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Swing traders must consider the opposite execution for every setup that triggers through a pattern breakoutPATTERN FAILURE The best trades could be in the opposite direction when patterns don’t behave according to plan. Many classic formations have built-in setups that trigger contrary positions from their natural bias. Alex Elder illustrated this poorly-understood concept with his Hound of the Baskervilles signal in Trading for a Living. He offers the interesting example of a head and shoulders neckline that just won’t break. Traders take notice of the failure and enter long positions to ride price back up to the old highs. Patterns appear at the end of thrusting price movements. Constricted swings between key support and resistance characterize their development. Patterns complete when a new trend leg breaks through this wall and expands outward. The direction of this new thrust may be the same as or opposite to that of the previous one. A pattern between adjacent price moves in the same direction continues that trend. Alternatively, when a breakout turns and retraces the last trend, the intervening pattern reverses the prior move. Classic tutorials categorize patterns by their tendency toward continuation or reversal. This familiar bias underlies the predictive power of these odd formations. Patterns also tend to repeat themselves through all time frames. These two characteristics generate a well-marked charting landscape that traders use to locate profitable opportunities. Most market players view patterns according to common knowledge. The majority choose the strategy that matches the formation and enter positions where directional movement will likely erupt. But sometimes patterns don’t do what the crowd expects. A powerful entry signal may flash when a setup fails to act according to its tendency. This pattern failure can trigger sharp price movement in the opposite direction from the formation’s natural bias. Swing traders must prepare contrarian entry tactics to capitalize on this secondary event. But first exercise sound risk management to recognize failure in progress and wait for low-risk opportunity. Probability underlies all prediction. Swing traders anticipate future price and enter positions to profit from it. Most times this strategy dictates execution that aligns with the highest odds. But trading plans must be flexible enough to capture setups for the less likely outcome. Start at the opposite edge from the formation’s common breakout level. For example, study the declining tops of a bearish descending triangle to locate long entry if price fails and thrusts into a rally. The classic head and shoulders pattern has been analyzed over the last century more than any other price range. In fact, one investigation concluded that this well-known pattern triggered the expected result about 74% of the time. While this intriguing measurement lies well outside the range of random outcome, it clearly illustrates just how often losses are taken when speculators sell short at the head and shoulders neckline. And consider how common knowledge further deteriorates this pattern’s reliability in our modern markets. Pattern failure now goes well beyond concepts presented in recent trading books. The contemporary market crowd recognizes most classic price patterns and takes positions according to textbook logic. This decreases the odds that price will move in the direction of the most accepted prediction. Fortunately, few tutorials teach participants about the virtues of contrary thinking. Rather than abandon their positions, the masses tend to hold on through the early stages of pattern failure in an effort to be proven right. This often leads to an eventual panic. Swing traders must consider the opposite execution for every setup that triggers through a pattern breakout. This additional evaluation tracks the same reward: risk parameters as the original opportunity. Trade planning then visualizes what steps will be taken if the setup fades and breaks against the high-odds direction. Each failure trade must stand on its own merits. Don’t consider flipping unless the new setup passes all the usual filters. Also realize that this combined workflow defines natural stop loss for both intended execution targets. Prepare for anything that the market gives and act according to a predefined plan. Common knowledge raises the failure threat for every well-known price pattern. This unsettling fact admonishes swing traders to stand aside far more often than in the past. Lower odds for success dictate that the potential reward must be worth the additional risk. Don’t jump on every neat triangle or bull flag, believing that it will provide an easy profit. Many times the failure pattern offers a far better setup and should be the only side under consideration. Train the mind to pay attention to the chart before the failure appears. These setups often signal with little warning and have a very small window of opportunity. Pattern failure setups don’t end with trendlines that refuse to crack. Whipsaws characterize modern markets and fill the pockets of insiders. Many classic patterns break out as expected, carry a few ticks, and reverse violently. If price then pulls back into congestion, swing traders can enter failure positions well before a move back through the opposite break point. The original false breakout dissipates demand in that direction and lowers risk. The whipsaw also signals that the market will likely trend sharply the other way. Contrary entry signals arise from different S/R considerations than the original setup. An unyielding trendline does not trigger a failure trade all by itself. Congestion shows unique upper and lower boundaries. Failure patterns depend on violation as much as the opposite