• : Prashant Shah
Patterns

We discussed about traditional price patterns in Line-break charts. Like other Noiseless charts, there are some price patterns that can be designed using the unique features of line-break charts. The combination of Lines can be a useful tool to read price patterns. The computation or construction part is most important part of Noiseless charts and they are Objective in nature. Objective setups can be really helpful in taking decisions while trading. We will discuss the trading systems in detail once we complete the discussion on patterns.

Let us start the discussion with a basic pattern.

Change of Lines


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Change of line is a simple & basic formation of Line break charts. A line in the Line-break chart changes the direction when the reversal criteria is fulfilled. Three-line break charts changes the trend when extreme price of last three lines is breached. Bearish line turning to bullish is 'Bullish change of line' & bullish line turning to bearish is a 'Bearish change of line' formation.

See below chart.

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All patterns marked with ‘A’ are bearish change of line and all patterns marked ‘B’ are bullish change of line.


The first thing that comes in mind is, can we trade this? Is it profitable? It is objective in nature, the high price of bullish line and low price of bearish lines are actual closing prices. We can enter the trade upon change of the line. Below are the possible rules of this trading system:

Trading Rules could be:
  • Buy when there is a bullish change of line
  • Exit when there is a bearish change of line
  • Short when there is a bearish change of line
  • Cover when there is a bullish change of line
It becomes SAR (Stop-and-reverse) method of trading on the Line-break charts. As discussed earlier, the level where change of line will occur can be known in advance and stop-loss can be kept in the system accordingly.

When we analyse it on the chart, it seems to be working well during strong trending phases, but whipsaws increase during volatile phase where more lines get printed. So, that is the nature of breakout and trend following systems. Important question is, can whipsaw be reduced during difficult times and reward be improved resulting in more productivity of trades.

The objectivity of this charting category gives us opportunity to test the occurrences. Let us test this pattern.

Method of Data testing:

Nifty 500 is the largest universe of stocks available in NSE and it includes most of the stocks from different groups and sizes so that we have a sufficiently big sample size. I am taking the period of 15 years from October 1, 2010 to September 30, 2020 or the listing date which is earlier for the stock in Nifty 500 group as on September 30, 2020 for back testing. Approach I am adopting here is to test the performance of patterns. They are not trading systems, hence slippages or any other charges are not considered while testing, so the numbers are gross. Bullish and Bearish patterns are shown separately so that both can be analysed independently. Open trades are not considered for tests.


Entry and exit rates are considered as closing price of the line, so the numbers are practical and dependable.

Below is the explanation of columns presented in the back-testing tables.

Occurrence: Number of times pattern has occurred. It can vary as per the exit criteria defined.

Average Return: Gain or loss generated per occurrence

Risk Reward ratio: Average profit of all successful trades divided by Average loss of all failed trades. It shows the reward generated against the risk of 1 point or Re 1.

Success Ratio: Ratio of occurrences that resulted in positive outcome. It is also known as Gain-loss ratio or Hit ratio.

Expectancy: While performing tests on pattern occurrence, Success rate alone or Risk reward for that matter is not sufficient to analyse the performance. A pattern can have lesser winning rate but more rewarding over a period due to higher risk reward rate. Hence, outcomes can be evaluated based on expectancy, below is its formula:

Expectancy: (Success Ratio x Risk Reward Ratio) - Failure Ratio


Failure ratio is percentage of occurrences that resulted in negative outcome. Positive expectancy basically indicates that the strategy is profitable.

Back-testing of Change of line formations

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The Data has significant sample size to make results dependable. Expectancy is positive and numbers are encouraging for bullish trades. But it is not a profitable system for bearish trades.

We can ignore bearish trades and only focus on bullish trades. So, we can think of applying filters to this pattern and try to improve it. We can also perform chart analysis and filter the trade. But the number of trades is high here, there could be 5-6 trades per stock in a year. There are two possibilities in that case: Run this system on small universe of stocks or indices, or there should be some filters to run it on a larger universe.

