 6600, 6450, and
6500, respectively,
▪ the first pivot method would give a projected first resistance level (high) of 2 ×
(6600 + 6450 + 6500)/3 − 6450 = 6583.
▪ DeMark‘s projected high is different, based on the way today‘s opening price
relates to the previous close.
▪ If the open is lower than the previous close, we get (6600 + 6500 + 2 × 6450)/2
− 6450 = 6550;
▪ if the open is higher, we have (2 × 6600 + 6450 + 6500)/2 − 6450 = 6625; and,
▪ if the open is about the same as the previous close, then the projected high is
(6600 + 6450 + 2 × 6500)/2 − 6450 = 6575.
▪ It seems reasonable that the pivot point method returns a value close to
DeMark‘s neutral case when the market opens unchanged from the previous
close.
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7. Time of Day
▪ Market participants, especially floor traders and day traders, are the cause of periodic
movement during the day. Angas called these the ―tides of the daily prices.
▪ The classic pattern in both stocks and futures shows the greatest volume near the open, the
next highest volume near the close, and the lowest volume at midday.
▪ Trading Habits Form Lasting Patterns
▪ Many investors evaluate their positions and study market reports in the evenings and then
place their orders in the morning.
▪ The close of the day is a common time for trading because many investors believe that the
closing price best represents the correct value.
▪ Positions entered in the morning will be closed out by the end of the day to avoid depositing
the margin required of positions held overnight. Accounts are settled using the closing price.
▪ Scalpers and floor traders are active during the opening minutes but frequently have a mid-
morning coffee break, and more take a lunch break; this natural phenomenon causes liquidity
to decline and may result in a temporary price reversal.
▪ All traders and investors develop habits of trading at particular times. Some prefer the
opening, others 10 minutes after the open.
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8. Tubbs’ Intraday Patterns
▪ Tubbs‘ Stock Market Correspondence Lessons (―Tape Reading‖) he explains the
six dominant patterns in the stock market (based on a 10:00 a.m. to 3:00 p.m.
session).
▪ 1. If a rally after the open has returned to the opening price by 1:00 p.m., the
day is expected to close weaker.
▪ 2. If the market is strong from 11:00 a.m. to 12:00 p.m., it will continue from
12:00 p.m. to 1:00 p.m.
▪ 3. If a reversal from 1:00 p.m. to 1:30 p.m. finds support at 1:30 p.m., it will
close strong.
▪ 4. If the market has been bullish until 2:00 p.m., it will probably continue until
the close and into the next day.
▪ 5. A rally that continues for 2 or 3 days (as in Pattern 4) will most likely end on
an 11:00 a.m. reversal.
▪ 6. In general, a late afternoon reaction down after a strong day shows a
pending reversal.
8

9. Tubbs’ Intraday Patterns
▪ Putting these together, the following two patterns (among
others) can be expected:
▪ 1. A strong open with a reversal at 11:00 a.m. not reaching the
opening price, then strength from 11:00 a.m. to 1:00 p.m., a
short reversal until 1:30 p.m., and then a strong close;
according to Pattern 5, there will be a strong open the
following day.
▪ 2. A strong open that reverses by 11:00 a.m., continuing lower
until 1:00 p.m., then reverses again until 1:30 p.m., will close
weak.
9

10. Merrill’s Intraday Patterns
▪ Merrill‘s work shows the hourly pattern of the
stock market in Table 28.1, where a plus or minus
sign indicates rising or falling prices during the
preceding period.
▪ During the four years shown, the grid clearly
indicates a strong opening and follow-through to
11:00 a.m.
▪ Prices begin strong and continue the first hour.
Having exhausted the early orders, volume
decreases, and price reverses due to lack of
buyers.
▪ By 2 p.m. the short sellers who faded the first
hour move to cover their positions, causing a
move back in the direction of the opening hour.
10

11. Updating Intraday Time Patterns, 2000–2011
▪ 2001–2002, strong bear market
▪ 2. 2003–2007, normal bull market
▪ 3. 2008, extreme collapse
▪ 4. 2009–May 2011, strong bull market
▪ First using the entire 11 years, the patterns are evaluated in three ways:
▪ 1. The cumulative change in returns for each 30-minute period
throughout the day.
▪ 2. The change relative to the direction of the open from the previous
close.
▪ 3. The change relative to the opening 30 minutes of trading.
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12. Updating Intraday Time Patterns, 2000–2011
▪ If the 11 years are separated into the four periods that represent clear regimes,
the results are more interesting. Figures 28.4a–d show the results, which can be
summarized as
▪ 2001–2002, a strong bear market shows that the average move ends the day
lower and the direction at the close of the first bar persists slightly throughout the
day.
▪ 2003–2007, a normal bull market shows the average move steadily increasing
throughout the day as did the direction from the previous close. However, prices
tended to reverse slightly relative to the direction of the opening bar.
▪ 3. 2008, the extreme collapse due to the subprime crisis, is the most consistent.
All three measures continued in the direction of the opening moves and the
overall market direction.
▪ 4. 2009–2011, a strong bull market, shows in the average move, but is different in
the other measurements. Rather than continuing in the direction given by the
prior close to end of first bar, or from the open to the end of the first bar, prices
reverse, giving back earlier gains or losses.
12

