Technical Analysis

How To Trade & Profit From Pattern Failures

The best trade could be in the opposite direction when a classic price pattern doesn’t behave according to perfect rules outlined in popular books and web sites. In fact, well-known patterns such as the head and shoulders and bull flag have clearly defined levels that can trigger trade entry signals that are contrary to the direction in which they’re naturally leaning. Alex Elder examined this phenomenon with his Hound of the Baskervilles signal in Trading for a Living when he highlighted a head and shoulders neckline that just wouldn’t break, encouraging observant traders to jump into long positions, rather than following the herd and selling short

We’re taught early in our trading careers to buy breakouts and sell breakdowns, but many contrarians attempt to pay the bills doing the exact opposite. Simply stated, they wait for a rally or selloff to fail and sell the breakout or buy the breakdown. Oppositional tactics don’t end there because tacticians employing these against-the-grain methods take the concept one step further and buy when the failure fails. Let’s back up and examine this inverted thinking one step at a time.

Most of us follow a common path — we pile into stocks, futures or forex pairs when they break out above easily observed resistance, but modern algorithms have been programmed to anticipate exactly how human traders will react when a breakout fails to attract momentum and rolls over. Using this knowledge, they intervene and guide price action down to levels where breakout traders are trapped and execute rapid fire short sales to generate additional downside momentum that completes the failure swing

Now, twist your brain and take this contrary reasoning to the next level. You’re victimized by this diabolical price action enough times that you learn from your experience and sit on your hands when a favorite play breaks out. The rally stalls and it sells off but you still wait, watch and do nothing. Then, once selling pressure has dissipated and it closes back above the breakout level, you jump in and buy, knowing that weak-handed players are no longer positioned. Make sense?

Let’s deconstruct what just happened. The original breakout attracts the typical momentum crowd, chasing the stock, futures contract or forex pair to higher ground without too much thought or strategy. The upside fizzles out and price turns lower, trapping those who haven’t protected positions with stops or profit-taking strategies. Fear takes hold when the decline cuts through the level that first signaled the breakout, forcing additional downside that sets off more bearish signals. The falling instrument eventually finds its footing and bounces in a fresh assault that penetrates the broken level. New buy signals go off, drawing our contrarian into a long position.

How do algorithms know where human traders will act emotionally? Simply stated, most of us take market exposure utilizing common strategies that have been deconstructed by smart money and their software code. As a result, stock, futures and forex prices seem to pass through support and resistance levels more easily now than in the past.  Fortunately, when modern markets find new ways to take your money, they also provide new ways to make it.

Let’s look at three pattern failure setups and find contrary ways to profit from them.

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A. A-B-C Failed Breakout

Walt Disney (DIS) topped out at84 inMarch after a strong rally. It built a trading range into May and broke out, but the uptrend stalled just two points higher, giving way to a failure swing that broke new support (blue line). The decline ended at the 50-day EMA, with the Dow component testing new resistance for two weeks and then surging higher. The second buying impulse off the low triggered a failure of a failure buy signal that preceded a new rally high.

It helps to visualize the breakout process as A-B-C wave patterns in which “A” marks the initial breakout surge, “B” the failure swing and “C” the resolution wave that lifts the price to a new rally high, or completes the failure with a decline that breaks the “B” low and sets off all sorts of short sale signals.

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B. The 50-day EMA Flush

Apple (AAPL) ended a historic rally near101 inSeptember 2012 and entered a long correction. It returned to resistance in August 2014 and spent two months grinding sideways on top of the 50-day EMA (exponential moving average), before breaking down on October 15th. The stock hovered under new resistance for three sessions and shot higher, closing back above the 50-day EMA and then breaking out in a major uptrend just one session later.

This pattern failure occurs frequently, but many traders fail to notice the enormous opportunity it sets into motion, especially when price action unfolds in a widely held issue like Apple. It also illustrates how failure swings can interact with other charting features, generating positive feedback loops that ignite long-term trends. This is especially true when the 50-day EMA comes into play because it denotes the most common intermediate support level, with successful tests having the power to draw many sidelined players into new long positions.

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C. The 62-78 Fibonacci Whipsaw

Small cap biotech Esperion Therapeutics (ESPR) tapped into a supply of momentum traders when it broke out of a long base in September 2014. The vertical rally nearly doubled the stock’s price in just two weeks, yielding a short-term top at 30.38 followed by a steep retracement that accelerated mid-month, when it gapped down into the upper teens on heavy volume.  A  Fibonacci grid placed over the edges of the uptrend organizes the chaos, with the decline breaking typically strong support at the 62% retracement and coming to rest at the 78.6% retracement. This 62-78 failure combination occurs frequently and often precedes a major buying opportunity by a few price bars. The trade entry strategy is simple: wait for price to close back above the 62% level and enter a long position as close to that price as possible

Intraday traders should find this pattern failure technique especially useful because it shows up frequently on 15-minute and 60-minute charts. Relatively tight stop losses are needed regardless of holding period because price action tends to be volatile near these major inflection points. It also helps when other support criteria align with the 62% retracement level, like the 50-day EMA in this example.