Let us explore other possibilities for trading the patterns in the Line-break charts.
But wait - success ratio in above table is around 40% and I said results are good. That means 60% of trades will be losing trades. How can I call this good? It should be much more if systems have merit, right? – Wrong.

We can improve the hit ratio of above strategy. Let us exit immediately on next line itself. Below is data that shows what would be the result in that case:

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The success ratio would increase to more than 80%. But look at risk-reward ratio. I earn 0.28 when trade is in profit and lose 1 rupee when trade is in loss. Serious money can be made over a period with this.


So, there are two takeaways:
  1. Success ratio of any strategy can be increased by compromising on risk-reward ratio and booking the profits early.
  2. Money is made in trading if risk-reward ratio is high, not the success ratio.
These rules apply to any format of trading, including very short-term trading to long-term investing. There can be strategies built by compromising on the risk-reward to increase the success ratio, but you should be aware that there is an inverse relationship between success ratio and risk-reward ratio.

High success ratio and high risk-reward do not coexist.

I agree that it is easier said than done. Sustaining at moderate hit ratio needs high conviction on system and more of a market understanding. In the beginning, you can compromise on risk-reward and improve on the success ratio to build some capital from the profits. The approach is fine, but you should be aware about this mathematics.


Line-break charts has much more to offer. The whole discussion on patterns will be based on the data analysis. I will keep both things in mind, chart analysis and Data analysis while discussing the patterns and trading systems based on the Line-break charts. I wish to present it as a tool to develop understanding of market behaviour and price patterns. Understanding the Line-break chart was a journey, I wish to relive it and present the thought process while exploring it.

Let us discuss patterns using combination of Lines.

Swing Patterns

Like other Noiseless charts, Line-break charts are basically swing charts, and they capture the swings elegantly. Swing high or Swing low can be defined as shown in Figure 2 below.


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Breakout from last swing high qualifies for the Bullish Swing high breakout and breaching the previous swing low qualifies for Bearish swing low breakout.

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Remember, swing high in a Line-break chart forms when price has dropped below the low of the previous three closing prices and swing low is formed after price moves above at least previous three closing prices. Hence, swing high and swing low marked on these charts are important observations and it makes swing breakout trading on these charts’ objective and easily scannable.

We know the value of the previous swing high and low in advance. So, it is possible to design a system for trading based on previous breakout of previous swing high or low instead of change of every line. This will reduce the number of trades compared to trading based on change of line.

Trading Rules:
  • Buy when there is a bullish swing breakout
  • Exit when there is a bearish swing breakout
  • Short when there is a bearish swing breakout
  • -Cover when there is a bullish swing breakout
This system also gives us clear entry and exit points that should benefit us in trending markets. It becomes SAR (Stop and Reverse) strategy.

Featured below is a Three-Line break chart of Reliance showing the swing breakout trades explained above.
 
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Let us back-test this strategy.

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As expected, the number of trades were reduced. Risk-reward ratio, Return per trade and Expectancy improved significantly for bullish trades compared to exiting based on simple change of line. Risk-reward ratio improved significantly because of the trailing method of stop-loss based on bearish swing breakout compared to aggressive method of exit based on simple change of line. But the numbers are not encouraging for bearish trades in this strategy as well.

Is this because Indian markets have mostly seen bullish phases during this period? Anyway, we can improve this system with filters but let us explore more possibilities of trading patterns on the Line-break charts.

How about changing the exit criteria? See the revised rules mentioned below:

Trading Rules:
  • Buy when there is a bullish swing breakout
  • Exit when there is a bearish change of line
  • Short when there is a bearish swing breakout
  • Cover when there is a bullish change of line
So, we are merging both the systems we have discussed earlier. This is not a SAR method now. It becomes more of a trend following method.

See the Backtested numbers of this system below.

