made any significantprogress to make these three to five day pro-jections. Our problem is one of time and man-power. Chris returned to finish his college edu-cation so it was necessary to replace him, Dr.Pat now enters the picture.
Dr. Patrick McGuire is a 27-year-old Ph.D.in applied mathematics from the University ofArizona. He is extremely well qualified andvery interested in neural networks. Patrick hasbeen working with me over the last six monthstrying to solve this problem. We are makingprogress, but it is much slower than | wouldlike to see. For the first few months it seemed122
Larry Pesavento
that I was only buying more memory and ex-tra gadgets for the computer. The daily neuralnets work so well | frequently wonder if Ishould be satisfied with what I have and leaveit at that. There must come a time when youfinally stop pouring money into a project dueto the concept of diminishing returns, What-ever happens from this point forward is not asimportant as what has happened so far. TheTomahawk neural network software systemdemonstrates that speculative markets are nottotally random, Within the chaos of the mar-ket, vibrations are identifiable patterns that re-appear over and over again. Each of these pat-terns brings a trading opportunity. It is the re-sponsibility of the trader to determine whichpattern is present and the risk involved. Risk
 
is the only thing we can control in a trade! Noone can tell us with 100 percent accuracy whatis going to happen next.
He who knows notwhat he risks—trisks all!
Risk!!The perception becomes real!
yuan melt of the aFTO He Wire of the markets, I'd like to co diidioe through
atical example. Sele:
y two. numbers between one and infinity ee, ene use.
207, and 11; 02 ) Now tet $ Bethrough the following calculations.
£11,492+11,789".» #23,281435,070.+58,351693,421+151,772+245,193+396,965
add thi um to the next number
~ sacred geometry. ach day the Tomahawk neural network system starts with two — :
two- eminute time ne oe and oy Hie
fu
 Stock Trading Using Pattern Recognition and Geometric Ratios
123
| ee
When the strike of a hawk breaks the bodyof its prey, it is because of timing.—Sun Tzu, The Art of War
Tony Robbins lists seven beliefs in success thatall successful people use in their quest forexcellence. Success belief number four reallydescribes my relationship with the Tomahawkneural network, Number 4 states: "It is notnecessary to understand everything in order tobe able to use everything." It would be about aseasy as teaching brain surgery to you in a fewpages as trying to explain a neural network. Buthere it is in layman’s terms with the leastamount of technical jargon,
Machines that think, that use reason andlogic to solve problems, have long been the ul-timate fantasy of science fiction writers, Nowit is the computer scientists who are pokingabout the fundamental concepts of how themind works in an effort to develop programsthat imitate the brain's behavior and actuallythink.
In 1955 Herbert Simon of Carnegie-Mellon University developed a program thatworked out simple REM (Rapid Eye Move-ment). Since then, research in theoreticalmathematics, coupled with advances inmicrotechnology developed for the space pro-gram, has led to development of the science ofArtificial Intelligence. A driving force in thisfield is neural network technology, a new classof computing that uses from hundreds to hun-dreds of thousands of simulated neurons, allconnected to one another, to perform analysesand draw conclusions in a primitive imitationof how the human brain functions
These simulated neurons, or nodes, aresimple processors wired so that each one cancommunicate with or send signals to a groupof other nodes. This internal exchange of in-formation teaches the network relationships or
associations. When a single node is given aninput data point A it responds with an outputresult B, “Training* a neural network meanspresenting it with a series of input-outputpairs, or associations, called “facts.”
The output portion of a fact is referred toas a training pattern. Neural networks aretrained by presenting them with a set of factsover and over!
It takes over 500,000 iterations for asingle analysis. Every time a neuron reads aninput it calculates what it determines the an-swer, or output, should be, Outputs from oneneuron are used as inputs for another,
Although individual neurons, or logicpoints, may ¢ach only work on a small portionof a total problem, collectively this trainingprocess is repeated until the network uses allof the “facts” correctly, meaning the final re-sult or “solution" is within an acceptable groupof parameters, and the problem is solved. Inthe brain this process is known as parallel dis-tributed processing.
It is the job of the programmer to prop-erly define the problem and select the appro-priate set of facts for the network to analyze inorder to get a “correct” answer.
Neural networks as an analytical toolhave a number of advantages over standardcomputing, They can process a great deal ofinformation virtually instantaneously and si-multaneously, making them much faster thanconventional programming.
Nets are also more reliable because theydistribute data throughout the entire systemfor processing. This means most of the net canstill function if a few nodes break down, orsome of the inputs are questionable, This“graceful degradation® allows analysis ifenough input passes are made in the training.
Perhaps the neural nets' greatest advan-tage is their ability to generalize. Training124
Larry Pesavento
 
