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(first appeared in March 2003 edition 'Leverage' in Shares Magazine) As traders, our search for trading opportunities usually begins with a positive expectation. We may look for instances where price action confirms our perceptions of a move. These can be tools such as using various oscillators, moving average cross-overs or chart patterns. But what happens when the signal we were expecting fails to materialise? In this situation, most traders simply move on and look for another signal. This is a mistake, as the failure of a signal to eventuate is a powerful trigger. This reversal away from your expectation is known as a failed signal. The failed signal is among the most powerful and reliable signal in technical analysis. By recognising these failed signals and acting appropriately, you can profit. This holds true whether you use instruments such as futures, shares, short-selling, options or warrants. Bull and bear traps are breakouts that are followed by a sudden reversal of sentiment. This sudden reversal of sentiment is often indicative of major highs or lows. Bull traps
Consider
the Adobe Systems graph below. The price had been making a recovery
from a September 2001 low and had entered into what appears to be a
classic congestion, or a "Stage 3 formation", according to
Stan Weinstein's classic text Secrets
for Profiting in Bull and Bear Markets. Stage 3 is characterised by a sideways progression at the top
of a trend prior to a share price decline. Towards the end of this
formation, price gaps upwards, out of this sideways band, and makes a
new four-month high. Ultimately, the high fails to hold and the price drops back into the congestion zone, meanders for a few weeks and then collapses. During the collapse, the share price more than halves. In trading this style of formation, we have the following time line:
Bull traps are not usually obvious until it becomes apparent that a move to the upside has failed. However, there are a few warning signals that can alert the astute trader to their formation. The breakout has a minimal increase in volume, thereby conveying a lack of commitment to the move by traders. In addition, the MACD-H is demonstrating a bearish divergence. Bear Traps Bear traps are exactly the opposite of bull traps. They indicate that a new low is in place. As such, the methodologies used to interpret and act upon them are the same. Consider the Coates Hire graph below. The price breaks to a new low under moderate volume, only to reverse back into the congestion. As this move unfolds we can predict with a certain degree of confidence that a new low is in place. This new low and reversal are now a set-up condition, and the trigger is given by the break to the upside. The use of a failed signal as a set-up condition requires a degree of psychological flexibility. Unfortunately, the tendency for most traders is that if an expectation is not met then they move on to the next stock, unaware of the fact that the market has provided them with a powerful signal to act.
You can combine your knowledge of other chart patterns to help you to examine failed signals. Let's look at the failure of triangle patterns, in particular the ascending and descending triangles. Triangles Traditionally, triangles come in three generic styles - symmetrical, ascending and descending. A symmetrical triangle is characterised by a convergence of an uptrend and downtrend line. Symmetrical triangles suggest trader indecision. Traditionally, price stalls and future direction is questioned. Typically, the contrasting psychology of bulls and bears fights for ascendancy. As the trend lines converge, the force of their convictions is almost equal. Price movements higher are met by selling by the bears. Dips are seen as an ideal entry point for bulls attempting to catch a retracement. Eventually, the triangle narrows to an apex. Volume may also drop during this final phase. From a trader's perspective, the symmetrical triangle generally resolves itself in the direction of the primary trend. As such, they are often characterised as a continuation pattern. Because symmetrical triangles are simple continuation patterns, it is difficult for them to fail. The traditional wisdom of trading a symmetrical triangle is to trade in the direction of the breakout. The National Australia Bank graph shows the formation of a symmetrical triangle. An ascending triangle displays a series of higher lows, with a strong zone of resistance characterised by highs at the same price point. They usually form during a strong medium-term uptrend.
In ascending triangles, the prevailing psychology of traders initially resists pushing prices higher. Bullish sentiment then re-enters the market and prices move to the old highs where trader conviction fails once again. This thrust and retreat may occur several times. Each time, the price makes higher lows and trader psychology becomes more focused upon moving through the old high. Eventually, price breaks through the old highs. As such, ascending triangles are strong breakout signals and should be traded as such (see the ascending triangle formation on the CBA graph). A descending triangle is the reverse formation to an ascending triangle. In this formation, the bottom part of the triangle appears flat as bulls resist any attempt to push prices lower.
The dominance of the bears is reflected to add to their positions as they attempt to in the prevailing downtrend. However, the bulls see any halt in price as a justification bargain hunt or bottom fish. The small retracements are seen as triggers for bears to engage in retracement trades (see the descending triangle on the ResMed graph).
Triangle Failure The ability to correctly act upon a failure of a triangle will add an important tool to the arsenal of traders. However, as with all trading tools, it is the failure to act upon a signal that most hampers the performance of most traders. The use of these patterns as entry signals is no different. It is pointless to be able to identify patterns but then take no action to potentially profit from the unfolding price action. To overcome this hesitancy it is necessary to generate some simple rules to prod us into action.
The Dow graph, shows a failed ascending triangle unfolding. As you would expect, this pattern was mirrored in the S&P 500 index and its smaller cousin, the S&P 100 index. The rules for such patterns are quite simple. In the example of the Dow, the long-term trend was still down. This implies that we would discount the breakout to the upside. Our interpretation would be that initially this breakout would be a countertrend rally. If the move progressed and the long-term trend changed, then we would enter the market in the direction of the new bullish trend. However, this was not the case with the Dow, as a new uptrend failed to materialise. The move stalled a few days after the breakout. This is in line with the predominant bearish direction of the Dow, so it is not surprising that the attempted break to the upside failed. The failure of price to break higher confirmed the strength of the existing downtrend and provided an ideal entry signal for anyone wishing to trade in the direction of the trend. The signal to enter comes after the collapse of the move back below the line of initial resistance. Some traders may choose to stipulate a number of successive closes below the line of resistance before entering a position. The trading of failed signals requires a high degree of flexibility. Too often, traders will correctly identify an embryonic formation, but walk away from it as it fails. Failed signals offer powerful entry triggers, so be flexible in your approach and more profitable opportunities will be revealed. |
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