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Has chart trading become unreliable?

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Charts don’t work like they used to!

This is the first of three blog postings on the (un)reliability of chart patterns for trading. This posting lays the claim that chart patterns are increasingly unreliable for trading. The second posting (when I get to it) will pose the possible reasons why this has occurred. The third posting will address solutions to the problem.

I’ve traded futures and forex on the sole basis of classical chart formations since 1980. I have not used volume or open interest, Commitment of Traders data, moving averages, oscillators, or any of the “latest and greatest” technical indicators. In fact, I am not a fan of indicators because they are simply derivatives of price. My attitude has been, “Why study derivatives of price when I can study and must trade price itself?” If you disagree with me and have been consistently successful, your success speaks for itself. In the business of trading, everyone must find their own niche that works.

If anybody has earned the right to speak about chart patterns, I think I should at least be on the short list. My conclusion – chart patterns are far, far, far more unreliable today than at any other time in my trading history.

There was a time (in the 1980s – many of you were not even born then) when as a chartist I would enter a trade based on a classical chart pattern and mentally and emotionally “bank” the profits. Patterns were extremely reliable. But, when patterns did not work, at least traders on the other side of the market made money! If I am long and wrong, I want traders who are short to make money. That is the way it should work. The worst possible trading environment, in my opinion, is when both long and short position traders are eating humble pie.

There is one other dimension to this. In the “good olde days,” when a chart pattern failed it told me something important about the market. Now, patterns just fail and provide no lessons. I have never been a very good “range” trader.

My guess (I wish I had kept good data back then) is that 50-plus percent of chart patterns worked in the 1980s. I define “working” as reaching the measured-move target without digging back into the completed pattern. Usually patterns worked immediately and decisively.

In recent years only 25 percent of patterns have worked. We have entered a period I call “chart morphing.” This may represent the new norm. Chart morphing occurs when one identified chart pattern breaks out, but fails, only to become a component of a larger chart pattern, that in turn breaks out, but fails, only to become a component of a larger chart pattern, etc., etc.

The following chart of Sugar demonstrates this chart morphing concept. In this case I identified and traded six patterns in real time. Only one delivered a profit. There was a time when three or four of six patterns, not one of six, would have delivered a trend to the implied target. We now have a six-month trading range in Sugar with no clue as to the next dominant chart pattern. As a chartist you may have labeled May Sugar in an entirely different way. That’s what makes a market.

 

The above reality of chart morphing is that a trader can lose 80 points in a 30-point trading range over a sequence of trades and months only to become gun shy just in time for the real breakout to occur. If you are a chart trader, is this a world you can relate to? 

Does all this mean that classical charting is no longer a valid way to trade? Not at all! It does mean that the time frames, tactics and money management principles of using charts must be modified. I will have more to say about these things in future posts.

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How do you spell bubble?…S I L V E R

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The Silver market is within months, or even weeks, or even days of a major top.

The Silver market has entered a classic blow-off top. There is no question but that Silver is a bubble in the making…and will soon be a bubble in the breaking.

The similarities between the current exponential spike in Silver and the Nasdaq in the late 1990s are striking. While Silver could surge significantly higher before the top (driven by investor mania and CFTC-sanctioned cornering /short squeeze maneuvering), perhaps even to $60 or $70 per oz., the odds are very high that Silver will be back in low teens within the next five years.

Silver currently is right in the blow-off sweet spot that drove the Nasdaq from October 1999 to the March 2000 high. Once again the individual investor will be burned badly.

Millions of investors have bought into the idea that the Silver is the best thing going – that between global supply and demand factors and a hedge against paper currency, Silver actually deserves to be priced at current levels. There are actually web sites touting $200 and even $1,000 Silver prices.

The Silver market reminds me of the mania surrounding the Nasdaq – just prior to the start of its 81% decline into 2002. Do I think Silver could experience an 80% decline? Absolutely! Of course, the shorts could go broke before Silver finally tops, so I have no desire to step in front of this run-away train.

Many of the investors in the raw material markets today are unfamiliar with the boom-to-bust-to-boom-to-bust nature of the commodity markets. So, if this is you, enjoy your profits now, because if you are a long-term bull on Silver, your definition of “long term” is likely to be redefined in the decades ahead.

