Charles Schwab article: "Automated Chart Pattern Recognition"

Thursday, February 16, 2012

By: Mark Eidem - CMT, CFA, Active Trader Market Manager, Charles Schwab

When it comes to investing, there are two main types of research:

Fundamental analysis is the traditional financial statement-based examination of a company's revenues, earnings, cash flow and financial strength. It focuses on how a company is performing as a business. Proponents of fundamental analysis believe it can help traders identify what to consider buying or selling, or, perhaps more importantly, what to avoid investing in.

Technical analysis is the chart-based examination of price history and volume, or the study of "supply and demand," if you will. It focuses on how a company's stock is performing. Proponents of technical analysis believe it can help traders determine when to buy and, more importantly, when to sell.

In this article, we'll focus on an exciting new tool in StreetSmart Edge®—Recognia—that helps to automate the process of technical analysis.

Previously, we looked at the trend in price and why it matters. We learned that when a trend changes, traders should consider potentially entering or exiting a trade. Now, let's look at how Recognia can help identify possible entry and exit points.

What Is Recognia?

Technical analysis uses certain chart patterns that may indicate trend changes. This helps identify price targets and time horizons for a stock to reach those price targets.

Chart pattern recognition has been around for decades. Before personal computers were readily available, stock traders would literally keep books of charts plotted by hand every day. Using their chart books, traders would recognize certain chart patterns as they plotted that day's price into their books. However, this process was not only time-consuming but also limited the number of stocks that a trader could realistically follow.

What Recognia brings to traders is the automation of these classic technical analysis techniques. This expands the number of stocks a trader can review from a few to a several thousand. Further, Recognia applies a consistent method for identifying price targets and time horizons that individual traders are unlikely to be able to do on their own.

Recognia has three sections; here, we will focus only on Technical Insight. This is the heart of Recognia—chart pattern recognition.

Where's Recognia Located?

Recognia can be accessed within StreetSmart Edge by clicking the Launch Tools button, as shown above.

Using Recognia for chart patterns

Let's walk through an example showing how Recognia can help identify potential chart patterns. In the chart below, XYZ is mired in a downtrend throughout the period shown. Even if you like the fundamentals, buying the stock during this period has a high probability of producing losses.

In this example, the downtrend becomes the trader's friend keeping him out of the stock "until the end when it bends." This happens on December 23, 2011, when the price rises to a higher high as shown by the horizontal green line below.

XYZ in a Downtrend

Stock prices can form patterns that may indicate a trend reversal. These patterns can sometimes be useful in identifying recurring human behaviors.

In the chart above, notice that there are two lows in price at about $28. This type of chart pattern is known as a double bottom.

The repeated behavior is that when price returns to the $28 level the second time, some traders recognize that level as the previous low and choose to buy the stock at that price, thereby turning the stock higher.

As shown below, Recognia identified this double bottom pattern in XYZ on December 23, 2011. Recognia issued both a price target, in this case $32.00 to $32.40, and a time horizon for the stock to reach that price target, in this case 28 days. Recognia also provided a description of the pattern. Indeed, using Recognia has educational side benefits in that it teaches you more about technical analysis in general.

In this example, XYZ reached the price target projected within the time horizon estimated. But this is not always the case. Anything can happen in the markets and quite often does. It is for this reason that Schwab emphasizes proper risk management and loss control discipline.

Recognia Identifies a Double Bottom

Using Recognia for bullish and bearish events

Recognia also identifies stocks that meet either bullish or bearish technical events each day. Traders can use lists of these stocks for further research.

I want to emphasize that Recognia is a technical analysis screening tool; it doesn't provide fundamental analysis research. This is a critical point, for there could be circumstances where stocks of companies with deteriorating fundamental business prospects generate bullish technical events and appear on Recognia's bullish events list.

The screenshot below shows the Technical Insight section of Recognia. On the left, you'll see the Bullish and Bearish Events.

On the right is Recognia's Educational Material, where traders can learn about a new technical chart pattern or event every week. This particular week, the focus was a continuation diamond (bullish). After reading about a topic, traders can use Recognia to identify companies that meet specific technical criteria.

 

Recognia's Techncal Insight

Now let's take a more in-depth view of the Bullish Events. When a trader selects list of Bullish Events, the screen below appears. Please note this screenshot shows only the first six of 50 stocks experiencing Bullish Events on this particular date. Five additional Bullish Event listings and five more Bearish Event listings are not shown in any of these screenshots. In short, it would be very difficult for a trader to run out of stocks to consider in Recognia.

Bullish Events

Bottom line

My hope is that this article piques your curiosity about the capabilities of Recognia. We've only scratched the surface and next month we'll examine additional features. Until then, good luck and good trading!

The original article can be found within the Resource Section of the Charles Schwab website.

Source of all photos: StreetSmart Edge

Important Disclosures