outcome. Learn to recognize the location of these reverse breakouts for each classic formation. For example, the head and shoulders neckline points to a classic short sale when violated. But the fade position does not execute until price mounts the descending line formed by the tops of the head and right shoulder. The most recognizable patterns carry the greatest risk for failure. Perfection attracts attention and invites those who might stay on the sidelines in other circumstance. When setups look too good to be true, most participants enter positions on one side of the trade and attract whipsaws. Manage entry with narrow-range bars before price breaks in either direction to reduce risk and allow for a fast exit. Execution after a high-volume breakout and pullback to the trendline also improves trade success. Pattern failures provide higher-reward opportunities than textbook breakouts because they catch the crowd leaning the wrong way. Most participants understand how patterns should work but get confused when price behavior doesn’t match their expectations. They freeze like a deer in the headlights and get trapped as the failure event proceeds. This feeds on price movement until they finally capitulate. For this reason, these contrary setups exhibit highly dependable outcomes with few false moves. INDICATOR TOOLS Build and manage indicators to support the price pattern. Use them as truth serum to confirm or refute promising setups. Tune them properly to the intended holding period and competing crowd. BOLLINGER BAND TACTICS Bollinger Bands (BBs) draw their power through two important characteristics. First, they exhibit an underlying trend-range axis just like price or moving averages. Second, they constrict or expand as they move. The interaction between these two forces draws unique patterns as bars unwind through their boundaries. Candle-sticks work especially well with bands. For example, a doji that strikes through a constricting band effectively signals a short-term reversal. BBs bend and twist in response to price movement. These undulations predict how far trends should stretch before central tendency forces them back toward a central axis. Complex relationships develop between price-band direction and price-band constriction. For example, a trend tends to pause when constricting bands oppose it. It takes great skill to predict the bands’ ultimate impact on price, but is well worth the effort. BBs pinpoint hidden swings better than any other tool, and telegraph whether the profit door lies open or closed. Bands may swing through relative highs or lows and then pull back in proportional retracement to start another trend thrust. Or they may enter extended ranges that meander back and forth without direction. Movement frequently stops dead in its tracks when price rises into a falling band or drops into a rising one. Sideways bands can appear in both rangebound and trending markets. Price often fails to reach new high or low territory until bands expand to clear the path. In many ways, Bollinger Bands predict time better than they predict price. The skilled eye watches constricted bands in real time to estimate the buying or selling force required to push them out of the way. They work extremely well during the second test of an important high or low. When markets finally break out, expanding bars often shoot into the band’s edge where congestion forms a flag until the BB allows further movement. Bands constrict tightly around narrowing price in sideways markets. Apply NR7 methodology here to anticipate an impending positive feedback event. Bollinger Bands signal early warning of trend change. Sharp price movement forces bands to expand outward. When these active markets finally turn sideways, the bands slowly tighten and roll toward price. Time passes and the BB door closes on rapid vertical movement. Experience enables the swing trader to quickly estimate the time required before bands will tighten and plan accordingly. Strong buying or selling may push price well outside a band. A tall bar can even print completely through the barrier in extreme conditions. General tactics suggest that violent reversals often follow these major band violations. But trading against these events carries risk because markets can print a short series of these volatile bars before the reversal takes place. Also note that this price action infrequently occurs during intraday markets, except at the open. Reduce risk by dropping down to the next-lower time frame and waiting for a reversal there before executing a countertrend position. Odds also improve if the thrusting bars run into other forms of S/R that allow cross-verification for the entry level. Stay defensive during the trade. Once price returns within the band’s limits, the underlying trend can reappear quickly unless the pullback generates other reversal signals. Look for dark cloud cover or a similar candle pattern that fills any gap created by the bar outside the band. This complex setup can produce windfall profits if managed properly. Thirteen-bar, 2 std dev Bollinger Bands work extremely well for intraday markets. Combine them with the 5, 8, and 13-bar simple moving averages to improve information flow. Use the averages to measure trend strength and the bands to target the length of each bar print. At new highs or lows, strong price movement will wrap tightly between the 5-bar and outside band while all three averages line up and point in the direction of the trend. As price rolls, bands tighten and signal a changing market while averages pinpoint pullbacks and new S/R. Eventually, bands shift direction, averages flip over and price breaks through toward the other extreme. Swing traders work the quiet middle ground of Bollinger Bands for consistent profits. Build strategies that enter countertrend