When Strong Patterns Fail, Trade Those Failures

07/29/2015 9:00 am EST

Focus: FOREX

Since pattern failures can be just as strong as the original move that a forex trader was expecting, Huzefa Hamid, of DailyFX.com, outlines how these pattern failures can also be traded, which is an oft-overlooked, yet can be a highly profitable method of trading.

Sometimes you have the perfect setup for your strategy and the market literally moves in exactly the opposite direction. This is called Pattern Failure. Those pattern failures can be just as strong as the original move you were expecting. That means they can be traded too. This is a very often overlooked method of trading but it is highly profitable.

Let’s dive right in with an example. The below chart is the EUR/USD weekly chart. At the end of the chart are three consecutive bullish Pin Bars. This presented to me a bullish scenario and I was expecting the support created by the Pin Bars to hold and EUR/USD to move up.

chart
Click to Enlarge

[Recap: a Pin Bar is where the body of the candle is in either the top third or bottom third of the entire candle length. If it is a bullish Pin Bar, the body is in the top third and for a bearish Pin Bar, the bottom third. I don’t mind if the body is black or white.]

What happens next? Well, you’ve guessed it: EUR/USD breaks to the downside.

chart
Click to Enlarge

Now, let’s break it down step by step.

Step 1. Recognize that the pattern can fail. We plan our trades, we put in our stop loss, but we pretty much think of the trade hitting the target. Once you recognize that the pattern can fail hard on you, you can plan for that also.

Step 2. Let’s assume you’re in that EUR/USD trade somewhere around the third Pin Bar. Your stop loss would be a few pips below the low of the three Pin Bars.

Step 3. You’d want to stop and reverse that trade if it hits your stop loss. There are several ways to do this depending on which platform you use to execute your trades. If you’re using MetaTrader or MT4, there’s no in-built stop and reverse function. You would simply have a second sell order at the same level as your stop loss. Of course, with the new short trade, make sure you put in a stop loss and target.

If you weren’t in the original long trade but you saw the Pin Bars fail, you can still just enter a short trade.

Look back at some of your trades that failed but had perfect set-ups. Look to see if the moves in the opposite direction from the original entries were consistent enough to justify stop and reverse trades.

On a final note, entering stop and reverse trades require psychological discipline. You have to not only admit you were wrong on the original trade, you have to also be immediately prepared to make money on the other side. Nobody said trading was easy.

By Huzefa Hamid, Contributor, DailyFX.com

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