Trading the GARTLEY 222 Sometimes old trading ideas are the best ideas — if you can quantify them with modern analysis and testing procedures. Here, a "classic" chart pattern is defined mathematically and tested to see if it can produce profits. BY AARON BEHLE AND MARK CONWAY s an increasingly challenging market has weeded peak-to-trough or trough-to-peak) as a certain percentage of a out traders over the past few years, many sur- preceding price swing. Pesavento required these percentages vivors in search of an edge are revisiting the to be Fibonacci ratios: 0.618, 0.786, 1.00, 1.27 and 1.618. works of the original technical analysis masters, The problem is that if you disregard those patterns whose including Richard Schabacker, J.M. Hurst, W.D. Gann and price swings are not proportional using precise Fibonacci Harold M. Gartley. ratios, the Gartley 222 pattern is quite rare. Using a "tolerance Gartley wrote Profits in the Stock Market in 1935, and what percentage" (T%) that expands the range of acceptable price- makes the book striking is not that it shows how much techni- swing ratios produces more pattern examples and, thus, more cal analysis has advanced since then, but rather, how little it trade opportunities. For example, if T% = 10 percent, segment has changed. In many cases, "modern" patterns with catchy names are simply rehashes of price behavior observed long ago by people like Gartley. One example is a pattern commonly known as the "butterfly," named for its resemblance to a pair of butterfly wings America Online (AOL), daily (see Figure 1, right). However, Gartley described this pattern in Profits in the Stock Market as the "Gartley 222," a refer- ence to the page number on which the discussion occurred. The Gartley 222 can be defined objec- tively by establishing specific propor- tions for the four price swings (XA, AB, ВС and CD in Figure 1), or legs, that comprise the pattern, as well as by set- ting criteria to define the magnitude of the swing ("pivot") highs and lows — points А, В and C. Percentage relationships In his book Profitable Patterns for Stock Trading, analyst Larry Pesavento used certain ratios to define the butterfly pat- tern, measuring each price swing (from 38 www.activetradermag.com • August 2003 • ACTIVE TRADER AB (the second price swing) can be between 51.8 percent and 71.8 percent of segment XA (the first price swing), rather than exactly 61.8 percent. Another criterion that can be applied Morgan Stanley (MWD), daily to the pattern is the "strength" of the pivot points. For example, a pivot high has a strength of 3 when the three bars preceding the high and the three succeed- ing it are all lower than the high; a pivot high with four preceding and succeeding lower highs would have a strength of 4. Each pivot in the 222 pattern must meet this strength requirement. As the pivot strength increases, so does the length of the pattern and the likely duration of a trade based on it. However, the higher the pivot strength, the fewer patterns that will qualify for trading, and the longer those patterns will be. Pivot strength can also be measured in percentage terms — e.g., a 2-percent swing from peak to trough on a 60- minute chart, or a 10 percent swing on a daily chart. These parameters should be appropriate to the time frame; price moves on an intraday chart peak X to trough A defines the segment XA, trough A to peak will be proportionally smaller than those on daily or weekly В defines the segment AB, etc. charts. (With all these criteria, finding the pattern by scanning High В retraces a percentage of trough A but is lower than charts is difficult, at best. Accordingly, code for defining the pat- high X. Again, segment CD retraces all of segment ВС but does tern in both the TradeStation and Wealth-Lab analysis pro- not reach the point X high. Point D is the sell short point. grams can be found at www.activetradermag.com/code.htm.) The pattern lines in Figure 2 are based on the following cri- Using objective criteria for defining price patterns allows teria: you to build a consistent strategy for trading them. We will use specific Gartley 222 pattern parameters to enter both long and 1. Pivot strength = 3 short trades on different time frames. Back-testing on the 2. Maximum