Tips on Technicals - The Real World
Another major tenet of technical analysis is the repetition of price patterns. Patterns repeat because people in the markets repeat their activities given similar market conditions. Unfortunately, in the real world, the term "similar market conditions" is subject to interpretation. Let's follow one market as it trends and reverses to see how much leeway there is in a technical pattern and what to do when things "sort of" happen.
Best Fit Patterns
The US Bond (30 year) yield was in a downtrend starting in early 1992. Figure 1 shows that for much of 1993, the yields had been in a tightening trading range centered at 6.9%. An ascending triangle pattern was emerging and momentum, as indicated by the 9-day RSI, had broken down through its own uptrend line.
In looking at this chart, the first thing the technician should do is draw the downtrend line from the November 1992 peak. Next, the triangle pattern should be drawn connecting the market bottoms in February and April. The top of the triangle is a clear horizontal line at 7.07. Here, the observation is that the triangle top and the November downtrend line meet at a local market reversal to the downside. Since triangles are generally continuation patterns, the evidence points to an eventual down side break of the triangle and a continuation of the declining trend.
Figure 2 adds the next three months of trading. In early June, the market broke the triangle pattern and continued its decline. Here, the observation is that the new short-term trend is much steeper than the longer-term trend line. Seven months earlier, this same situation occurred and the market responded by consolidating into the triangle just analyzed. In early July, there was a small correction but it did not take prices back to the trend line. The likely target was the longer-term trend line and since it was not reached, this trade would have produced a small loss.
From that point on, the only way to trade this was to stay with the trend and use trailing stops since it would be very difficult to trade very close to market reversal points. RSI remained very oversold.
Finally, in October 1993, while the market was making a lower low, RSI made a higher low on its own chart. (Figure 3). This divergence finally gave the preliminary signal that a bottom had been reached. Note that this bottom pattern can be classified as an imperfect double bottom.
When the short-term trend line was broken in November, the buy signal was given and once again the target was the longer-term trend line. When yields reached that line, they stalled and traded in a narrow range for several weeks. Since momentum was neutral, we had to wait for the next signal for direction -- presumably
a breakout from the imperfect rectangle pattern indicated. The sideways breakout from the long-term trend line was due to the passage of time rather than the result of price movement. This situation required further confirmation to establish the validity of the break. In figure 4, yields broke to the upside, confirmed the long-term trend break and established a strong upward trend.
Conclusion
Many of the patterns examined here were imperfect and, based on the time frame of the analysis used (daily over several months), some losses were produced. This is a much more likely scenario in the markets than any "text book" case. The key is to be able to recognize a wrong trade early and to see the bigger picture of the long- and short-term together. Technical patterns are rarely crystal clear because some market participants do not wait until they complete before acting. This forces patterns to distort slightly even though the general meaning is not changed.