teaches the nets to recognize more than justthe specific examples or patterns they have al-teady seen. They can also recognize patternsthat resemble the training examples and inter-polate and manipulate them as well
These attributes make neural networktheory a logical choice for commodity analy-sis. One of the most promising applicationsuses cycle theory data to determine outputpatterns that define timing points to identifytrend changes in commodity price move-ments.
The Tornahawk® neural network programis incredibly complex. The idea began with aneural network system used by the UnitedStates Navy in offensive mechanisms in the
Tomahawk heat seeking missile. The missileshad to differentiate between submarines, largewhales, rock formations and other large oce-anic forms. The harmonic vibrations illus-trated by the Doppler effect give a simplifiedexplanation of how the missile operates. Thefeedback vibrations of a submarine are charac-teristically different from any other object.Wave vibrations in speculative markets alsohave identifiable patterns, These wave pat-terns can be categorized, Armed with this in-formation, the neural net forecasts the nextday's market forecast. This is why I think theTomahawk works so well: 1) Markets are non-linear; 2) markets are chaotic, but within thechaos are predictable patterns; 3) The patterns
A Simplified Graphic Description ofHow Neural Networks Can Operate
2 Heee PSFY
Thousands ofpatiorns and cyclesare cataloguedand indexed
>
COMPUTERWORKSTATION
By process ofelimination andtralning, onty « fewpatterns remain
Final forecast ofwhat the market isexpected to dotoday
>
COMPUTERWORKSTATION
 Stock Trading Using Pattern Recognition and Geometric Ratios
125
———
are repetitive in both price and time; 4) Thevibrations and harmonics are predictablewithin certain limits, but they can be indexedand categorized; 5) Time and price are theonly vehicles in the input data.
Those of you familiar with Excel can ap-preciate what 50 to 100 spread sheets wouldlook like with each connected to the other andsome overlapping. Then you would have abrief glimpse of the very basics of simple neu-ral networks. The Tomahawk was developed topredict what would happen the next day inany liquid speculative market. This holds truefor listed stocks, bonds or any popular invest-ment vehicle that is actively traded, It hasbeen tested on New York Stock Exchange stockfavorites such as IBM, Eastman Kodak, Coca-Cola and most of the Dow Jones stocks. ActiveNASDAQ stocks were tested with positive re-sults. The Tomahawk does not work with illiq-uid stocks or bonds. Nor does it work withIPOs (Initial Price Offerings) because of thelack of any back data and low liquidity,
The process that the Tomahawk goesthrough to forecast the next day's trend isstarted automatically at the close of the S&P500 at the Chicago Mercantile Exchange (4:15p.m. CST). All two minute price bars for thepast 30 days are saved; the oldest date isdropped automatically. Macro keys process thedata. It is then transferred to the neural net-work computer hy floppy disk. After threehours of hatd work, the neural net is finishedand the predictions are ready for the next day.I then transfer the floppy disk from the neuralnet computer back to the trading computerwhich has on-line price quotes from all majorexchanges.
The neura! net forecasts are then laidover on-line price bars. Now it is in the trader'shands, He must look at the comparison of theactual market versus the forecast of the neural
net. If the patterns match two questions mustbe asked: 1) Is the price pattern matching theneural network? 2) Can I afford to take the riskin the trade? If the answer to both of thesequestions is yes, then the trade must be taken.The reason it must be taken is simple: no oneknows which trades will be profitable. We areoperating in a world of probabilities. Lossesare as natural as breathing! If you cannot takea loss, or find it difficult to admit you arewrong, then find another career. It will saveyou a great deal of money and, more impor-tantly, it will increase your chances for peaceof mind and happiness.
The segment of computer science fo-cused on problem solving comes under thebranch of artificial intelligence, commonly re-ferred to as A.I. by its supporters. Within therealm of A.l’s kingdom are several substates.Here are only a few of them:
A, Expert systems—These programs tryto mimic the human brain by providing solu-tions automatically when a whole series ofquestions are answered. The sequence takesthe form of “what-if questioning.
B, Case-based reasoning—Here all pastproblems and solutions are indexed and classi-fied. They are stored in memory and will berecalled when the appropriate solution is indi-cated or repeated
C. Chaotie systems—Nonlinear differen-tial equations are used to find the predictablepatterns within the chaos, This is particularlysuited to financial markets because it mayalert the trader to an impending change inmarket dynamics (i.e., trend change, increasedvolatility).
D, Fuzzy logic—This mimics the humanbrain by its ability to make judgments. Thesejudgments are then classified and stored foruse in the next set of problems/solutions.126 Larry Pesavento
The Doppler Effect
  
 
   
