FuturesTechs Blog

One of the premises of tecnical analysis is that price patterns tend to repeat themselves. But what are these patterns? Today, we’re going to lookat reversal patterns, i.e. where a change of trend is indicated.

Perhaps the most famous of these is the Head and Shoulders pattern.

Here is the Dow weekly candlestick chart, showing how this topped out in 2007.

The general picture behind the Head and Shoulders is as follows: we start off with an uptrend, which proceeds as normal creating higher highs and higher lows.

The initial warning sign is a failure to create a higher high. This is the top of the “Right Shoulder” on the above chart.

Our technique then is to connect the two most recent lows. This isn’t a proper trendline (which should really connect three points) but instead is the “Neckline” of what is still only a potential Head and Shoulders pattern.

The Head and Shoulders pattern is completed by the break through the Neckline. Sometimes, the bulls will have a go at recapturing it, just as they did in the case of the Dow. What really strengthens the bear story, and is something you can look for, is if the broken Neckline then turns resistance. This happened with the Dow, making this a textbook case of the Head and Shoulders pattern.

Note that the Neckline was broken briefly on the retest; the danger of getting a false signal in this way is limited by placing certain conditions on what sort of a break is required. For example, demanding two consecutive closes above the Neckline (the “Two Day Rule”) would have prevented us from getting whipsawed by thinking that the Head and Shoulders pattern was being negated.

The above chart shows the standard method for constructing measuring targets with the Head and Shoulders pattern. Find the height of the head and then target that distance below the Neckline, measuring from where it broke (so we would target the red horizantal line in the above case).

The Inverse Head and Shoulders is based on the same idea, reversing a downtrend. Here’s Light Sweet Crude Oil changing direction in this way in 2007. Observe the broken Neckline providing support twice:

Now let’s look at Double Tops and Double Bottoms. The Double Top is formed when, in an uptrend, we run into resistance twice at the same level. We then fall through the intermediate low, completing the pattern and providing a sell signal. The broken Neckline can turn resistance, as it did with the DAX futures between 2007 and 2008; see the weekly candles chart below

Here’s an example of a Double Bottom, this time on a bar chart. It’s Vodafone at the bottom of the bear market in 2009, finding support at the same level twice, then beating the intermediate high and continuing the move.

In this case, our measuring target would be similarly calculated as with the Head and Shoulders patterns, i.e. the height of the pattern projected from the breakdown point. In this case, it’s 123.60 plus 12.40, i.e. 136.00.

Here’s an example of a Spike, or V-Reversal.

The Spike is really just the name for a market which reverses direction without giving any proper clue in tertms of hte preceding pattern that this was likely. This is the market turning “on a dime”, and the most difficult to trade.

The only clue at the top of the above chart that Wheat was turning was the “Harami Cross” candlestick pattern at the top (that’s the Doji contained within the range of the long green candle). When a Spike happens, our only recourse is to short-term signals such as candlesticks.

Finally, here’s a Saucer Bottom in Corn futures (the Saucer Top is the equivalent reversal of an uptrend). This is the opposite to the Spike, the price very gradually changing direction.

As technicians we much prefer to see a Saucer Bottom or Top than a V Reversal, with the slow move giving us lots of time to change skew.

Volume

One thing we haven’t mentioned much so far in this article is the role of volume in all of these patterns. Volume - the level of trading activity taking place over any period - is an essential component of technical analysis and an important part of pattern recognition.

The general principle is that volume accompanies movements with the trend. In terms of trend reversals, then, we should see the volume faltering during those final movements with the old trend, and eventually picking up as the new trend takes over.

In the case of the Head and Shoulders pattern, for example, volume should be weakest during the Third Shoulder, as enthusiasm for the dying bull market begins to evaporate.

A distinction can be made here between tops and bottoms. It is generally recognised that volume is not so important for tops as it for bottoms: at tops, market can “fall of their own weight” with buyers simply failing to show up, and volume not increasing.

Bottoms, on the other hand, generally involve mass participation, with active buyer enthusiasm being the main driving force behind the move.

Variations

There are several variations on the patterns mentioned here, in particular the Complex Head and Shoulders, the Triple Top and Triple Bottom. The Triple Top and Triple Bottom are fairly self-explanatory, while the Complex Head and Shoulders generally involves multiple shoulders on one or both sides of the Head.

The principles of volume analysis and the measuring techniques for these patterns are much the same as for the patterns already described here.

Conclusion

These patterns, without being infallible, help us to map out major changes in trend. They are generally medium and long-term patterns, with their significance and measuring targets in proportion to their size.

We incorporate these patterns into our daily analysis of the futures and FX markets. If you would like to sign up for a trial of our services, click here. For a free trial, click here.

Graham Neary MSTA (graham@futurestechs.co.uk)

Whether you are Spread Betting, trading CFD’s, or trading DMA Futures, you need an edge.

Trading is tough, and managing your emotions is one of the toughest things you will have to learn in order to make a success of trading for a living.

The human brain is wired up all wrong for trading, in fact.