I am also including a chart of the last grand bull move in Silver. A picture is worth a thousand words.

In the commodity markets, what goes up will eventually come down.

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Up, Up and Away — U.S. Stock Market

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I’ve never liked the taste of Humble Pie!

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AKA, when I short AAPL pie, I need to prepare to eat HMBL pie

A number of readers have asked me to recap my recent trades in Apple Computer. Of course, I was a busy little beaver posting the details of my shorting campaign – mainly motivated by all the hate messages I received from my initial AAPL posting, then the post that laid out a trading strategy to risk 75 basis points (3/4 of 1%) to make 1420 basis points (14.2%).

I detailed my trading in AAPL during the course of six blog posts and 15 StockTwit posts. See the chart for the graphic representation of my trading. The sales are circled.

So, here is how my AAPL trade unfolded.

  • Sold 100 shares on 4/8 at 338
  • Sold 100 shares on 4/8 at 334.90
  • Bot 100 shares on 4/12 at 332.02
  • Sold 100 shares on 4/14 at 332.41
  • Sold 100 shares on 4/18 at 322.87
  • Bot 100 shares on 4/18 at 328.34
  • Bot 100 shares on 4/18 at 331.81
  • Bot 100 shares on 4/18 at 331.82

Bottom line:

  1. I planned and executed a short play in AAPL
  2. AAPL ended up springing a gigantic bear trap
  3. I ended up shorting and covering 400 shares per $100,000 of capital
  4. My net gain was 42 basis points (4/10th of 1%)
  5. The bulls won out in the end (or so it seems as of today)

Lessons:

  • The AAPL lovers appear to be right after all – congrats. A trader needs to be a good loser to be a good winner
  • Trading is all about risk and trade management
  • Without hesitation, I would do the short campaign all over again in any other market that displayed the same chart construction

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Thank God I’m a trader, not an analyst!

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Thank God I’m a trader, not an analyst!

There is a huge difference between being a trader and being a market analyst.

Analysts are paid by being right. On this basis alone I am not smart enough to be an analyst. Traders are paid by managing risk. These two skill sets are a world apart. In my experience, people who try to be traders by being analysts usually lose their grip at both ends of the rope.

An analyst will be judged negatively by poor market calls. When wrong, a trader closes the trade and moves onto the next opportunity. Hopefully, little harm done! Being wrong is a fundamental assumption for a trader.

Analysts study industries, companies and economic conditions. Traders, at least most traders, study price and could care less what company the price represents.

Analysts – even technical analysts – become heavily vested in the rightness of their opinions. Analysts gain reputational equity based on their correct calls. Traders become economically vested by what they do with their losing trades. Traders gain capital equity based on their handling of losing calls.

When an analyst changes an opinion on a stock or the general market, it is called a “revised forecast due to changing fundamentals.” When a trader changes an opinion on a trade, it is called “flexibility for capital preservation and survival.”

I am a classical chartist. I view charts as a trading tool, not a method to forecast prices. I don’t believe charts can forecast prices. I have a disdain for “chart book economists.” I do believe that charts can provide unique high potential/low risk trading opportunities. To me, that is the only real value of charts. The idea of forming some grand economic scenario based on a chart is absolutely ludicrous.

The reality is that most chart formations fail to deliver the goods, especially chart patterns of shorter durations. This is why so many novice traders give up on charting, claiming that charts don’t work.

Chart patterns fail and morph into new and larger chart patterns, which morph again and again and again. I term this process “chart redefinition.” All massive chart patterns of six to 12 months in duration are made up of dozens of short-term daily patterns and hundreds of intra-day patterns that mostly failed.

Eventually a chart pattern will mature and provide a grand speculative opportunity. It is this type of opportunity that I seek. But along the way I am wrong on 65% of my trades. During some shorter-term periods of time that figure can be as high as 80%.

This is why I look for particular chart set-ups that offer a reward to risk relationship of 10 to 1, or 20 to 1, or even as high as a stage in a recent trade I made in Apple Computer, 70 to 1. I am not sure what the price of AAPL will do in the days and weeks ahead, but if refuse to take a trade with this type of reward to risk relationship I need to be put out to pasture.