positions at one band and exit at the other. These swing setups face far fewer whipsaws than breakout entries at band extremes. The center band presents a natural profit obstacle that needs special consideration when calculating reward:risk. Make sure a safe exit near this center point still produces a decent profit for the trade. Keep in mind that all bands change dynamically in response to price. This allows continuous feedback that shifts target values with each bar. Experience with this powerful indicator helps swing traders anticipate how it will move. The longer that price travels sideways, the tighter the bands become. Trend change for the bands themselves first begins with a turn by the band closest to the prior price trend. For example, when an uptrend prints along a top band, expect this side of the indicator to turn down before its twin when price moves into a range or down-trend. Combine Bollinger Band study with momentum-based indicators. This uncovers hidden directional movement and improves trade timing. Add MA ribbons to price and display the MACD histogram across the lower pane. Price often remains well within band constriction during the early phases of new positive feedback events. As these indicators show rising momentum, shift attention to natural pattern/band breakout levels and look for entry within narrowing bars. MACD HISTOGRAM Gerald Appel’s classic MACD (moving average convergence-divergence) tracks the interaction between two moving averages over time. Momentum increases when a shorter average turns away from a longer one and decreases when it turns toward it. The indicator smoothes these raw numbers to reduce false readings and whipsaws. It then generates a relationship between this slower average and the original calculation to trigger buy or sell signals. The indicator yields an excellent pattern tool when drawn with vertical bars instead of two plotted lines. Alex Elder popularized this classic variation in Trading for a Living. The method calculates the distance between the plots at each data point and illustrates that length below price. It builds rising and falling slopes as momentum oscillates that accurately track subtle changes in a market’s underlying trend. MACD histograms locate reversals and time breakouts. Start with classic settings and customize as experience builds. Most swing traders rely on standard 12- and 26-period moving averages smoothed by 9 periods. Use this popular output through all time frames to track crowd behavior. But never apply the indicator in a vacuum. Momentum means little unless the markets offer good opportunities to capitalize upon it. Because everyone who watches the classic settings sees the same thing at the same time, successful entry requires superior trading tactics. MACD histograms generate two types of signals. The early one rings when the histogram changes direction from an extreme level. These sharp turns often occur before price but print relatively few false readings. The later signal flashes when price crosses the central -0- line. Most whipsaws will occur right near this axis. Always cross-verify this center signal against key S/R and breakout levels on the price pattern. Histograms often print double bottoms or tops when they shift direction from extreme levels. This natural tendency saves swing traders from unprofitable entry. While the indicator often turns ahead of a market, its double top or bottom generally forms after price reverses. One effective strategy filters setups through this lagging confirmation and then enters on the first pullback or other lowrisk opportunity. Unfortunately, histograms may just draw sharp V bottoms or tops, so be prepared to miss the execution boat when this occurs. The indicator’s zero line pinpoints the center balance zone. Positive acceleration flags as columns thrust above this point. Likewise, down steps below the line point to negative acceleration. Markets may flatten as histograms approach this important signal level. Pay close attention to the angle of the indicator’s rise or fall as it approaches. The sharper the inclination, the more likely that price will break through with little or no resistance. Buy and sell signals generally track the same territory. Exit positions on -0- line violations after deciding that MACD will not whipsaw. Or use the first reversal column at an indicator extreme to exit or enter in the opposite direction. Histograms often reach the same level for two continuous price cycles before reversal. Many participants notice the first extreme and how it flagged a turnaround on the last pass. This triggers a self-fulfilling event as the histogram reapproaches that level. Customize MACD values to speed up signals or view specific markets. Faster histograms increase false readings but allow quicker response to new trends. Try the 8-17-9 MACD for buy signals but use the traditional 12-26-9 to locate sell zones. Or place both histograms in separate panes below price and use one to filter the other. For example, when the faster calculation triggers a buy signal but the slower one does not, look to the price pattern and decide which reading offers the most reliable information. Intraday traders can experiment with an 8-13-8 MACD histogram on 1-minute and 5-minute charts to capture very short-term momentum swings. But switch back to the traditional 12-26-9 for 60minute and longer views. Intraday signals must trigger faster than daily or weekly ones because short-term opportunities come so quickly. With these very narrow settings, the histogram will flip more often and act more like an oscillator than directional indicator. Continue to rely upon the MACD in the time frame above the holding period for many signals but focus timing through these shorter readings. |
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