Tips on Technicals - When to Stay Out
Even with the abundance of technical tools available today there are times where the answer to the buy or sell question is simply "I don't know." This could be the result of conflicting answers among indicators. It could also be a low confidence result from a trading model. In either case, it is often better to stay out of the market and preserve capital for a better opportunity in the future. Let's examine a few examples where the analysis is unclear.
No Follow-through
In figure 1, July CBT Soybean Oil was trading in a range from October to December 1996. On January 9, 1997, the market made a strong move higher on very heavy volume. This broke the 50-day moving average to the upside. The combination of volume and average was a good buy signal and the next day the market was limit-up1 on a gap and heavy volume.
Traders smart or lucky enough to have bought on January 9 were then faced with conflicting signals. Gaps, especially those on high volume, are powerful signals. The penetration of the moving average and move above a technical trading range are also good signals. However, a candlestick chart (not shown) reveals a bearish "hanging man" pattern2 on January 10. Western bar charts show no follow-through on the gap, making the rally suspect.
As can be seen in the chart, the market did a slow drift lower until it met the 50-day average. Somewhere in that decline, the long position would have been closed, conceding that the trade did not work. Even though the buy signals were correct for a longer time frame, this market may be one to avoid until more solid technical patterns develop.
Whipsaws
Sometimes the markets just jump around without any apparent rhyme or reason. The foreign exchange charts below exhibit trend line violations, false breakouts and general erratic behavior.
Figure 2 is the Australian Dollar/ US Dollar rate for 325 days. Note the short-lived upside break in September 1996 from an unorthodox flag pattern. In November, the market broke below horizontal support in what traders call a "head fake." It reversed immediately. Trend following systems, such as moving averages and even the relative strength index, were unable to consistently forecast correctly.
In Figure 3, the US Dollar/ Canadian Dollar rate is shown weekly for three years. This market reversed course constantly and was especially confusing during mid-1996. Short-term analysis may have worked during that time but position trading was nearly impossible until smooth trends developed in March 1996.
Forcing a market into a buy or sell mode is a mistake. The market will tell us what it wants to do. If we don't understand what that is or if the market is telling us that it doesn't know either, the best trade is the one we don't actually make.
1 Limit-up means that the market moved by the exchange set maximum allowed for the day. No trading is permitted above that price for that day. This prevents markets from running away in panics.
2 In a hanging man, the market opens and closes at or near the day's high but trades significantly lower than the high intraday. This is a fairly good bearish reversal pattern.