number of bars in pattern =100 Nasdaq 100 stocks over the past several years will provide an 3. T% = 10 percent indication of the strategy's potential. Gartley 222 strategy Defining the swing relationships A Gartley 222 setup should always have a minimum potential In Figure 1, which shows a bullish 222 pattern, low X to high A reward/risk ratio of 2:1. This system uses a stop-loss at Point X defines segment XA; high A to low В defines segment AB, and and a profit target equal to 61.8 percent of segment CD ("DT" so on. The first thing to determine is how the size of these price in the following calculations). The profit target for a bullish swings should relate to each other. butterfly will be equal to Point D + DT, and the short target for Low В retraces a certain percentage of high A, but is higher a bearish butterfly will be D - DT. than low X. Segment ВС is an even smaller retracement of high The calculations used are: A, but segment CD retraces all of segment ВС but is above low X. Point D is the buy point. XA = | X - A | To measure the retracements, we'll use the proportions AB = | A - В | defined in Appendix I of Pesavento's book: BC= | B-C | D = A - (0.786 * XA) for bullish butterfly AB should be 61.8 percent of XA D = A + (0.786 * XA) for bearish butterfly ВС should be 61.8-78.6 percent of AB CD=|C-D| CD should be 127.0-161.8 percent of ВС AD = | A - D | AD should be 78.6 percent of XA DT = 0.618 * CD Tolerance = T% Figure 2 (above) shows a bearish 222 pattern, which resem- bles the letter "W." Reversing the logic of the bullish pattern, continued on p. 40 ACTIVE TRADER • August 2003 • www.activetradermag.com 39 222 trade. The stock twice closed within 10 cents of the pattern high. A short trade initiated at this level would have a profit target of at least 60 cents with risk limit- ed to 10 cents - a 6:1 reward/risk ratio. Note the two different lines denoting segment CD. In a bearish 222 pattern, D is the price level at which to short — e.g., it is based on the high of a bar satisfying the condition that segment CD retraces at least 127 percent of segment BD. If this condition is true, the pattern is drawn. Now, suppose the next bar's high price is lower, and that segment CD now retraces only 125 percent of segment BD. This is not a valid Gartley pattern and no pattern is drawn. In this case, though, the second bar did have a higher high, so a new segment CD line is drawn. Although the strategy calls for entry at point D on the initial bar that completes the pattern, it is useful to keep tracking subsequent bars that fulfill the pattern criteria in the event you miss the first Entry rules opportunity and need a second chance to enter the trade. Bullish Gartley 222: However, if the next bar's high is higher and comes back 1. A > С and С > В and В > D and D > X into the "Gartley range," the pattern will be drawn again. 2. The pattern must be a trough-peak-trough-peak These "multiple" patterns tend to develop when price is trad- sequence ing in a range. The T% has been loosened to 20 percent in this 3. AB / XA > 0.618 - T% and AB / XA < 0.618 + T% case; the higher the tolerance, the more patterns that will occur. 4. ВС / AB > 0.618 - T% and ВС / AB > 0.786 + T% Although this is a modified version of the Gartley setup, we 5. Repeat for CD / ВС and AD / XA. prefer to see all potential patterns as they take shape. 6. If the conditions above are true, then buy at price D with Varying the input parameters to reflect different swing pro- a limit order. portions and pivot strengths will identify different kinds of Gartley setups. For example, higher pivot strengths will reveal Bearish Gartley 222: setups that are developing over longer time frames. A higher- 1. A < С and С < В and В < D and D<X 2. The pattern must be a peak-trough- peak-trough sequence 3. AB / XA > 0.618 - T% and AB / XA < 0.618 + T% 4. ВС / AB > 0.618 - T% and EMC Corp. (EMC), 60-minute ВС / AB > 0.786 + T% 5. Repeat for CD / ВС and AD / XA. 6. If the conditions above are true, then sell short at price D with a limit order. Exit rules Bullish Gartley 222: 1. Profit Target: D + DT 2. Stop Loss: X Bearish Gartley: 1. Profit Target: D - DT 2. Stop Loss: X Example 1 Figure 3 (left) is an example of a very 12/23 12/24 12/26 12/27 12/30 