By nature we will take a profit too early (GREED kicks in and we snaffle up the winnings on the table), whereas if a trade goes into the red we won’t get out. Instead we’ll start to cross our fingers and hope that it comes back. As the trade goes further into the red pride gets in the way even more, and we allow the situation to get even worse. We FEAR booking a loss, and seeing that loss crystallise on our account, so we sit tight even more (or even worse we add to the losing position), waiting for it to come back (actually HOPING it will come back), except it probably won’t.

“The first cut is the cheapest” is a phrase commonly used by Professional Traders. When I go into my professional clients’ trading rooms I see stickers on traders’ screens with phrases like “get out of bad trades” and “run the winners”.

To become a successful trader you need to rewire your brain almost, and teach yourself to have the DISCIPLINE to get out of bad trades early on, and run the good trades as long as possible.

How can you do this? By using the charts.

You can use Technical Analysis to:

• Trade in the direction of the trend.
• Look for buying or selling opportunities
• Set clear targets and stops, preferably with a decent risk/reward (ie put on trades knowing where you’re going to get out, and knowing that the possible loss will always be much less than the potential profit)
• Trade at the important technical levels, and not in “no mans land”.

All of this will help you to manage your emotions. Only the very best traders in the world can ELIMINATE emotion. Most of us will have to content ourselves with finding a way of REDUCING the emotional side of things in order to help us make better trading decisions.

If you’re a novice at trading and/or technical analysis you will need some help with this, and FuturesTechs can provide you with the levels to trade around, as well as offering market leading guidance and analysis on a daily basis.

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Have a good week,

Yours,

The FuturesTechs Team

Have a look at this “mystery” chart and tell me what you think?

Does anyone think this (whatever it is) is going down any time soon?

Hopefully we’re all thinking the same thing: That it looks very much like something that’s got a bright future, something that’s going up in the world. There doesn’t seem to be too much evidence that it is topping out, would you agree? In fact if this was a stock and you owned it you’d probably be more than happy to hold onto it, yes? And if you felt the market was going to head lower and you wanted to find a short trade to put on you probably wouldn’t chose something as strong as this, agreed?

It was Charles Dow almost 100 years ago who suggested we can define an uptrend as a series of higher highs and higher lows. In contrast a downtrend is defined as lower highs and lower lows, which brings me on to the next chart.

As you can see this is a chart for Royal Bank of Scotland between October 2006 and the present (August 2008 in case you’re reading this in retrospect). Now I’d like to point out straight away that I could have chosen any number of bank stocks from any number of countries for the purpose of posting this blog. I used RBOS because I’ve got a couple of mates who work there and I’ve got a sadistic streak. Sorry fellas.

Because I think it’s fair to say this chart is quite a bit different to our first chart, wouldn’t you say?

Well the eagle eyed amongst you may actually have noticed that it is actually THE SAME CHART, but “flipped”. We have effectively put a mirror below the real chart to create our “mystery chart”. So the mystery chart is RBOS with 7 quid at the bottom and £1.50 at the top.

Now think about the paragraph above, and think about your reactions when you read it. I would imagine it was something like this:

“… it looks very much like something that’s got a bright future (I agree!), something that’s going up in the world (yes indeed). There doesn’t seem to be too much evidence that it is topping out (too right, it’s a stonker!) , would you agree? (yes) In fact if this was a stock and you owned it you’d probably be more than happy to hold onto it, yes? (yes please, love it!!). And if you felt the market was going to head lower and you wanted to find a short trade to put on you probably wouldn’t chose something as strong as this, agreed? (agreed, let’s short something else, surely).

Which brings us to the title of this Blog: “The most common question of 2008″. Which is, of course “Should I buy Bank Stocks?”. I reckon you just answered your own question!!

NOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO!!!

If you want to gamble go to a casino. If you want to play the stock market or make money spread betting follow some simple rules and don’t just put on stupid high risk trades. I’m sick of being asked this question. It’s a joke. It’s simple: Don’t buy things that are still going down.

Let the pros tell you when to buy, ie let the market tell you when enough professional buying has happened in a Stock that it is now in an uptrend.

If you “flip” the chart and there’s no way in the world you would SELL our mystery chart, then what the heck are you doing even thinking about BUYING it when we put it the right way round?

The point I’m making isn’t that Bank stocks haven’t bottomed out. They might have done, but there isn’t enough weight of evidence yet. It’s a dangerous trade, and there’s no need to rush in. These stocks could go sideways for years now, or even keep heading lower, after all we haven’t broken our series of lower highs and lower lows yet, have we?!

Can I finish by saying that we have the chappies at Updata to thank for making “flip” a standard part of many charting systems these days. I’m pretty certain it wasn’t until they started to expound exactly what I’ve done above.

Cheers,

Clive.

PS. August is turning out to be a bit of a damp squib in Equity markets so far, and the best advice I can give is to suggest you don’t get too carried away if you’re trading Equity Indices like the Dow and the FTSE. The market has a habit of taking money off of you in quiet periods. There could be some really solid trends to trade between now and the end of the year. Don’t take yourself out of the game trading during low volume quiet periods like now.