Markets Technical Analysis

and

Algorithmic Trading Chapter 8: The True Value of Failed signal

Saeed EbrahimijamFall 2012-2013

Faculty of Business and EconomicsDepartment of Banking and Finance

Doğu Akdeniz Üniversitesi

FINA417

2

Failed signals Bull Trap Bear Trap Failed Trendline signals

Contents

Fundamental of Technical Analysis and Algorithmic Trading

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Book: TECHNICAL ANALYSIS THE COMPLETE RESOURCE FOR FINANCIAL MARKET TECHNICIANS Charles D. Kirkpatrick II, CMT

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Valid signals Failed signals

Singnals

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when a breakout occurs and the price fails to move at least a certain percentage in the direction of the breakout before reversing by 20%.

We will use a 10% gain as the criterion to determine whether a failure has occurred.

In other words, we will relate the percentage of breakouts from each formation that fails to reach a 10% gain before reversing 20%.

Bulkowski's definition of a failure

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Experienced technicians know that a failed signal is one of the most reliable of all chart signals.

When prices fail to follow through in the direction of a price breakout, there is a high probability of a significant move in the opposite direction.

Skilled technicians recognize the true value of failed signals and are not only able to exit a losing trade, but to do a 180-degree turn and enter a trade in the opposite direction.

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What should you do when prices fail to follow through in the direction indicated by a price breakout?

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When a price breaks outs out of a pattern, climbs less than 10%, reverses back into the pattern, and breaks out in the opposite direction, it is called a trap.

Because it catches all the bulls that thought the price would continue to rise from the initial breakout, a bull trap is one in which prices first break out upward, reverse, and then break out downward.

A bear trap is the opposite, where the initial breakout is downward, and then prices reverse and break out upward.

Traps

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The trap percentage is the percentage of times that a pattern has developed a trap.

This is a little different from a failure because the reversal need not extend the 20% from the peak.

It depends on the height of the formation and the relative position of the two breakout zones. It is important, however, because it helps establish in conjunction with the 20% correction location where the initial protective stop should be placed and how often that stop will likely be triggered for a loss. You will find that in most patterns, the percentage of traps and failures is about the same.

Trap percentage

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Figure 8-1 presents an example of a bull trap in the trading of Harley Davidson.

Prices broke out of a symmetrical triangle chart pattern to the upside, thus signaling higher prices. However, after a brief move to the upside, prices reentered the symmetrical triangle and moved quickly through it and sharply lower.

This type of failed signal is known as a bull trap since it leaves those who were bullish, having bought on the upside breakout, with losses. The higher the volume in the trap, the more bulls are caught.

BULL TRAP

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The bear trap is less common than the bull trap. It occurs when prices break out on the downside from a

trading range or other chart pattern and then rally back up through the top of the trading range or upper-boundary line of a chart pattern.

Similar to the bull trap, the higher the volume in the trap, the more bears are caught.

Figure 8-2 provides an example of a bear trap in the trading of Baxter International. After prices established a trading range, prices penetrated the lower-boundary line. However, they were unable to follow through to the downside. Subsequently, a reversal occurred, and prices moved significantly higher up through the top of the trading range.

BEAR TRAP

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Trendlines are one of the most often used tools in the technician’s toolbox. They are also particularly prone to false breakouts.

It is not unusual for slight penetrations of trendlines to occur with no follow-through. For that reason, many technicians use time and price filters before recognizing trendline breakouts as legitimate.

A time filter means that prices must remain above or below the trendline for a certain number of periods,

A price filter requires that prices move a minimum of a certain amount or percentage points away from the trendline before accepting the signal by the technician.

FAILED TRENDLINE SIGNALS

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Even if you use time or price filters, there will still be failed trendline signals that offer profit-making opportunities, since prices tend to move dramatically in the opposite direction of the signal shortly after it appears.

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