In this issue:
Two Patterns to Catch New Trends Early: The Bowtie and the First Thrust
Contributed by Dave Landry
The trend is your friend is one of the few true market adages. Critics will argue that a trend is your friend until it ends. And, admittedly, this is true. Trends do not last forever. Eventually they exhaust themselves but quite often, a new trend in the opposite direction emerges. However, established trends can often last much longer and go much further than most anticipate. Trying to buy a stock (or other market) because it is low or sell short a stock because it is high is a loser's game. The good news is that the stock will leave clues that a trend is turning and will usually have a minor correction before resuming its new trend. Looking to enter after that minor correction and only if the new trend shows signs of resuming is the goal of my transitional patterns and is illustrated below.
When you catch a new trend early, the payoff can be huge. Unfortunately, since you are fighting
what could turn out to be only be a correction in a longer-term trend, you have to realize that there will be a higher failure rate than trading pullbacks in established trends. Like the pioneers, when trading transitions you are either going to get the gold or the arrows.
Let's look at two of my favorite transitional patterns, First Thrusts and Bowties.
Markets in major trend transitions often begin with a bang. They make a sharp thrust in the new direction. This tends to catch participants off guard. Trapped on the wrong side of the market, they find themselves waiting for the market to reverse so they can get off the hook. Bottom pickers and top pickers who missed the top or bottom and do not want to pay up are also waiting for some sort of meaningful correction. Unfortunately for these traders, the meaningful correction may never come. Often, markets making a sharp thrust in a new direction only pull back very briefly before resuming their new trend. The old market participants will soon be forced out at adverse prices and the bottom/top pickers must pay up or risk being left behind. By waiting for the market to have a sharp thrust in the new direction, you avoid the pitfalls associated with picking tops/bottoms. By looking to enter at the first signs of a correction rather than waiting for something more substantial, there is the potential for your position to be helped along by the predicament of the aforementioned traders. Let's look at the pattern. Referring to figure below, after making a significant new low (1), the market should have a sharp thrust in the new direction (2) and then make a lower low and a lower high; in other words a 1-bar pullback (3).* Look to enter above the high of the pullback (4).
*Rule 3(a). Occasionally markets are in such sharp reversals that they will only make a lower high (vs. lower high and lower low). These make for somewhat risker trades. With risk comes reward though. Sometimes you're able to get into a major trend early. The best transitional patterns come off of markets that are making major new lows for longs. This helps to ensure that the most people as possible are on the wrong side of the market when the trend turns. Notice below that Berry Petroleum is at its lowest level in over a decade (1). The stock then has a sharp thrust higher (2). The stock makes a lower-low and a lower high (3). Go long (4) above the high of (3).
The great thing about transitional patterns is that they occur in all markets and in all time frames. Here's an example in the weekly Australian Dollar (AUD/USD). The currency makes an all-time high (1) and then begins to sell off (2). It then makes a higher high and a higher low (3) to complete the setup*(4). A short is triggered when the stock turns back down. The contract resumes its slide over the next few weeks.
*Note: a somewhat more aggressive entry would have been to enter after the higher low only (a)
Bowties The First Thrust is a fairly abrupt pattern that occurs over very short periods of time. These new trends begin with a bang. Sometimes though, new trends start more gradually. Markets go through a distribution phase and then begin to accelerate in the new direction as the new trend emerges.For this pattern, I use a 10 day simple, 20 day exponential, and 30 day exponential moving average. Although all indicators are prone to lag, I did notice that these moving averages would often come together and then spread out in the opposite direction right before a market makes a major transition. That is, they would go from proper downtrend order - the faster moving averages (shorter periods) below the slower moving averages (longer periods) - to proper uptrend order - the faster moving averages above the slower moving averages. When this happens over a short period of time, it gives the appearance of a Bowtie. This is illustrated below. Notice that the moving averages are in downtrend "proper downtrend order" 10-SMA < 20-EMA < 30-EMA but quickly flip over to uptrend proper order 10-SMA > 20-EMA > 30-EMA). Ideally, this should happen over a period of three to four days (1). After this occurs, it suggests that the market has made a major trend shift. However, it is still prone to correct. Therefore, you wait for the market to have at least a 1-bar pullback (2) and then look to enter after that minor correction (3).
Like all my transitional patterns, I prefer those that come off of major highs or lows.Let's take a look at an example. USG Corp. (USG) makes 6-year plus lows (a). Notice that the Bowtie moving averages are in downtrend proper order (10SMA <20EMA <30EMA). Then as the stock begins to bottom, the moving averages come together and then change to uptrend proper order (10SMA>20EMA>30EMA) over a short period of time. This creates the appearance of a bowtie( 1). This makes a lower low and a lower high followed by another lower low and lower high (2). Enter when the high of (2) is taken out (3).Although I'm not a big fan of day trading, the following Bowtie caught my eye on the 5 minute chart when asked about the ETF during a recent webcast. It actually was triggering during the live show.The Direction Small Cap Bull Shares (TNA) make an intra-day high (a). In fact, this is actually also a multi-day high. The moving averages come together and quickly cross over to form the bowtie (1). The ETF pulls back (3). Enter as the trend begins to resume (3).
Staying on the right side of the market
Transitional patterns can often alert you to the fact that an old trend is coming to an end and a new one is emerging. In fact, they can signal the beginning of major bull or bear markets for stocks and other markets (e.g. Forex, commodities, bonds, etc). This is especially true if the market is making a longer-term high or low. If you study major market turning points - such as the stock tops in 2000/2007 and the bottoms in 2003/2009, and now the top (?) of 2011, you'll see that transitional setups occurred as the market turned on a variety of time frames. Not every transitional pattern will turn into a major top or bottom but all major tops or bottoms will have some sort of transitional pattern. Let me repeat, all major tops or bottoms will have transitional patterns. This is what makes watching for them so worthwhile.
Trying to picks tops or bottoms is a loser's game. You're much better off waiting for the market to show signs that the trend is turning and then look to enter after the first correction. The First Thrusts and Bowties are two of my favorite patterns I use to catch new trends early. The best setups occur after major highs and lows. Multi-year or even lifetime highs/lows work the best. This helps to ensure that the most traders are trapped on the wrong side of the market. Not all transitional patterns will turn into major tops or bottoms but all major tops or bottoms will have transitional patterns. Like the pioneers, when trading transitions you are either going to get the gold or the arrows. I think the chance for gold makes it all worthwhile.
For more information
For more information on trading transitions, see Dave Landry's 10 Best Patterns and Strategies (www.davelandry.com/books.htm) and his newest book "The Layman's Guide To Trading Stocks". Amazon.com: http://tinyurl.com/2vo395r
About Dave Landry:Dave Landry has been have been actively trading the markets since the early 90's. In 1995 he founded Sentive Trading, LLC,(d/b/a www.davelandry.com)--a trading and consulting firm. He is author of Dave Landry on Swing Trading (2000), Dave Landry's 10 Best Swing Trading Patterns & Strategies (2003), and The Layman's Guide to Trading Stocks (2010). His books have been translated into Russian, Italian, French, Japanese, and Chinese. He has made several television appearances, has written articles for several publications including Technical Analysis of Stocks & Commodities, Active Trader, and Traders Journal-Singapore. He has been publishing daily web based commentary on technical trading since 1997. He has spoken at trading conferences both nationally and internationally. He holds a Bachelor of Science in Computer Science and has an MBA. He was registered Commodity Trading Advisor (CTA) from 1995 to 2009. He is a member of the American Association of Professional Technical Analysts.
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