The Most Important Rule in Chart Analysis

My observations below should be viewed as general advice and may not be right for you.

I have received a lot of enquiries recently about what I mean by "failed patterns" and I thought this would make for a very interesting blog post. A bit of background first. Like many of you I began my career by reading about and trading classic trading patterns like Head and Shoulders tops, breakouts, breakdowns and triangles. Very soon however I became disillusioned by the fact that these patterns very rarely came to fruition despite the many clean and beautiful examples in the books. I was frequently stopped out for a loss and my success rate was rather low. What I did notice was that the markets very often moved in the complete opposite direction to my original trade idea in a BIG way! After a while I started to investigate what would happen if I faded these classic setups once it became clear they were not playing out. These findings became a very powerful tool for me and remain part of my analysis today.

The title of this post was actually taken straight out of one of my favourite trading books, "Schwager on Futures". The author illustrates through countless examples that a failed signal is amongst the most reliable of all chart signals. I couldn't agree more through my own experiences. What this really means is that when a market fails to follow through in the direction of a chart signal, it very strongly suggests the possibility of a significant move in the opposite direction. The crowd is positioned in anticipation of the trading pattern and when this fails to play out, they are forced to unwind on mass. A market that cannot hold a breakout after a solid consolidation pattern is a sign of underlying weakness as there is no genuine buying to support the market. This really is a key point to recognise and act upon. It could be argued that this happens more frequently, in a perverse way, as Technical analysis has gained increasing popularity thus more traders are piling into the same positions.

Here are a few examples to better illustrate.

S&P500 Daily 2009: Failed Head and Shoulders

Below is the S&P500 in July 2009. We had seen a very strong rally off the March lows which looked set to end after a "classic" Head and Shoulders pattern formed from May to July. However, there was little follow through in the direction of the short signal below the neckline, and price exploded higher in a huge bear trap.

S&P500 Daily 2010: Failed Double Top

After selling out of the resistance zone, the S&P500 looked to be forming a double top pattern. However, the inability for the market to follow through to the downside led to a sharp short covering rally. Once price closed above the previous highs, a strong trend higher ensued.

XJO Daily 2012: Failed breakout 

A recent example for traders in Australia. After building a huge multi month base pattern, the ASX200 looked set for a breakout with a strong closing candle above the range. Note that this occurred on the day of a suprise 50bps cut. However, there was no additional buying above this zone and very soon all those traders who had taken long positions were forced to cut, leading to a strong sell off. 

AUDUSD Daily 2009: Failed breakout

A triangle type consolidation pattern and breakout formed. However, there was no follow through to the upside and a rapid decline ensued. 

As can be seen in these examples, sometimes failed signals lead to very powerful moves in the other direction. It would appear that the market moves just high or low enough to set off stops orders beyond the boundary of the pattern. However, no additional momentum is uncovered and this is an indication of a very weak underlying technical picture.

This poses a difficult question for many traders- how do you know when to take the underlying signal? There is no easy answer here. To me, if you have researched your patterns and setups and place faith in them, then you have to take your signal. IF there is no follow through, we must have plans to take the stop loss and even look to trade the opposite direction. Be flexible and adapt. We position ourselves and put our ears to the track and really that is all we can do as traders. If the market fails to follow through to the upside after a breakout from a solid consolidation pattern, this is a sign of underlying weakness. Similarly, if price does not uncover any additional selling pressure after a “breakdown”, then this is a sign of market strength. We can't possibility know this in advance until we are positioned. We can draw up confirmation rules or position sizing plans to aid these setups but we genuinely do not know if the market will do.

This kind of answer will probably get laughed at by most but this is the reality of trading. Understanding the vulnerabilities in technical analysis is as important as understanding the supposed strengths and setups. I see classic technical patterns fail time and time again, and you just have to recognise what others might be thinking or experiencing if they were in a similar position.

In conclusion, the amateur trader will often ignore a failed signal, riding his/her position into a larger loss hoping for a turnaround. The more experienced trader, having learned money management, will exit quickly once it becomes apparent that the trade is not working out. As Schwager says, “the truly skilled trader will be able to do a 180-degree turn, reversing his position if market behavior points to such a course of action.” It takes great skill and discipline to capitalise on failed signals, but such flexibility is essential to good trading.

I thought this was particularly relevant given the potential failed breakout signals I am seeing in European markets:

Eurostoxx 60mins: Current setup

A week long consolidation pattern was followed by a breakout above 2450. However, there was no real strength post this breakout and price sold off back into the range. This is a potential sign of underlying weakness. Thus a breakdown below 2400 would signal a potential short.

 

Contact:
Austin Mitchum. Senior Market Analyst

First Prudential Markets

Email: a.mitchum@fpmarkets.com.au
Office: +61 2 8252 6800 Ext 120
Mobile: +61 0431547026