Succeeding With Failed Patterns
Sometimes failed patterns can be the strongest patterns. Here we’ll look at
three simple patterns — expansion bars, gaps and flags– and show examples of how their
failures can lead to sizable moves opposite
the direction anticipated by their patterns.
Expansion Bar Failures
Expansion bars, or bars with larger-than-normal ranges, generally
provide a strong indication that a market will continue moving in the direction
of the expansion. They are a good clue that a market will
follow through in the direction of the expansion’s momentum. To demonstrate
examples of successful expansion bars, take a look at the following
10-minute chart of the yen. I’m using intraday bars to highlight that patterns
work in multiple time frames and are relevant for futures as well as for stocks.
On July 27, 2001, two expansion bars — two of the widest-ranging 10-minute bars
of the session — ratcheted the September yen
(
JYU1 |
Quote |
Chart |
News |
PowerRating) to higher levels.
But when this bar pattern does not work out and follow through in the
direction of the momentum pulse, a sizeable move in the opposite direction
may be in store. As a guideline to determining the
“failure”
of an expansion bar,
if a market closes below the low of an upside expansion, or above the high of a
down-expansion bar within the next few bars, than that is considered a failure.
Again in an intraday timeframe, let’s take another look at the yen and notice
how two successive downside expansion bars failed to follow through. In both
instances in the chart below, the yen expanded (two of the biggest downside bars
of the session) to new intraday lows, but quickly (the next bar!) turned around and traded back inside the previous range.
Notice that such expansions left a “spike” or a
“tail,” bars themselves that are often associated with a reversal. In
essence, spikes and tails are often just failed expansion bars. In this case, the failure to
expand to new lows resulted in an explosive intraday move in the yen opposite
the intended
direction of the pattern on the following day.
Gap Failures
Gaps come in different flavors and their reliability as pattern indicators
depends on where they occur in the trend. Breakaway, continuation (or measuring) and exhaustion gaps are the three broad categories of gaps that have
directional meaning to technicians. Exhaustion gaps happen at the end of a long
price run-up and signal the end of the trend, awaited reversal patterns
themselves that will not be considered here, although some of their underlying
principals are the same. Here, our focus is on the failure of continuation
patterns. Breakaway and measuring gaps, since they have the potential, still, to at least
double from where they occur, are continuation patterns.
As an example of successful continuation gaps, have a glance at the chart in
feeder cattle. After both the breakaway and the continuation gaps, feeders moved
decisively in the direction of the gaps.
But in the chart below, you will see an instance of a failed
continuation (or measuring) gap in sugar. Notice that the gap and expansion
initially failed to follow through. Sugar closed below the low of the gap
on the day following the gap, an unhealthy warning sign. And on the fourth day
after the gap, sugar closed below the close of the day prior to
the gap: confirmation of a failed continuation
gap pattern.
But a wrench was thrown into this
market. On the day following the confirmation of the failed measuring gap, sugar exploded out of a Pullback From Highs
setup — the expansion bar on the chart — essentially reversing
the confirmed gap failure. But in an added twist, sugar again
reversed on the next trading day in an even bigger downside bar that closed both
below the gap, the failed gap confirmation, and below the low of the upside expansion.
In this case, you had the confirmation of two failed patterns: a failure to
follow through on the continuation gap and a failure to follow through on the above
described expansion pattern.
Confirmation of the double failure laid to rest any hope of additional
upside. And although sugar did move back to test the initial confirmation of the
gap failure — the close that closed the gap — it did not rise above that
level and proceeded to lose 13% in three weeks.
Flag Failures
Flag formations are widely known, consolidation pullback patterns that occur
after a rapid, sharp
price move. The flagpole — the sharp price increase or decrease — is part of
the key to this pattern because it identifies the presence of momentum and the
enhanced likelihood of a continuation move in the direction of the pole. After a
sharp move, markets, obeying the laws of physics, often consolidate to gather
“steam” prior to proceeding in the directing of their momentum
impulse, forming the flag.
A failed flag pattern occurs when a market shows successive closes beyond the
flag formation but in the opposite
direction of the flagpole’s momentum. A failure to move in the direction of the
flag pattern can be explosive, as the 15-handle move from the flag’s failure
point in the S&Ps
(
SPU1 |
Quote |
Chart |
News |
PowerRating) on August 10, 2001, demonstrates in the
following chart.
You may want to bear in mind three additional factors that make flag patterns
more prone to failure. One, the flagpole is too short, showing insufficient
momentum. Two, the flag itself is too long, generally greater than 15 periods,
essentially “timing” the flag out. Three, the flag occurs in a
severely overbought or oversold market where the momentum has run out.
In thinking about the ever-present likelihood of failed patterns and the —
at times — explosive moves that result from their failures, I like to keep in
mind one of the sayings friend and TradingMarkets Co-founder Jeff Cooper uses as
a linguistic memory device to keep track of all the trading information in his
head: “Fast Moves Come From False Moves.”