In Summary
Pattern failure setups can provide higher reward opportunities than textbook strategies because they catch the emotional crowd leaning the wrong way. While most traders understand how patterns are supposed to work, they get confused when real-time market behavior doesn’t match their expectations. In addition, they tend to put on blinders and get trapped as these failure events unfold. This deer in the headlights paralysis feeds on directional movement until the pain becomes too great and they capitulate. Given the emotional dynamics, trade entry after the losing crowd is finally eliminated tends to elicit more dependable trends with fewer whipsaws.

The investor who is willing to act against what may seem intuitive has thus factored other complexities into his/her calculations, and can see how various stock trends interact with other chart features, and thus is not stunned by variations in, or deviations from, textbook patterns. Such an investor is also aware of how these deviations can become more pronounced due to the emotional reaction of investors, which is a factor in itself that must be embedded in an assessment of market movements. These various factors, in combination, create unique scenarios which the investor anticipates, and which present an opportunity for him or her to make bold market moves, and even take long positions — which could, against all odds, bring great profits.

Alan Farley can be contacted on this link: Hard Right Edge

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is author of the McGraw-Hill best-seller "The Master Swing Trader", and popular columnist for The Street.com. Alan has been on the market scene for well over a decade as a trader, advisor, and author. He is a powerful lecturer on swing trading, including the original strategies and tactics found at Hard Right Edge.Alan is a frequent contributor to CNBC. He has also been featured in Fidelity Outlook, Forbes, Technical Analysis of Stocks and Commodities, Barrons, Smart Money, Futures Magazine, Tech Week, Active Trader, MSN Money, Technical Investor, Bridge Trader, Online Investor, America-Invest, the Los Angeles Times, and Trading Markets. He consults regularly with industry leaders on the issues facing today's traders, and is a strong voice for the revolution changing our modern markets.

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term tr...

winny

Junior member
11 0
has anybody practice this theory ?it would be best if more practical review can be provided .anybody agree?
 

options-george

Well-known member
483 92
theory is good when you can use it correctly. You create theory with past events. I agree with Winny. This needs to be tested to see if it works correctly. We need practical examples.
This could be well tested in ForexTester2 - just decide which instruments you want to test, decide which patterns/failed patterns you want to go for, and then devise a tactic for how to entry/manage/exit.

I have been playing around with the idea suggested in the article a bit as well since I use some common patterns in my trading around key support/resistance levels. I also think the market-maker tactics that Martin Cole discusses relate to this.

Good article!
 

richieforex

Member
60 5
Failed patterns can offer great opportunities. The key is waiting for confirmation of the failed pattern and not getting in too early assuming the failure as you can easily get caught out.
 

Brew23

Newbie
6 0
I haven't practiced it yet but it looks pretty interesting
 

TechQuant

Well-known member
264 52
Patterns fail as often as they don't. But what makes them interesting if not useful is that they posses self-conscious awareness of focus of interest and intent. If looked at in real time they will more often than not fail, but only after giving sufficient indication of successful pattern completion to lure pattern traders into taking the trade. Unless you're planning on trading the failure of the pattern in which case they will function as per textbook definition of successful pattern formation and completion, but only after giving sufficient indication of failure to lure failed pattern traders into taking the trade. If looked at in retrospect they will more often than not show every indication of predictive capability and those that do not will eventually appear as to not have exhibited all, or any when you look really hard, of the necessary prerequisites of the formation anyway.
 
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timsk

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. . . If looked at in real time they will more often than not fail, but only after giving sufficient indication of successful pattern completion to lure pattern traders into taking the trade. Unless you're planning on trading the failure of the pattern in which case they will function as per textbook definition of successful pattern formation and completion, but only after giving sufficient indication of failure to lure failed pattern traders into taking the trade . . .
Every so often on T2W a member thinks they've had a light bulb moment when they hit upon a variation on this theme which goes something like this: 'Currently I'm losing 60% of my trades, and the losses are greater than the gains made on the 40% of winning trades. If I do the exact polar opposite of what I've been doing I'll instantly switch from being a net losing trader to being a net winning one. Problem solved, oh happy days!' Unfortunately for them, it simply doesn't work and never does. TQ's excellent post explains why.
Tim.
 
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Fugazsy

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All patterns fail, and the failures often fail, but a failed failure is a second
entry in the original direction and has a high probability of success.
 

TechQuant

Well-known member
264 52
All patterns fail, and the failures often fail, but a failed failure is a second
entry in the original direction and has a high probability of success.
Sounds good in theory. What happens in reality is that the pattern traders walk away to lick their wounds after it fails and don't normally also trade pattern failures. The failed pattern traders walk away to lick their wounds after it fails to fail and don't normally trade patterns. And both classes posses the very human tendency not to get bitten twice. So once this trade, whichever one it was, has let them down, they'll likely not look at it again for a while and miss any opportunity that presents. Unless they fall into the revenge trade category and they immediately enter an opposite position or another one in the original losing direction but with an even tighter stop to ensure they minimise their chances of success, and they they lose on both legs.