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Key observations are:
  • Number of trades increased.
  • Expectancy and other numbers of bullish trades are compromised but the results of bearish trades improved.
Confirmation from other tools, patterns, trend lines, indicators etc can improve the performance.

Exiting based on change of line is an aggressive method. An important learning could be, overall performance is better for bullish trades when exit method is not aggressive. Exiting based on swing low and trailing the stop-loss would yield better returns. For bearish trades, aggressive method of exit is better. Perhaps because overall phase of the marker has been bullish. 


An important observation from a trading perspective is that all Bullish change of lines occurrences are more interesting when they occur above the previous swing low. They can be called as Higher low change of line patterns. Similarly, Bearish change of lines are interesting when they occur below the previous swing highs, they can be called as Lower High bearish change of line patterns.

Have a look at the chart of DRREDDY featured below.
 
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All bullish change of line patterns marked ‘A’ are higher low patterns, and all bearish change of line patterns marked ‘B’ are lower high patterns.

Let us see what more the Three-Line break charts have to offer.

Four Line Reversal Patterns


In a downtrend, the Three Line Break chart reverses when the price goes above the highest price of the previous three lines. Similarly, in an uptrend the reversal happens when the lowest price of previous three lines is breached.  Hence, the number of prices required before reversal are four and every reversal formation consists of four lines. Hence, every change of line is actually a four-line pattern. Combination of lines before the reversal line provides information about the price structure.

All possible reversal formations can be defined and classified into Four-line reversal formations. The names of these patterns are borrowed from traditional theories of Technical Analysis just to make it simple to remember and understand.

I hope you know the answer for: Why Four lines?


Three-line reversal is a most widely followed chart. If you will carefully think about the pattern of reversal in the three-line break charts, it always happens in the fourth line.

There are four patterns in this category.  Let us understand these patterns first.

Pattern 1: Bullish and Bearish Trend reversal


As shown in Figure 3A, Bullish trend reversal is a pattern when a series of three bearish lines are followed by a bullish line. And Bearish trend reversal is a pattern where a series of three bullish line turns to a bearish line.

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In simple words, Bullish trend reversal pattern can be defined as a series of three bearish lines followed by a bullish line. Similarly, a bearish trend reversal pattern can be defined as a series of three bullish lines followed by a bearish line.

The name of the pattern is kept as trend reversal because reversal after a series of lines in the same direction shows a reversal of a strong trend in place.

Hence, all the Trend reversal patterns are Change of line formations as well but not all Change of line formations are Trend reversal patterns. Any pattern where previous three lines before reversal are not in the same direction is not a trend reversal pattern.

See Three-Line break chart of JSWSTEEL shown below.

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It shows the Bullish and Bearish trend reversal patterns. The reversal patterns where previous three lines are not in the same direction are not considered as trend reversal patterns.


This definition separates the bullish trend reversal pattern from other reversal patterns. How about a system where we decide to trade only the trend reversal pattern and ignore other patterns?

The rules of this trading system are:
  • Buy when there is a bullish trend reversal
  • Exit when there is a bearish change of line
  • Short when there is a bearish trend reversal
  • Cover when there is a bullish change of line
It becomes a method of trading a particular occurrence. It is not a SAR method and it is not necessarily a trend following method. It is a method of trading objective price patterns. We will talk about back-testing of this pattern later in this chapter.

Pattern 2: Shakeouts

During strong trends, some sharp reversals occur that will shake out the weak traders and make the overall trend stronger.

When the trend is strong there would be a series of bullish lines. The price goes below the previous three lines to form a bearish reversal line. Weak bulls will get shaken out in the process and they exit the positions. People who felt the price went too fast would probably initiate short positions as well.

Imagine instead of going down, price goes above the previous high and forms a bullish line. This will ensure weak traders are out and weak shorts are shaken out.


Figure 3B shows the Shakeout pattern defined as Four-line reversal pattern.

