Pattern Failures Must Be Understood

Posted in: Trading Article

There are a handful of trading patterns that have a statistical edge in the market.  One of the most popular among traders is the simple bull or bear flag otherwise known as a pullback.

The pullback pattern actually capitalizes on the basic principle of how a market trends:  strength with impulse moves in the trend direction with pullbacks and consolidations in price.

That’s it.

Of course this simple market movement is wrought with overthinking in terms of pullbacks to moving averages and Fibonacci ratios but in reality, it is so much easier than that.

To oversimplify:

  1. Look for a momentum move in price
  2. Wait for a pullback to begin
  3. Look to enter when momentum appears to be showing back in the trend direction

You can certainly use a moving average as a gauge for price to retrace to but make sure you have a wide zone around the average.  There is no magic in a moving average as they are calculated through the price movement.  You can even use a channel formation for the pullback, my choice, and monitor the price action within it.

 

When Do I Ignore The Pullback?

Any impulse move in a trending market is put on a list of sorts to look for a pullback in price.  This is not the only pattern I trade but it is useful to highlight the importance of what I wrote in the title of this trading tips post.

I swing and position trade in Forex and I was recently watching the NZDJPY currency pair form a pullback in price

download (1)

  1. Price is in a downtrend which is obvious through the lower highs and lows price was making
  2. An impulse move to the downside that showed momentum near the end but wasn’t much different than the one before
  3. A weak pullback in price sets up a bear flag

When trading a pullback, there are a few things you need to see in order to put the odds in your favor:

  1. The market has to be trending unless you are trading a pullback after a breakout from a consolidation
  2. You want to see a momentum move that sets up the flag formation which indicates there is conviction in the desired direction
  3. The pullback must be “lazy”.  You don’t want to see conviction in the move against the trend

This chart was picture perfect in terms of what I look for in a clean pullback trade.

The important thing is knowing what I high probability pullback looks likes.  What’s also important is knowing when the imbalance is no longer there.

download (2)

Out of nowhere, a momentum candlestick to the upside appears which is very different from the lazy and lack of conviction in price that came before it.

That momentum candlestick was also the time I took any idea of shorting this currency pair off the table.  A high probability trading setup dissolved when adverse price action disrupted the pattern.

 

When Does Your Setup End?

Everybody who ever wants to make a career in trading must have a way to determine what a setup is for them.  Not only should they be exact in what to look for, traders should also know what they don’t want to see happen during the setup.

You can visit our trading room for free for a few weeks to see how trades “come off the table” when using one of our trading systems.

In my opinion, know what you don’t want to happen during your setup is one of the keys to trading success.

Why?

Go back to the last chart and you will see that after price broke out of the channel to the upside, price began to consolidate.

What happened next?

A large engulfing bearish candlestick took out the previous two days of price movement and in many textbooks, this would be a short setup given the overall trend.

But the large move out of the lazy pullback took shorts off the table for now (not replaced by longs) and kept me out of a losing trade.

Does your trading plan have in it what you don’t want to see when looking at a trading setup?  If it doesn’t, now is just as good as time as any to get what a failed setup looks like into your trading plan.

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CoachShane

Trader at Netpicks
Shane his trading journey in 2005, became a Netpicks customer in 2008 needing structure in his trading approach. His focus is on the technical side of trading filtering in a macro overview and credits a handful of traders that have heavily influenced his relaxed approach to trading. Shane started day trading Forex but has since transitioned to a swing/position focus in most markets including commodities and futures. This has allowed less time in front of the computer without an adverse affect on returns.

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