Tips on Technicals - Success from Failure
Most of the time, the technical trader identifies a chart pattern and then waits for a breakout higher or lower. However, the market often gives advance warning as to its intentions within these patterns allowing the aggressive trader to capture additional profit with an early trade.
Failure That Forewarns
When a market is trading in an identifiable pattern, such as a flag, rectangle or channel, it moves from the top of the pattern to the bottom repeatedly. The more often prices touch these borders, the stronger the pattern and the more significant the eventual breakout will be. If the market has developed an underlying strength, prices often fail to trade back down to the lower border. This failure, when combined with other bullish technical indicators, tells the trader that the direction of the breakout from the pattern will most likely be up and that it should occur the next time prices approach the top border.
Figure 1 shows 200 days of daily data for the Financial Times 100 Index. The rally from July 1993 paused to consolidate twice that year, each time in a flag formation. The second correction, which started in October, showed a very clear pattern where prices failed to trade to the lower border in late November. The 9-Day RSI (not shown) was rising and prices broke through the top of the pattern with considerable force.
Markets sometimes trade in a range for long periods of time. In fact, some long-term analysts find stocks or commodities trading in identifiable rectangle patterns for years. When these analysts find failure in the charts, their clients have ample warning to analyze both technical and fundamental information to make very high confidence trading decisions. Even traders with shorter time horizons can see the signs that an otherwise "boring" market is about to wake up. The Nikkei Index (Figure 2) was locked in a three-month trading range starting in June 1994. In early August, prices failed to reach the bottom of the rectangle but this was not confirmed by indicators such as Stochastics (not shown). However, later in the month, prices failed to reach the top of the pattern and that time, the failure was confirmed by Stochastics. Remember, successful technical trading demands that any signal be confirmed by other indicators -- the more the better.
Failure That Cuts Losses
Earlier in the pattern, in late July, the Nikkei exhibited another kind of failure. Prices broke down below the support line of the rectangle which signaled many traders to sell. However, the very next day prices exhibited a one-day reversal pattern and closed back within the rectangle. This failure to maintain the breakout signaled all traders who sold the previous day that they were wrong and that their short positions should be closed with a small loss.
Even more complex patterns can show failure. A head and shoulders formation, normally a reversal pattern, completes when prices break through the neckline. The pattern that developed in September 1994 CBT Corn futures in April and May 1994 was forecasting an eventual rally. However, when prices eventually reached the neckline, instead of breaking through to the upside, they failed and headed lower. Traders who anticipated the breakout higher knew immediately that they were wrong and that existing long positions should be closed.
In June, Corn rallied toward the neckline once again but failed to even reach it at all. This failure was the advance warning that the market was weak and it was confirmed by several indicators. The market broke down from there.
Summary
Trading with failure can provide advance warning for a move to give aggressive traders an additional profit opportunity. It also lets traders know when they are wrong quickly to minimize losses. Like all technical trading indicators, confirmation from other technical indicators is the key to understand the market's true intentions.
