A Pattern Every Trader Should Be Watching

08/31/2010 12:01 am EST


I think too many traders focus on setups or trading patterns when they should be focusing on trying to really understand what is driving market action at any point. Focusing on oscillators or other indicators usually only serves to exacerbate the problem. Real mastery of market patterns follows naturally once a trader has an intuitive sense of buying and selling pressure, but intuition only grows out of constantly thinking about market structure and exposure to tens of thousands of pattern variations. Having said that, today I do want to share a pattern that I have found extremely useful in short-term trading.

This pattern is simply a failure test of support/resistance. (The examples I am giving all show shorts, but the pattern applies exactly reversed to buys.) The pattern is probably best applied after multiple trend legs up, but, in general, most breakouts fail (ask yourself, did you know that?), so disciplined application of this pattern has a positive expectation under most conditions. Perhaps a picture can best illustrate the concept:

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From a mechanical standpoint, entering these can be a little bit difficult. I traded them for about a year on a very large basket of stocks, entering the orders as close to the market close as possible. This was extremely difficult because a large number of stocks would trigger on some days (due to correlation to the market), but it is possible. Another alternative, especially in forex and futures, is to do your homework after the market close and then try to enter unch in the electronic overnight market. This can be done well over 90% of the time, but there will be a certain percentage of the trades that you have to enter at the market on the next regular session open, at a much worse price. These are often big winners, so I don’t think it makes sense to skip on this set of trades. Intraday, patterns are not as clean, but it is still possible to trade this concept on anything from one-minute to 120-minute bars.

Trade management is a bit of a potential issue because a certain number of these will give you a chance to short and then the market just explodes higher. Actually, it happens a lot, so you must be prepared and execute your stop with iron discipline. Giving these a little more room or doubling up when it moves past your stop will guarantee you have a short, but very interesting, trading career. (It also should go without saying that this is not a great overnight plan for certain kinds of stocks, like biotechs, or for anything in front of an earnings announcement or significant report.) Surprises happen, so you must have a plan that encompasses every eventuality. You also need a plan for possible re-entry if stopped out, and clear rules for profit taking, but those are beyond the scope of this post.

It is also useful when people show actual trades when discussing patterns. Here are two trades that I called several days before the entry in my daily market report (themacroreport.com). I was able to alert readers to the possibility of a good trade setup because these markets were overextended and were showing momentum divergence. Note that I have added a momentum oscillator to these charts to illustrate the divergence, but I do not actually use an oscillator in analysis or trading. The choice of oscillator is not important, but the concept that the market is making another leg higher on weakening momentum is key. Here are two example trades on daily charts, in real time.

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First, a short in ten-year Treasury note futures:

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And another in the S&P 500. Note that this bar, so far, was the exact high of the year. This raises a real issue as you consider your exit strategy on this pattern, because most of these should be treated as scalps. The majority of these patterns will give you a nice profit (one to two times your risk), and then the market continues higher, but a few of them come at major turning points. Here was a sell on the close of the high of the year in the S&P 500. Again, this is not wishful thinking…this was a trade actually done in real time.

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Speaking of major turning points, consider this sell in crude oil futures. Major turning points in commodities have this pattern more often than not, but there is also a fairly high false positive rate. (Disclaimer: This is a hindsight trade not taken in real time as I was not trading this market at the time.)

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If you are interested in more information on this pattern, Victor Sperandeo has written about it at considerable length with a number of good examples in his first two books. Again, if you choose to use this pattern in your trading, it is extremely important that you are disciplined and consistent with it. Start by examining a few hundred examples on charts in your chosen markets and time frames, then apply it on the smallest size possible for a few months, then scale up. That is pretty much the plan for learning any trading technique, but risk management and having a game plan for disaster management is especially important in a potentially risky countertrend pattern like this one.

By Adam Grimes, trader, SMB Capital
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