Dragon Patterns
Pattern Recognition’ in Technical Analysis is defined as a process
where we recognize recurring events identifying certain predictive patterns
of price behavior. These patterns are clear derivatives of human behavior manifested in the markets. Although patterns very rarely repeat exactly at the same trading levels or the same dimensions, there exist patterns that repeat with similar shapes and similar sequences. Identifying
these patterns and trading them with a set of rules adds to a trader’s success. Successful pattern recognition and execution must consist of a framework and a rule based trading methodology. In this article,
I would like to describe one of my favorite patterns in trading called ‘Dragon’
with a pattern recognition framework and its trading rules.
The Technical Analysis arena provides plenty of patterns, cycles and indicators for a trader’s arsenal. A powerful basic pattern is the ‘Double Top’ or ‘Double Bottom’ pattern. Most traders are familiar with the concepts of ‘Double Tops’ and ‘Double Bottoms’ or ‘M-Tops’ and ‘W-Bottoms.’ However, all of these patterns have variations and different characteristics.
Markets rarely transition from bearish mode to bullish mode (except in V-Tops and V-Bottoms) without going through a series of price action sequences to test support and resistance areas. Major market bottoms or market tops involve a series of turning points (Swing Highs in M-Tops or Swing Lows in W-Bottoms) followed by some congestion before picking
a countertrend direction from prior moves. The Dragon pattern highlights
these turning points (Swing Lows/Highs) and provides a rule-based methodology for trading them. Dragon patterns are visible in all-time frames and in all market instruments.
Dragon Framework
The Dragon pattern is similar to the ‘W’ pattern or the ‘Double Bottom’ pattern with a few different trading rules and targets.
Inverse Dragon patterns are similar to ‘M’ pattern. Dragon patterns usually
form at market bottoms. Dragon patternswork in all timeframes and in all market instruments. Like most ‘Double Bottom’ patterns, Dragon patterns present excellent trading opportunities with low risk to reward ratios.
The Dragon pattern starts with a ‘Head’ formation and price declines from the head level to form two legs of the Dragon.
These two legs usually form within 5% to 10% of the price difference. The second leg has a strong indication of reversal as it posts a key reversal bar or a divergence in any oscillator indicators. A spike in volume usually follows the price rise of the second leg. A trend line is drawn connecting the head of the Dragon to the hump. When price closes above the trend line and is confirmed by price action or divergence in any oscillator, it signals a reversal.
The second confirmation of the Dragon pattern occurs when the price closes above the hump, which is 38% to 50% of the range or the Swing High/Low
between the two Dragon legs (or peaks for Inverse Dragon) from head to the low of the first leg.
Anatomy of a Dragon Pattern
A. Head of the Dragon
B. Formation of first leg
C. Hump (must be 0.38 to 0.5 of Amibroker)
D. Second leg (can be 0.618 to 1.27 of
Amibroker)
E. Trend line breakout (Long Trigger)
F. First target at 1.27 of CD
G. Second target at 0.886 to 1.0 of BC
H. Third target at 1.38 of Amibroker
I. STOP: Place a stop few ticks below
the lowest low of two legs.
Trading Dragon Pattern
The left example shows a Dragon pattern formation from the Dow E-mini futures 30-minute chart. On January 3, 2007, Dow futures formed the head of the Dragon.
Prices declined until January 8th in the formation of the first leg. On January
8th, prices tried to recover as they rallied to 12520. A trendline is drawn connecting the top of the head and top of the first leg. On January 10th, the second leg was formed as price retraced from the hump area to 12420. A confirmation of the Dragon formation is signaled when prices closed above the trend line at 12500.
