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| When Timing Is Everything |
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(first appeared in September 2003 edition of 'Leverage' in Shares Magazine) In
the last couple of editions of Leverage, we looked at some commonly
occurring chart patterns with very funky names (so that you can impress
your friends at dinner parties). Here are some of the patterns that we
have reviewed so far; Double Tops and Bottoms, Triple Tops and Bottoms,
Bullish and Bearish V-Reversals as well as Head and Shoulder patterns. In this article I will set a couple of
exercises for you to complete to help you to test your knowledge.
The answers to these exercises will be revealed in the next edition of
Leverage. We will also have a look at some other important macro
patterns so that you can increase your charting skills. There are two distinct categories of
patterns. The main area focus of this series of articles is macro
patterns. Macro formations will help you to assess the broad market
conditions and trend. Micro patterns, such as candlestick patterns, will
help you time your entry into a position. When looking at macro patterns, the aim
is to define that the share is in a medium term uptrend or downtrend.
For this reason, I begin with an examination of a weekly chart, before
progressing onto charts of smaller time increments such as daily and
intra-day charts. The longer the time period of the chart, the more
enduring the effect of the formation. For example, Head and Shoulder
patterns on a weekly chart will have a more significant impact than if
the same pattern is displayed on an intra-day chart. Now it’s your turn to practice what you
have learned. Exercise 1 Have a
look at the chart shown here. Circle any significant patterns that you
can identify. Jot down on a separate piece of paper how you would trade
this opportunity and the instruments that you would use to profit from
your analysis.
Exercise
2: Circle any significant patterns that you
can see on this chart and discuss how you would trade this chart in
order to profit from your analysis. Try combining your knowledge of
pattern detection with some basic trendlines and support and resistance
lines. If you can notice any significant micro patterns, identify these
on the chart also. This will help you gain an overall picture regarding
the share price behaviour.
It’s
important to actually use your skills to review charts, rather than just
reading about the patterns. This practical experience will help you to
really improve your level of understanding. Let’s
have a look at some other valuable patterns that can provide you with
trading opportunities. Inverse
Head & Shoulders Description During an existing downtrend, Inverse
Head and Shoulder patterns are characterised by a central trough that is
at a lower price than the first and latter trough.
Location This is a significant bottom reversal
pattern. Resistance is formed at the ‘neckline’ where the highs of
this pattern align. When the share price closes above this level of
resistance, particularly on heavy relative volume, the reversal pattern
is confirmed. Trade in the direction of this break of resistance. Psychology The market has tried to continue the
existing downtrend on three significant occasions. When there is trading
above the neckline on heavy relative volume, the market becomes very
bullish. The buyers outnumber the sellers and an uptrend is initiated.
Price action below the central trough would be bearish. Strategy Trade
these patterns in the same manner that you would trade a Triple Bottom
pattern. Waiting for the neckline to break on a white, bullish
candle (showing a closing price above the opening price) with heavy
volume could trigger you to initiate a bought call option position, a
written put position, or you may choose to buy the share. The key with all pattern detection is to
keep your approach simple. Over-complicating your approach will do
nothing to enhance your bank balance. A disciplined trader, Kel Butcher,
once told me: “Trading is like life – you can make it as complicated
or as simple as you choose. In the end it all comes down to choices.” Dead Cat Bounce Description The Dead Cat Bounce looks like a Bullish V-Reversal pattern, but the subsequent share price action continues the existing downtrend. Typically, the lack of heavy relative volume on the upswing will signal that the rally will be short lived.
Location There is no top reversal equivalent to
the Dead Cat Bounce. This pattern is a failed bottom reversal pattern.
It is sometimes known as a ‘suckers rally’, particularly if it is
not accompanied by heavy relative volume. Wait for a higher level of
weight of evidence to suggest that the trend has altered before trading
a V-Reversal on low relative volume. Psychology The market has become temporarily
excited, sometimes initiated by a bullish news report. The ripples of
excitement did not spread with sufficient speed, or conviction,
resulting in the continuation of the existing downtrend. The stale and
exhausted bulls sold at the first sign of higher prices. If you are going to consistently trade bottom
reversal patterns to trigger your entry, make sure that you have several
pieces of evidence to suggest that trend reversal is likely. In general
terms, top reversal patterns require less confirmation than bottom
reversals. The emotion of fear is stronger than the emotion of greed,
which helps to explain why shares can drop from lofty levels at only the
whisper of a rumour. The bulls tediously climb the stairs while the
bears abseil down the elevator shaft. Strategy One of the key concepts with trading is to set
a stop loss. The main premise behind this skill is to preserve your
trading capital so that a string of losses does not prevent your ability
to trade due to a lack of equity. A Dead Cat Bounce is hard to predict in
advance. For this reason, there are no effective methods of trading this
pattern, other than preserving your trading equity so that you can trade
another opportunity. Rather than seeking to trade a Dead Cat Bounce, you
should be aiming to avoid it entirely. Recognise the warning signs, and
then walk away, in search of a more lucrative trading opportunity. Some V-Reversal patterns display a dramatic
upswing and then a time of consolidation or sideways progression. Chris
Tate from www.tradinggame.com.au
has coined the phrase ‘V-Reversal with a Step’ to describe this type
of pattern. If a period of consolidation is in place, this provides a
higher degree of certainty regarding the success of the V-Reversal. If
accompanied by heavy volume, the V-Reversal with a step is easily
distinguished from the more sinister Dead Cat Bounce. The V-Reversal
with a Step can also be seen as a top reversal pattern.
A stop can be placed below the area of
consolidation that forms the step for long trades, or above the
consolidation for short trades. This assists in providing a tight,
pattern based stop loss, and can assist in lessening the damage if this
formation does not end up reversing the overall trend. Pattern detection is part art and part
science. It can take quite a lot of practice to develop confidence in
this arena. Remember to watch for signal failures as well as
confirmations. This will provide you with two distinct opportunities for
effective trading. With any of the patterns that we have reviewed so
far, if you observe closing prices above the top reversal pattern, it
suggests that this signal has failed, so implement bullish strategies.
If there is evidence of closing prices below the bottom reversal
pattern, use bearish strategies to profit from your observations. In the next article in this series we will have a look at the suggested answers to the exercises that I have set you. You will also get the chance to have a look at some new patterns to help you trade effectively.
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