Monday, 20 June 2011

"The Most Important Rule in Chart Analysis"

The title of this post is taken straight out of one of my favourite trading books, "Schwager on Futures". The author illustrates through countless examples that a failed signal is amongst the most reliable of all chart signals. I couldn't agree more. What this really means is that when a market fails to follow through in the direction of a chart signal, it very strongly suggests the possibility of a significant move in the opposite direction. Sound confusing? Bottom line, if you think it is a Head and Shoulders top pattern, and everybody is talking about a Head and Shoulders pattern, and there is no follow through to the downside on entry- GET OUT and be prepared to go long. The key is being able to recognise counter-to-anticipated price action that completely invalidates the original setup. I have found this to be especially true in my own trading experience and I thought it would make for a very meaningful post given the current setups and patterns I am looking at in Asia.

Want an example to illustrate? Here is the S&P500 in July 2009. We had seen a very strong rally off the March lows which looked set to end after a "classic" Head and Shoulders pattern formed from May to July. However, there was little follow through in the direction of the short signal below the neckline, and price exploded higher in a huge bear trap.

S&P500 July 2009

Currently, a strong case could be made for a bearish breakdown in the Nikkei, the Hang Seng and the China Composite. Australia could be next to follow suit. No doubt these markets look ominous indeed as the charts below illustrate. However, to me these "classic" patterns are ripe for failed signals, especially given other global markets are not confirming these outlooks. Thus as traders, do we take the short signals and the obvious setup or do we try and stand in front of the train? To me it is quite simple- firstly we go short with the signal and if there is no follow through, we must have plans to flip and go long. Be flexible and adapt. We position ourselves and put our ears to the track and really that is all we can do. If the market fails to uncover any additional selling pressure after the breakdown, then this is a sign of underlying strength. We can't possibility know this in advance until we are positioned. We can draw up confirmation rules or position sizing plans but we genuinely do not know if the market will puke this or whether a bull trap will form. This kind of answer will probably get laughed at by most but this is the reality of trading. Understanding the vulnerabilities in technical analysis is as important as understanding the supposed strengths and setups. I see classic technical patterns fail time and time again, and we are now at a similar juncture.

Hang Seng Daily:
The low end of the range has broken with consecutive closes below the prior support. There should be strong follow through here if this is a genuine breakdown.

Hang Seng Daily ii
What is the plan if there is no real follow through to the downside?  I could argue this is a potential ABC down trade where A=C at Fridays close. Note price is testing the low end of this channel. If price re-enters the previous breakdown level above 22,000, I will be getting long for a bear trap trade.

China- Shanghai Composite Daily
Price tried to build a base at 2700 but price has subsequently broken down. This looks like a good risk/reward setup to get short as support has broken. Only a move back above 2750 would be indicative of a bear trap.

Nikkei Cash Daily:
Months ago I wrote about a possible parallel scenario playing out in the Nikkei to that of the S&P500 post the flash crash: No doubt I have taken my eyes off the ball in this one of late but this post has proved very accurate thus far. A clear rounded top is forming here, triggered on bearish closes below 9400. This would set up a move right back to the lows. However, once again be wary of any failed breaks below 9400 as the whole market can see this level clearly.

Double bottom trade in play here. Note that the top was formed by a failed breakout of the previous high at 5000. We are now testing the low end of the range. Nothing changes for me here- I don't think this is a shorting region and I am actually be looking for buy setups.

I put up a detailed post here on my thoughts for this market: Nothing has changed and I believe 1240/1255 will be a solid buying area.

In sum, the patterns in many Asian markets are looking ominous indeed. However, this is not being confirmed in other global markets such as the S&P500, DAX and FTSE which are making higher lows and with momentum clearly slowing to the downside. Personally, I am very skeptical of being short here as I envision a strong short squeeze round the corner. Making money being short is tough especially with this degree of pessimism and negative news headlines. However, we must trade the signals thus I think the key is being flexible here and making contingency plans for possible reversal etc

Good Luck