12/31 1/2 favorable reward/risk ratio for a Gartley 40 www.activetradermag.com • August 2003 • ACTIVE TRADER parameters to your holding period. In this case, the pivot strength was set to 5 and the pattern developed over seven trading days. A trader may decide to hold a position over the same period for "time symmetry" - that is, sometimes the moves that spring from a Gartley setup are proportional to the original pat- tern length (in time). Figure 5 (left) is a good example of time symmetry. The bullish setup devel- ops over 16 trading days, and 16 days later EBAY had gained more than six points from the entry. Here, the stop-loss amount is less than one point, so even if you chose to exit the trade on the first up move, the trade's reward/risk ratio was at least 3:1. As long as price stays in the zone between the troughs, the pattern is valid until price either breaks below the first trough or moves above the second trough. strength pattern combined with a lower-strength pattern is a Some traders wait for a confirmation bar - a close above the open powerful combination for trading these setups. In some situa- or a close greater than the previous close. However, if the tions, a lower-strength (shorter-term) pattern will form within a reward/risk ratio is good, place a limit order close to the bottom higher-strength pattern, in which case you can enter a trade of the pattern and let the price action do the rest. based on the shorter-term pattern and have the potential to cap- Figure 6 (below) shows another intraday (five-minute bars) italize on the longer-term pattern. setup. Like the Figure 5 example, this pattern is time-symmet- ric, and the high occurs around one hour later. Also, this setup Intraday setups was based on a pivot strength of 4, and the pattern is 16 bars in These patterns can also be traded on intraday charts. A Gartley length — referred to as a "4x4" because of its perfect symme- 222 setup on a 60-minute chart is suitable for a swing trade try and compact form. with an approximate holding period between one and three Gartley 222 patterns can be traded on 1-, 2-, and 3- minute days. charts. The only caveat regarding these time frames is to be In Figure 4 (opposite page), the stock does not initially hit careful of a bullish setup that occurs after a run-up - you the profit target, but pulls back to the continued on p. 42 buy point. However, it stays above the stop-loss point at the bottom of the chart and, finally, the real move occurs two days later. Remember to adjust the pattern Additional reading Professional Stock Trading: System Design and Automation by Mark R. Conway and Aaron N. Behle. (2003, Acme Trader LLC, Waltham, Mass.). Profits in the Stock Market by Harold M. Gartley (1935, Lambert-Gann Publishing Co., Pomeroy, Wash.). Profitable Patterns for Stock Trading by Larry Pesavento 10:05 10:20 10:35 10:50 11:05 11:20 11:35 11:50 12:05 12:20 12:35 (1999, Traders Press Inc., Greenville, S.C.). ACTIVE TRADER • August 2003 • www.activetradermag.com 41 could be looking at an "M" top pattern. above a favorable threshold, such as 3:1). Similarly, a bearish setup after a mid-day The test reflects only one set of pattern correction may be a "W" bottom pattern. parameters, in this case, a T% of 10 per- Context is important for intraday pat- cent and a pivot strength of 7. One terns, so keep an eye on the longer-term parameter set does not capture all the time frames. possible patterns that occurred over the three-year period. Test results The approach used here makes it pos- Table 1 (above) shows the back-testing sible to find price patterns using objec- results for daily Gartley 222 setups using tive criteria, which in turn makes it pos- the rules we defined earlier. The results sible to test trading ideas based on the reflect 165 trades in 100 stocks. In all the pattern to see if they have potential. tests the profit factor (gross profit divided by gross loss) was consistently in a range For information on the authors, see p. 10. of 1.4 to 1.5. These trades were not filtered in terms of their reward/risk ratios (that Code for this pattern can be found at is, all setups were traded, not just those www.activetradermag.com/code.htm. 42 www.activetradermag.com • August 2003 • ACTIVE TRADER