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Short Term Trading Strategy Based on Chart Pattern

Recognition and Trend Trading in Nasdaq
Biotechnology Stock Market

Conference Paper · May 2010

DOI: 10.1007/978-3-642-15402-7_10 · Source: DBLP

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 Short Term Trading Strategy Based on Chart Pattern
Recognition and Trend Trading in Nasdaq Biotechnology
Stock Market

Saulius Masteika

Vilnius University, Faculty of Humanities, Muitines 8, 44280 Kaunas, Lithuania

saulius.masteika@vukhf.lt

Abstract. The main task of this paper is to show the results of stock market
trading strategy based on short term chart pattern. Proposed short term chart
pattern is a trend following pattern and is relative to fractal formations and
chaos theory. The proposed trading strategy consists of two steps: on the first
step the stock screening algorithm is used to select volatile stocks in Nasdaq
Biotechnology market; on the second step technical analysis and mathematical
calculations for selected stocks are applied and profitability of strategy is calcu-
lated. The proposed trading strategy based on short term chart pattern was
tested using historical data records from the USA Nasdaq Biotechnology mar-
ket (2008-2010). The trading strategy applied in Biotechnology stock market
had given higher returns if compared to the main USA stock market indexes
(Dow Jones, S&P, Nasdaq).

1 Introduction
When taking decisions in the stock markets, investors rely on various criteria. Two
main directions of market analysis are distinguished. One is fundamental analysis,
based on financial indicators the other is technical analysis, based on historical data of
price changes [8, 10]. With the increasing use of computerized technologies and di-
minishing trust in financial reports of enterprises, technical analysis is increasingly
applied for market analysis [12].
Chart pattern is a part of technical analysis. A chart pattern is a distinct formation
on a stock chart that creates a trading signal, or a sign of future price movements.
There are two types of patterns within this area of technical analysis, reversal and
continuation. A reversal pattern signals that a prior trend will reverse upon completion
of the pattern. A continuation pattern, on the other hand, signals that a trend will con-
tinue once the pattern is complete [15]. Continuation pattern is used in volatile and
unstable markets where there can be many overreactions, which cause the market
movement trends to last longer than anticipated [9, 11, 13].
Typically the time required to build chart pattern varies from 5 till 60 periods [1,
7]. In these days’ unstable economic environment and volatile markets the decision
was made, that it is less risky to use short term trend trading strategies which in case
of a sudden change in the market behavior can cause the adequate reaction.
The main goals of this article is to present a newly build trading strategy based on
short term continuation pattern, to formalize it and to show the results of experimental

W. Abramowicz, R. Tolksdorf, K. Węcel (Eds.): BIS 2010 Workshops, LNBIP 57, pp. 51–56, 2010.
© Springer-Verlag Berlin Heidelberg 2010
52 S. Masteika

investigations in a volatile stock market. The method of formalization of chart pattern

was chosen from previous research [7].

2 Basic Concept of the Proposed Short Term Trading Strategy

The proposed short term trading strategy is based on trend following chart pattern.
Proposed chart pattern is relative to fractal indicators, presented by Ph.D. Bill
M.Williams [2, 3]. The fractal indicator is build from chart bars and is used to deter-
mine when there is continuation in the market. There are many forms of fractals. That
fact makes many uncertainties when using this indicator. The proposed chart pattern
with 3 periods lets increase prediction sharpness because of ignoring older data in-
formation. Generalizing the proposed short term trading strategy one can be stated
that the trading system looks for securities with the biggest price increases; if the
trend of increase is confirmed, such securities are bought.

2.1 Chart Pattern Used for Trading Strategy

The block scheme of the identification algorithm of the chart pattern is provided in
the next figure:

Fig. 1. Block scheme of the identification algorithm of chart pattern

The algorithm uses the FOR cycle, which allows to identify the formed signals in
the period i. The cycle starts from i=3, because the data of the previous periods i-2
and i-1 are necessary for the identification of the signal. The cycle ends with variable
N, which determines the last period of experimental investigation. If there are no open
positions and the variable Poz is equal to zero (block 4), a signal of buying is sought.
 Short Term Trading Strategy Based on Chart Pattern Recognition 53

The signal of buying is formed by checking whether the highest price H of period i-2
is higher or equal of the highest price H of period i-1 (block 6). If so, further check is
carried – whether the period’s i opening price O is lower or equal to the highest price
H of period i-1 (block 9). If the condition O[i]<=H[i-1] is not met, buying operation
is carried out, the variable Per being attributed the value of one in the period i. Also,
the value of one is given to the variable Poz (block 11). If the condition O[i]<=H[i-1]
is met, a check is carried out whether the highest price H of the current period i is
higher than highest price H of the previous period i-1. If so, a buying signal is identi-
fied (block 13). The same way the selling signal is identified by observing the lowest
prices L of periods.
Short term chart pattern based on trend trading is characterized in the following
way: after a large price increase of a share, price stabilization is awaited. After the
price stabilization, one awaits the moment when the highest price of the previous day
will be reached. At this point, shares are bought. With the application of this indica-
tor, one expects that the price rising trend will remain strong and will continue for
some time.