13. Updating Intraday Time Patterns, 2000–2011
13

14. Updating Intraday Time Patterns, 2000–2011
▪ The overall intraday time pattern of the S&P can be summarized in the same way
as Merrill in the following table, where a ―+‖ represents a net gain from the close
of the previous bar and a net loss:
▪ For the full 11-year period, the opening bar was generally lower, but each
subsequent bar was higher. From 2008 through May 2011 the first half of the day
was lower and the last half higher.
14

15. EURUSD Time Patterns
▪ The overall pattern is only slightly different from the S&P. There was a net gain in
the EURUSD, shown by the Average move; however, that gain was all in the
overnight move. From the end of the first bar, which occurs at 3 a.m. in New York
(9 a.m. in Frankfurt), prices tend to reverse. The move relative to the direction of
the open-close of the first bar is essentially flat.
▪ In the following table, trading begins at 2 a.m. in Europe and ends at 3 p.m. in
New York. The first 5 hours are actively traded in Europe but not the United
States. There are 3 hours of overlapping trading after which Europe closes (at 4
p.m. local time). The U.S. trades for another 5 hours, with only small volume
coming from Europe.
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16. Opening Gaps
▪ To any trader, an opening gap looks like an opportunity for a profit. Certainly, a
large gap opening implies greater volatility for the day, and we expect a greater
reaction. Based on the way the market closes, it may also forecast the direction of
the next opening price.
▪ A strong open followed by a stronger close would allow a trader to buy on a
pullback after the open. A consistently weak close after a strong open would be an
opportunity to sell short near the open.
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17. Opening Gaps
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18. A Simple Gap Trading Method for Stocks
▪ A basic approach to trading gaps was taken by Reverre.
▪ Beginning with a 1-year study of the distribution of opening gaps for General
Electric, Reverre noted that the distribution was very narrow, with 85% of the days
opening with less than a 1% gap, and only 5% of the days showing gaps greater
than 2%. Apply the following rules:
▪ Place limit orders to buy if prices open more than 1% lower, and sell if they open
more than 1% higher, than the previous close.
▪ Exit the trade at the close of the day.
▪ Reverre makes two important observations:
▪ 1. Trading the medium-sized gap of 1% showed consistency because gaps often
represented noise and were likely to correct.
▪ 2. Trading gaps greater than 2% gave much larger profits and losses. Larger gaps
were more likely to be structural and may not correct.
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19. Close-to-Close Gaps
▪ Reverre also applied a similar approach to large 1-day moves, looking for
a correction over the next one to three days. Using the largest 20%
moves in General Electric, or about 1.28 standard deviations, during the
period December 1995 to February 1999, a buy signal occurred when
prices fell by more than 1.96% and a sell signal when prices rose by more
than 2.24%.
▪ Tested over the 30 Dow stocks, maximum returns came from 1-day
moves with gaps of 4% to 5%, holding for 1 day. A wider range of gaps,
from 2.5% to 5%, gave good results holding for 2 days.
▪ While less than half of the Dow stocks showed net profits, the overall
profitability was good. Both long and short positions performed well,
even though the test period was near the end of a strong bull market.
19

20. Main Points to Remember
- Analyze potential patterns in price data , they may be valid as a
trading signal
- Projecting Daily Highs and Lows (Using Pivot Points)
- Demarks Projected Ranges - based his projections on the
positioning of today‘s opening price relative to yesterday‘s closing
price . (If today‘s open is higher than the previous close, the
projections are biased upwards; if lower than the close, they are
biased downwards)
- Time of Days - The classic pattern in both stocks and futures shows
the greatest volume near the open, the next highest volume near the
close, and the lowest volume at midday.

21. Main Points to Remember
- Tubbs’ Intraday Patterns - explains the six dominant patterns in
the stock market (based on a 10:00 a.m. to 3:00 p.m
- Merrill’s Intraday Patterns - Merrill‘s work shows the hourly
pattern of the stock market
- Opening Gaps - , an opening gap looks like an opportunity for a
profit. Certainly, a large gap opening implies greater volatility for the
day, and we expect a greater reaction. Based on the way the market
closes, it may also forecast the direction of the next opening price.
- Close-to-Close Gaps - Reverre also applied a similar approach to
large 1-day moves, looking for a correction over the next one to three
days

22. Thanks