Don't forget, the pattern knows your innermost thoughts and plans, even before you do. They'll let you win one now and again just to keep you hooked as they known you'll promote these winners to pride of place in your memory and quietly allow the iceberg of losers to submerge beneath your consciousness.
 

Fugazsy

Veteren member
3,661 677
Sounds good in theory. What happens in reality is that the pattern traders walk away to lick their wounds after it fails and don't normally also trade pattern failures. The failed pattern traders walk away to lick their wounds after it fails to fail and don't normally trade patterns. And both classes posses the very human tendency not to get bitten twice. So once this trade, whichever one it was, has let them down, they'll likely not look at it again for a while and miss any opportunity that presents. Unless they fall into the revenge trade category and they immediately enter an opposite position or another one in the original losing direction but with an even tighter stop to ensure they minimise their chances of success, and they they lose on both legs.

Don't forget, the pattern knows your innermost thoughts and plans, even before you do. They'll let you win one now and again just to keep you hooked as they known you'll promote these winners to pride of place in your memory and quietly allow the iceberg of losers to submerge beneath your consciousness.
Thank you for your comment but I do not agree, a good trader does not have to enter at the pattern with all its degree of failure, he is not following the market around like a stoned dog, he made his decision prior dictated by the overall market conditions, he is waiting....... lets consider a break out, instead of entering at the break out the trader enters at the break out pull back: the break fails, its failure fails, the trader is still on the side line, if it gets another signal he/she enters, which is also a second entry and a stronger entry compared to the original one.
 
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TechQuant

Well-known member
264 52
Thank you for your comment but I do not agree, a good trader does not have to enter at the pattern with all its degree of failure, he is not following the market around like a stoned dog, he made his decision prior dictated by the overall market conditions, he is waiting....... lets consider a break out, instead of entering at the break out the trader enters at the break out pull back: the break fails, its failure fails, the trader is still on the side line, if it gets another signal he/she enters, which is also a second entry and a stronger entry compared to the original one.
That's not how most traders trade Fugazsy. It may be how you trade. It may well be how most traders would like to trade or even how they think they trade. Textbook trading like textbook anything makes everything look easy and simple. But the facts are your salmon en croute will rarely end up looking like the photo in the recipe book and only a very few of your trades will bear any resemblance to those in whatever trading guru's textbook you care to choose. I'm going to re-quote one of my earlier quotes to make the point.

"The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."
 

Fugazsy

Veteren member
3,661 677
That's not how most traders trade Fugazsy. It may be how you trade. It may well be how most traders would like to trade or even how they think they trade. Textbook trading like textbook anything makes everything look easy and simple. But the facts are your salmon en croute will rarely end up looking like the photo in the recipe book and only a very few of your trades will bear any resemblance to those in whatever trading guru's textbook you care to choose. I'm going to re-quote one of my earlier quotes to make the point.

"The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."
I express my perception of trading not any others or any text book....wherever I write is the expression of my experience and nobody's else, my posts have the intention to share and I cannot control what others for any reasons would like to perceive...What I posted earlier is my perception the way I trade and nothing more..

I do not think they way I trade is easy and simple, actually I think the opposite is true because I do what the minority does which is to think with my own head......

Regarding the recipe book, I do not care how good spaghetti alla carbonara looks I care how god they taste...:whistling

But I agree with your quote but honestly I think it is more relevant to yourself, myself I never pretended that I hold any truth and as a consequence I doubt I will be trapped by my own concepts, as I explained already above mine is only a perception of my experience and nothing more...if you think it will help you then I am very happy about it...if not...well..... there is nothing I can do about it......
 
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Fugazsy

Veteren member
3,661 677
I like to believe I am both, I am convinced that to be a great trader I need to know a lot about myself..........there is always something to discover....but at least I got to the stage where I feel not fear anymore.....maybe because I accept it and in the presence of my presence emotions just melts away by acknowledgement and at the same time giving me more space for discovery and creativity..... just as in my trading where my attention brings in my focus and my essence into play......and the all becomes effortless........does it happen in every session? No, as it does not happen everyday in life, but I am working on it.....
 

alexaherself

Established member
560 149
That's not how most traders trade Fugazsy.
Of course it isn't: perhaps one need only look at the relative proportion of winning to losing traders (whoever's figures you believe on this matter) to appreciate why? One surely wouldn't want to try to emulate "most traders"? :confused:

Ah, I've been had. I thought you were either a philosopher who trades or a trader who philosophises.
From what I've seen of Fugazsy's posts here, I think he's probably a bit of both. :cool:
 
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