One of the mental hurdles a novice trader must get past is the connection between being right on a market and making money in a trading operation. The two are disconnected. It is hard to explain this concept to a non-combatant, but all front-line soldiers reading this blog posting know exactly what I am talking about.

Trading is not for you if you have some pride of ownership in forecasting prices. If this is you, find a diet not consisting of buy and sell orders. Heck, perhaps you can find a job as an analyst. 

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The Apple has fallen (AAPL Part 6): 04.18.2011

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The Apple has fallen…look out below!

The decline by Apple today has completed a major reversal head and shoulders pattern. In the process I have now sold the final 1/3 (another 100 shares per $100,000 of capital) of my short campaign.

A close above today’s high at 328.14 and especially above the Apr. 13 high at 336.14 are required to negate the bearish interpretation of this daily chart. A close below 322 would confirm the top and establish an objective of 280. Retests of the neckline at 325 to 326 are probable, but the neckline should offer significant resistance.

As detailed by earlier blog postings and communications on StockTwits, my position is now short 300 shares per $100,000 of capital (100 at 338, 100 at 332.41 and 100 at 322.88). I am risking 100 shares to 328.32 and 200 shares to 333.41. So, my risk on the entire short position is 20 to 25 basis points. My potential gain is 1500+ basis points. This trade now has a reward/risk ratio in excess of 70 to 1.

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Apple Computer, Part 5: 04.15.2011

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Is a weak Friday close a sign of weak earnings?

Next week is earnings week for AAPL. The weak close expected today could be a “tell.” The H&S continues to form. I am short two layers of AAPL, waiting to place the final layer at the completion of the top. The rally on Wednesday sets an excellent opportunity to lower stops on my entire current position to 336.31. This locks in a net profit for the short position of 200 shares per $100,000.

At this point I have zero risk on the trade unless the earnings report results in a strong up gap. This H&S top is classic in form, symmetry, volume profile, and behavior. The symmetry of the pattern projects a pattern completion for early next week. However, right shoulders can become extended.

It is important to remember that a top has not yet been confirmed. A close below 322 is needed to firmly set an objective of 280 to 285.

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Special Report, Buy Soybeans & Sell Corn: 04.13.2011

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MercenaryTrader.com Interview

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Appless Computer – Part 4: 04.12.2011

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Apple is declining into support.

The poisonous wrath from the Apple Computer “fruit and nut club” continue to come my way. Here are just a couple of excerpts from the “fan” mail I have received because I suggested that AAPL might be topping out.

  • “This is nonsense. Never heard of a double head. This is a bullish flag, which means the upside will be equal to its previous rising leg. STOP giving false forecast.” (Emphasis not mine.)
  • “Charting[is] so 90…Hello High Freq Trading.”

I do not find these comments offensive or even irritating. I only bring them up because of the humor involved.

“Never heard of a double head.” OK, start with Edwards and Magee, 5th edition, pages 68, 69 and 76 for starters. A double head is not my invention.

“Charting [is] so 90s.” Well, with this in mind let me comment on the chart of AAPL.

The decline on Monday (the 10th down day in 11 days — not exactly a show of strength) has brought prices closer to the critical neckline of the 3-month H&S top. It is show time! The market is NOT oversold, yet I must emphasize that AAPL has NOT completed a top and until it does the trend must be viewed as being UP, not down. The neckline at around 224.50 (+/- 2) will be a magnet for prices.

A decisive close below 320.50 will be the kiss of death for AAPL, and will set up a target of 280 to 285. But if the market can hold above 320, turn back up, spend a full day above the neckline and then advance over 342, a major chart buy signal will set up. Until then I assume that the H&S top will become a reality.

I am short. I have moved stops to 335.81 and 340.27. My risk is presently about 38 basis points. I plan to cover some shorts today if the market opens lower and holds. I would then put the shorts back on if a rally develops. But, if the market opens lower and cannot fill the subsequent gap in the days ahead, my advice to Isaac Newton is… “Duck!”

BTW, there is an upside gap on the chart at 323.48 from Dec. 31. The market may be attempting to fill this gap. Or, the market may gap below the neckline and form an “area island top”….which, of course, like the double head, is also a chart formation I am just making up.

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