2.2 Quality Coefficient and Stock Ranking

In order to rank securities, there must be build a stock quality coefficient [7].
Proposed short term trading strategy is looking for securities, which during n day’s
period increased in price the most. The quality of the stock is measured using the
following equation:
Ci −1×100
Q = − 100 (1)
Ci −1− n

In the equation (1) Q represents the quality coefficient, C- the price of the period i-1,
n- the number of days used in calculation of price change. The biggest increase of a
particular stock in price during n day’s period means the best quality. When ranking
the stocks there are applied some rules: the price of the stock in period i-1 must be
bigger than $2 and the volume must be at least 100000 stocks traded per day.

3 Experimental Investigation
The efficiency of the proposed short term trading strategy was tested using historical
stock market data. The data set comes from USA Nasdaq Biotechnology stock market
and represents daily open, high, low, close, Adj.Close prices and trading volumes from
February 1, 2008 till February 1, 2010. The Nasdaq Biotechnology stock market was
chosen not by a chance but rather than looking for volatile and variable markets. The
conclusion, that Nasdaq Biotechnology market is one of the most volatile and variable
was made after doing some calculations of standard deviation. The calculations
showed that average standard deviation of price changes of companies that belong to
Nasdaq Biotechnology index is much greater if compared with other indexes. More
detailed comparison of calculations is shown in the next table:
The calculation shows that price changes of the companies belonging to Nasdaq
Biotechnology 125 index tend to be at least 50% more variable than price changes of
54 S. Masteika

Table 1. Standard deviation of price changes (average of index components)

Index Standard deviation

Nasdaq Biotechnology 125 5.00
Nasdaq100 3.26
S&P100 3.24
DowJones30 2.86

Nasdaq100, S&P100 or DowJones30 components. The conclusion can be made that

there are more companies with exceptional behavior of stock price changes in Nasdaq
Biotechnology market in comparison with the other markets.
A portfolio of the trader was filled with one stock with the highest rank when ap-
plying the proposed short term trading strategy. Only one stock with the highest rank
at that particular period was tested for chart pattern presence. If there were no chart
pattern signals generated (Fig.1) no action were taken at that period. The transaction
costs of 0.35 % were withdrawn from the returns per contract. Taking into considera-
tion the rules applied to formalization of technical analysis indicators specialized
standardization of historical data was used [7]. Specialized standardization of histori-
cal data consisted of the following parts:
- Recalculation of prices, taking into account share splitting and dividends
paid. Following equations were used to recalculate the prices:
Adj.Close × 100 , Open × Delta , High × Delta , (2,3,4)
Delta = Open (new) = High ( new) =
Close 100 100

Low × Delta , (5)

Low(new) =
100

where Adj.Close, Close, Open, High and Low are historical data of a particu-
lar stock at concrete time period. Yahoo!® Finance was chosen as data
provider.
- Elimination of lack of data. The securities with interruptions in their data se-
quences were eliminated from experimental investigation.
- Recalculation of absolute values into percentage values
- Buying/selling imitation of securities;
- Calculation of the results of trading.
The detailed functioning of the proposed short term trading strategy can be described
as follows:
- Obtaining and specialized standardization of historical data (Eq.2-5);
- Calculating the quality of stocks at particular period; the parameter of n=2
was chosen (Eq.1). Selecting the stock with the highest quality coefficient;
- Application of short term chart pattern algorithm (Fig.1);
- Buying/selling imitation of securities;
- Calculation of the results of trading.
The total returns when using proposed short term trading strategy are presented in
Figure 2 and Figure 3.
 Short Term Trading Strategy Based on Chart Pattern Recognition 55

Fig. 2. Profitability of trading strategy in Nasdaq Biotechnology and S&P100 markets

Fig. 3. Profitability of trading strategy in Nasdaq 100 and Dow Jones 30 markets

The results of experimental investigation have shown that the proposed short term
trading strategy serves the purpose when trading in companies bellowing to the in-
dexes of Nasdaq Biotechnology and partly S&P100. There are a low number of trans-
actions when using proposed trading strategy. Capital fluctuations are medium.
The comparison of results with other trading strategies presented by other re-
searches is not presented because the comparative analysis faces difficulties with accu-
racy and compatibility. It is so, because the indicators of technical analysis which are
used in other trading strategies are not formalized completely or formalized differently.
While doing experimental investigations other researches treat differently the quality
of historical data, precise description of indicator’s parameters and trading signals, the
strength of the signals and etc. This leads to the absence of unanimous rules concerning
specific indicators which affects analysis inaccuracies. In order to compare different
trading strategies and to eliminate possible heuristic deliberations about indicators, the
same formalization method of technical analysis indicators must be applied for all the
strategies that take place in analysis [7]. Generalizing the experimental investigation
one can state that the proposed trading strategy has proved that the best results were
gotten in volatile and variable market. The strategy has infrequent trading signals
which lead to periods when the investment capital is not used. In order do deepen the
56 S. Masteika

investigation further experiments with other trading strategies using the same method
of formalization of technical analysis indicators should be done.

4 Conclusions
Preliminary experimental tests have shown that the proposed short term trading strat-
egy tested with the companies that belong to Nasdaq Biotechnology index outper-
forms the main USA stock indexes. Less promising results were got with stocks that
belong to less volatile and variable indexes Nasdaq100 and DowJones30. The conclu-
sion can be made that the proposed strategy can be attractive to individual traders who
are intended to trade using short term strategies especially when volatile movement
appears in the markets. Despite of good preliminary results in Nasdaq Biotechnology
market, more extensive tests with the proposed methodology may be done (different
markets in other countries, time periods, portfolio diversification) to evaluate more
precisely the whole domain of possible applications of this strategy.

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