The Doppler Effect is a change in the observed frequency of sound or light resulting from themotion of a source or observer.
Successive wave crests emitted by a stationary source in all directions approach any stationa aryobserver (A) at a constant distance, or wavelength, behind each other and al a constant frequency.
if the source moves away from an observer or the observer moves away from the source {B), thewaves seem to be drawn out to longer wavelengths and are received at a lower frequency.
it the source approaches an observer or the observer moves toward the source (C), the wavesare crowded together; appearing shorter in wavelength and follow each other at a a higher frequency
                 Stock Trading Using Pattern Recognition and Geometric Ratios 127
Schematic of Tomahawk©Neural Network
My theory of market dynamics is based on the principle that markets react to two basicemotions: fear and greed. Through a complex system of patterns and cycles, all very liquid specu:lative markets behave in the same manner. In doing so, they can be quantified, thereby permittingestimation of the amplitude and duration of these cycles, Greed is dominant at cycle tops and feariS predominant at market bottoms.
That all markets behave the same way over time can be proven easily. If you were to take anactive chart and randomly select a period of time, then remove the x and y axis headings, what
femains is a bar chart, No one can tell you what the chart is describing—over time, all charts willlook the same.
 Larry Pesavento
128
 
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Appendix |
Description of Gartley “222”
 
This is the description of the Gartley "222"pattern exactly as it appears on pages 221- 222of Gartley's book, Profits in the Stock Market.
One of the Best Trading Opportunities
In the life of those who dabble on Wallstreet, at some time or another there comes ayearning—"just to buy them right, once, ifnever again.” For those who have patience, thestudy of top and bottom patterns will providesuch an opportunity every now and then—thechance does not arise everyday, but when itdoes, a worthwhile opportunity, with smalltisk becomes available.
Figure 27 (A)A
Buy
8 Place Stops
Let us look at Figure 27(A). When, afteran intermediate decline in either a bull or abear market, such as A-B in the diagram, hasproceeded for some time, and activity hasshown a definite tendency to dry up, indica-tion that liquidation is terminating, a minorrally like B-C sets in, with volume expandingon the upside. And when a minor decline, af-ter cancelling a third to a half of the precedingminor advance (B-C) comes to a halt, with vol-
 
ume drying up again, a real opportunity is pre-sented to buy stocks, with a stop under theprevious low,
In eight out of ten cases wherein each ofthese specific conditions occurs, a rally, whichwill provide a worthwhile profit, ensues. Inthe other two cases, only small losses have tobe taken. In trading this formation, the ob-server is depending upon the probability thatcither a head-and-shoulders, or double bottom,which are the two reversal patterns which oc-cur most frequently, is developing.
The art in conducting an operation ofthis kind lies in:
a. Having the patience to wait until a de-Cline of substantial proportions has de-veloped;
b, Observing that all conditions laid downare present;
c. Having the courage to buy just as soonas the minor reaction which tests thebottom shows signs of terminating;and
d. Having the courage to get out with afair profit (10-20 per cent), or at leastProtect it with stops.
Hourly charts of the averages, availablefor guiding the operation, repay the marketstudent for all the efforts he puts into keepingthem day after day, when they are of less prac-tical use.
Similar opportunities occasionally de-134
Larry Pesavento
SS
velop for that small part of the trading frater-
As one reads the "222" pattern described
nity which has the intestinal fortitude and | by H. M. Gartley, three basic virtues are sug-temperament to sell stocks short. The case in | gested for trading.
reverse is laid out in of Figure 27(B).
6 Place StopsSellcA Figure 27 (B)
Gartley's book was written jn the 1930sand things have changed dramatically aboutthe markets, Not the markets themselves, butthe way they are reported, Communication isnow instantaneous because of the statellitedishes around the world connected to all thecomputer trading desks around the world.During Gartley'’s era, the Western Uniontickertape was the method of communciation.As I wrote that last sentence, I realized that ishow I learned to trade soybeans with DaveNelson on his Trans Lux ticker tape.
Thousands of new stocks and commoditymarkets have been introduced since Gartley’stime. Most of these are very liquid and easy togain access to the chart patterns. This is par-ticularly true for the intraday charts. In thissection of the appendix, I have selected someintraday charts illustrating these patterns.
Included in teh appendix is the page onmy monitor that shows what commodititesand stocks I follow. Each has a monthly, dailyand intraday chart pattern. Intraday charts are2 minutes, 4 minutes, 30 minutes, 60 minutesas well as a tick chart to record every tick.This is helpful to gauge whether or not you arefilled on your order and at what price.
1. Patience to wait for the market forma-tion to develop
2. Courage to put the order in and a pro-tective stop to minimize risk.
3, Fortitude and temperament to sellshort. Again protecting the positionswith stops.
The "222" is one of the best patterns atrader can expect. When it does not work itusually means that a greater trend continua-tion is in progress. Failure of the “222” patterncan be anticipated in several ways:
1. The presence of a huge gap near the Dtermination point.
2, Wide range price ranges as point D isforming.
3. After the formation of point D themarket fails to reverse. This may indi-cate a level of consolidation before re-suming the trend.135
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