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Bullish lines followed by a single bearish line immediately followed by a bullish line makes it a Bullish shakeout pattern. Bearish lines followed by a single bullish line immediately followed by a bearish line makes it a bearish shakeout pattern.

Below is a chart showing bullish and bearish shakeout patterns.

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Concept is similar to traps in P&F charts, but Line-break price formations are different in nature. They can also be compared with one-back or two-back patterns of Renko charts, but they are plotted based on fixed length of boxes. The length of reversal would be significant in Line-break charts and it depends on the distance between current price and reversal price. Observe the first two patterns in the above chart, even though it is a single line reversal, the length of line is significant, telling us that corrective move up was sharp and significant enough to shake out the weak traders.

Distinguishing Line-break reversal patterns in this manner is important. They provide us a wealth of information about price patterns. From a chart analysis perspective, this pattern is more effective and extremely rewarding when the trend of the instrument is clearly established. The pattern is not productive enough when the instrument is in a sideways trend.

Below could be the trading rules to trade the Shakeout pattern.
  • Buy when there is a bullish shakeout pattern
  • Exit when there is a bearish change of line
  • Short when there is a bearish shakeout pattern
  • Cover when there is a bullish change of line

Pattern 3: Rounding Patterns

Price correction in an established trend is an opportunity for traders when identified.  As shown in Figure 3C, two bearish lines between two bullish lines forms Rounding bottom pattern. Similarly, two bullish lines in between two bearish lines form Rounding top.

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When time is spent in the correction, it will not appear in the Line break charts. Lines will appear only when there is a price correction. The shakeout pattern is a single line correction whereas the rounding pattern is an extension of the shakeout formation and it suggests that a deeper price correction has happened. The name 'Rounding' is given because the price structure looks like the traditional rounding formation that has resulted in a breakout. 

Below is a chart of SBIN showing the Rounding bottoms.

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I have observed that many times the Rounding bottom pattern of Three-Line break charts are seen as ‘V’, ‘M’, ‘W’ type patterns on bar and candlestick charts because of price reversal that breaches the extreme price of previous three lines.

So, two bearish lines between two bullish lines in four-line reversal pattern form the Rounding bottom pattern, and the two bullish lines between two bearish lines form the Rounding top pattern.

If you observe the Line break charts, you will frequently find Rounding tops and bottoms in a strong and established trend. Unless second bearish line is very narrow in the rounding pattern, shakeout and Rounding pattern has got separate importance. Shakeout shows a quick recovery. Reversal occurs after the follow through to a correction in case of rounding pattern.

So, the rules of rounding reversal pattern make it different from other four-line reversal patterns.

Trading Rules:
  • Buy when there is a bullish rounding pattern
  • Exit when there is a bearish change of line
  • Short when there is a bearish rounding pattern
  • Cover when there is a bullish change of line
Let us discuss the last pattern in this segment.

Pattern 4: Expanding formation

This is another interesting pattern of the Line break chart. Simple rules, but very meaningful.
Series of alternative lines in Three-Line break chart makes it a pattern of expanding triangle. See below image.

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It is an expanding pattern if all four lines in four-line patterns are series of alternate lines. If last line is bullish, it is bullish expanding pattern. If last line is bearish, it is bearish exploding pattern.

In simple words, the sequence of bearish line, bullish line, bearish line, and a bullish line is a Bullish expanding pattern. Similarly, a sequence of bullish line, bearish line, bullish line and a bearish line is a bearish expanding pattern.

People who know about Renko chart can relate it to Zigzag pattern in Renko chart I explained in my book Profitable trading with Renko charts. But series of alternate bricks show a pattern of consolidation because correction is of fixed brick size. Pattern of alternative lines in Three-Line break chart shows expanding pattern – why? Because the length of line is not fixed, and each line is a breakout pattern. Bullish expanding Line-break pattern is a series of bullish breakout followed by bearish breakout followed by bullish breakout followed by bearish breakout – hence, expanding.

