Trading Secrets

Detecting the Pattern Effect

by Louise Bedford

(first appeared in July 2003 edition of 'Leverage' in Shares Magazine)

Sometimes, even though we can understand the concepts of technical analysis, it can be difficult for us to recognise successful chart patterns as they occur. There is a temptation to 'kick ourselves' when we've missed the perfect entry, based on a blindingly clear pattern that happened three months ago. Unfortunately, we are not permitted to trade trends that have occurred in the past. We're only allowed to trade the right-hand side of the chart and to trade trends that are now unfolding.

Last month, we discussed four commonly occurring patterns - double tops and bottoms as well as triple tops and bottoms. By developing confidence with pattern detection, you will be provided with ample opportunity to profit from your analysis.

Before looking for any specific micro-patterns on a daily chart, it is helpful to take the macro approach of assessing the broad market conditions and trend. The aim is to define whether the share in which you are interested is in a medium-term uptrend or downtrend. For this reason, in general terms, I begin with an examination of a weekly chart, before progressing onto charts of smaller time increments, such as daily and intra-day charts. Now let's move onto a few other valuable patterns that can assist your trading results.

Bullish and bearish V-reversals

Description
The market dramatically reverses its existing trend within a few periods. This is often accompanied by a significant increase in relative volume levels.

Location
This pattern is a top and a bottom reversal pattern. An increase in volume would assist in adding bullish confirmation. For a bearish V-reversal, often there is no increase in volume required to provide a valid signal. The share can drop from a great height with just a few sellers initiating the slide.

Psychology
The market has violently altered its opinion of the value of the share, often initiated by a change in the fundamentals of the company. An immediate sell-off or rally is initiated, usually on heavy volume.

Bearish V-reversals epitomise fear as the sellers scramble over one another to exit their positions. The change in sentiment is often quite dramatic. Some traders will be caught like the proverbial rabbit in the headlights and react with complete shock regarding their new-found predicament. As stated by Mark Douglas in The Disciplined Trader: Developing Winning Attitudes: 'Fear will also limit your range of responses to any given situation. Many traders suffer considerably when they know exactly what they want to do but, when the moment arrives, find themselves completely immobilised.'

This means that the share's downward plunge will often find a level of support as the eager initial sellers slow down their frantic activity. After a few sessions of sideways progression, often these transfixed and terrified traders have had a chance to adjust to their situation, sell their shares, and continue the downtrend. The price may even bounce slightly to adjust for the apparent overreaction of the market participants, before continuing downward.

In the case of a bullish V-reversal, punters are often so overjoyed at the initial activity that they will buy more shares and add fuel to the bullish fire. For the share to continue to react bullishly, this is necessary and can be seen as an increase in relative volume levels.

Strategy
These types of patterns are notoriously difficult to trade. After the initial reaction, share price often travels sideways for a few periods before continuing in the direction of the reversal. This is called a 'V-reversal with a step'. As a suggestion, wait for at least two higher low share prices before attempting to bullishly trade in the direction of a V-reversal. Bearish V-reversals can use the same method by waiting for at least two lower high share prices before engaging a trade.

Instruments to trade in the bullish direction include the stock itself, a written put, or a bought call option or warrant. Bearish V-reversals may inspire you to write a call option, short sell, or buy a put option or warrant. Be aware that this type of pattern is not usually conducive to writing a covered call option. The small income that you will receive from this action will usually be completely eroded by the share price drop and the ensuing loss of capital that you will experience as a result of owning the physical share.

Remember to always implement a stop-loss on the physical share as this will help to protect you against this capital loss situation. This holds true even if you have written a covered call above the share price action. Stop-losses help to mitigate disastrous situations. You can always buy the share back at a later date if it provides an appropriate signal. Crossing your fingers and hoping for a last-minute reprieve has led to the downfall of many traders in the past.

The dramatic price adjustment will often create an increase in the volatility of the share. This can have an impact on the pricing for options and warrants. The share has broken out of its predictable behavior patterns. This can affect implied volatility levels of the option or warrant. Also, historically, based on the most recent periods, it has behaved erratically. This can have the effect of boosting option and warrant prices quite dramatically. For this reason, bought derivative positions can become more expensive, and written positions become a more attractive alternative.

If you are now involved in a written derivative position when this pattern occurs, you will suddenly find that it requires a lot more capital to exit your position. Unfortunately, this by-product of an increase in volatility is very difficult to predict at the time you entered your position. It suggests that a hard dollar stop is often more appropriate as an exit mechanism than using direction in isolation. A hard dollar stop can be effectively utilised for bought options/ warrants, or futures. For example, when you've lost a maximum of 2 per cent of your allocated trading equity in any particular trade, exit that position immediately.

The golden rule of trading is: keep your losses small and let your profits run. Stop-losses provide a sign that it is time to exit your position as the trade is no longer co-operating with your initial view. Every successful trader has pre-meditated the point of exit prior to entering the trade. Volatility and pattern-based systems tend to work well for short-selling, or trading shares.

Head and Shoulders

Description
During an existing uptrend, head and shoulder patterns are characterised by the central peak being located at a higher position on the share chart than the first and latter peak.

Location
This is a significant top reversal pattern. Support is formed at the 'neckline' where the lows of this pattern align. When support for the neckline is broken, the reversal pattern is confirmed. Trade in the direction of this break of support.

Psychology
The market has tried to rally three significant times. When support at the neckline fails, the market is flooded with fear, so the sellers outnumber the buyers. Price action above the highest peak means the pattern is not confirmed and market sentiment has shifted to bullish.

Strategy
Trade these patterns in the same manner that you would trade a triple top pattern. When you notice that a share is in the process of forming a double top, this can act as an ideal set-up for a short sold position. Alternative choices could be to enter a written call position, or a bought put position. Any of these will capitalise on the existing downtrend. Waiting for the neckline to break and for share price activity to appear below the support of the neckline could act as a trigger.