And this is where understanding the properties of different charting methods paly role. I wish Definedge will significantly contribute to this field and make people explore these possibilities.

So, the definition makes us identify expanding price patterns via Line-break charts. Occurrence of this pattern would be less compared to other four-line patterns. The pattern suggests that the volatility is more and there is an indecision amongst market participants.

Expanding phase is a difficult scenario for breakout traders and trend followers. Their systems go through the whipsaws during this kind of period. Whipsaws are unavoidable in any system. The phases of smooth trend, volatility phases, convergence and expansion are inevitable.

Does this pattern mean our stop has gets triggered frequently? Yes, if you are trading all change of lines patterns in that instrument. Expectancy of bullish change of line pattern is positive even after accounting for the losses due to these whipsaws.

Below is a chart of SBIN showing the Expanding patterns.

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Bullish expanding patterns marked at the bottom turned out to be a major bottom pattern. It was followed by bearish expanding pattern caused by small bullish lines. Price did not fell immediately and followed by Rounding top pattern. The Rounding top pattern was failed when price went above it.  We will discuss more about failure of patterns later.

Below is a chart of M&M showing the Expanding and other four-line reversal patterns.

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This bifurcation of four-line patterns is important work in this charting method because it makes us know the nature of reversal pattern and it can prove helpful from trading perspective.


Trading Rules:
  • Buy when there is a bullish rounding pattern
  • Exit when there is a bearish change of line
  • Short when there is a bearish rounding pattern
  • Cover when there is a bullish change of line
There is a possibility that bullish expanding formation is immediately followed by a bearish line that forms bearish expanding formation.

It is rare but possible solution is to wait for confirmatory line. What is that? We will soon discuss it.
If you will think carefully, you will realise that all reversal patterns on the Three-Line break charts will fall in one of the above-mentioned categories.

Below is a chart of ASHOKLEY explaining all four-line reversal patterns on the Line-break chart.

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Pattern A is bearish Trend reversal. Pattern B is Bearish shake-out followed by bullish trend reversal at pattern C. Pattern D is bearish trend reversal. Pattern E is Bullish Expanding. Pattern F is bullish shakeout followed by bearish trend reversal at patter G. The correction was a series of bearish lines followed by bullish trend reversal pattern at H. Pattern I and J are bullish continuation shakeout patterns followed by bearish trend reversal pattern at K. Pattern L is a bullish trend reversal pattern.


We will discuss more about trading them. If you could recognise the patterns explained above, then we have successfully divided all the possible reversal patterns on the Three-line break chart.
One more chart before we discuss the things further.

Below is a chart of BATA India showing the Line-break patterns.

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Pattern A is a bullish trend reversal pattern followed by series of bullish line. Pattern B is bearish trend reversal patterns. Pattern C is a bearish shakeout pattern. The bullish line is pattern C is a bullish trend reversal pattern which turned out to be a bearish shakeout pattern. Pattern D is a bullish trend reversal pattern followed by bullish shakeout pattern at E. Pattern F is bearish trend reversal pattern, but price reversed immediately. Pattern G is a bearish rounding bottom pattern followed by a series of bearish lines and a strong downtrend. Pattern H is strong bullish line that triggered bullish trend reversal pattern.


I hope you are clear on these patterns. All these patterns are objective in nature and trades can be planned if the universe is small. But it is also possible to pick couple of patterns and trade them on a larger universe of stocks. Patterns can be filtered based on chart analysis and other studies.

Below is an example of chart analysis of patterna long with trend lines. 

LB_Adanient

Bifurcation of patterns can help from analysis perspective. It is possible in TradePoint Desktop and Web to scan these patterns on any group of stocks on End-of-the-day as well as Real-time basis. 

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Let us perform some Data testing on these pattern in the second part of this chatpter. 


Click here to read Part II of this chapter