Sunday, June 25, 2017

Unmasking the VooDoo - Head-and-Shoulders

Whenever I think about the famous - or infamous - head-and-shoulders pattern from the world of chart reading I always seem to go back to the late, great Mark Haines of CNBC who in the summer of 2009 asked every guest, whether they were a technical analyst or not, if they were worried about the head-and-shoulders pattern that formed in the market. I cannot remember if he was looking at the Dow or the Spoos but that is far too picky for this episode.

Anyway, what he saw was this:

It sure looked like a head-and-shoulders, which as "everyone knows" is a reversal pattern. Keep in mind the environment we were in at the time. The Internet bubble popped and the raging bear market was only three or so months in the rear-view mirror. That is, for the few who recognized that it was actually over.

Haines and countless others were still in panic mode and in extremely skeptical of any rebound. Therefore, a possible reversal pattern was looming to squash investors one more time.

I also have to give Mark credit for recognizing the pattern with it variation of a left shoulder but we'll get more into the details of the pattern a little later.

Anyway, let's see what happened after the gentlemanly freak out on television:

Oh snap! What the heck happened? The world's most recognized pattern (by non technical analysts) failed to end the rebound. And the market went up - a lot. And fast. Hokey Smokes! (Think Rocket J. Squirrel).

Let's dig into the deets, starting with what exactly a head-and-shoulders (H/S) is supposed to be.

While the pattern works in bull and bear trends, albeit it must be upside down for the latter, let's stick to everyone's favorite - the rising trend.  

As we know, as trends trend they usually exhibit a bit of ebb and flow. Advance and pullback. Three steps forward and one step back.  You get the picture. It is good when each push up makes a higher high and each fall back makes a higher low.  

The fun happens when one of those pullbacks does not make a higher low. It can make the same low as the previous low or (shudder) it can make a slightly lower low. 

Fortunately, the market or stock or commodity or bitcoin heads back up.....but cannot get back to the previous high. What we have here is a warning. And dollars to doughnuts I bet that momentum readings or volume or some other indicator makes a lower high, as well. Actually, I'll bet it made a lower high when price made a higher high, too.

The trend may be in trouble here. But is it a reversal pattern? Well, not yet.  What has to happen to complete the H/S is a lower low below the level of the previous low, or in most cases the previous two lows since they were the roughly equal. 

What may also happen at the same time is a breakdown through a significant moving average, perhaps the 50-day.  And depending on how long the trend has been in place, we may also see a breakdown below the trendline that guided the rally the whole time.

You would think that would make a compelling argument, right? And it does.

But in technical analysis everything us open for discussion. Everything. A rally can turn around without any warning at all. A stock can break out from a trading range and then break down and then break out again. We operate with the odds, not with crystal balls. Iron, maybe but never crystal.

If the odds that a stock will rally after a solid breakout from a solid pattern are 95% (I made that up) that still leaves room for failure. It is our job as chart readers to recognize failure sooner rather than later, cut losses and live to trade another day. 
Nobody gets it like they want it to be
Nobody hands you any guarantee
- Jackson Browne, Boulevard (1980)

As we can see in the second chart, the market did indeed break down from the H/S pattern. I bet the folks at CNBC were pulling spare tighty whities out of their desk drawers. 

But the darnedest thing happened. The market turned right around and started to move higher - for the next seven months with nary a hiccup. Talk about damaging your shorts!

I saw two things back then. First, basic risk control and common sense said that four trading days after the breakdown - when the market surged higher and back above the broken support line - aka the neck line - the whole reversal thing was destroyed. And if you missed that signal, certainly you abandoned your short trade two days later when the market surged again. 

If you did not see that then you really should just give Vanguard a call and let Bogle manage your stash. 

The sentiment thing was a bit trickier. People were still crazy bearish or at least crazy nervous. And the publicity given this pattern seemed rather panicky. What a lot of people don't get is that sentiment - at its extremes - tells you exactly the opposite of what is likely to happen. If everyone is bearish then there is nobody left to get bearish. There will be nobody left to sell since theoretically everyone has already sold. Supply dries up.

It's like dry kindling just waiting for a spark of demand to appear to light things up/

Sorry, got off track with a discussion of supply and demand in the markets. Anyway, the breakdown failed and everyone came rushing back in to buy.  Up, up and away!

 Let's examine the H/S pattern in 2009 a little closer: 

The pattern is supposed to be a reversal pattern and therefore it must have a trend to reverse. Typically, I like to see it last no more than one third of the time the trend lasted before the pattern started. And, I don't want it to be more than a third of the price gain of the rally.

If the H/S pattern exceeds either of these two parameters it is not a H/S reversal pattern. It may look like it but it is far too big on a relative basis so it must be something else. It may send the market lower but that's not the point. We are examining the specific head-and-shoulders pattern here. 

What we see here is that the H/S pattern was about a third of the height of the rally that preceded it. I used the Fibonacci extension ratio to get 38.2% (almost). That's close enough for me. 

However, when we get to time the patterns falls apart. The rally lasted 40 days before the pattern and you are correct, we cannot tell that until well into the pattern's development. 

The next 40-day mark is drawn in for your viewing pleasure. As we can see, the pattern lasted longer than the rally it was supposed to reverse. that means it really cannot be a reversal pattern at all. Again, it may lead to lower prices but that would be due to a simple support break. 

Well, there you have it. The H/S pattern must be commensurate with the rally it is supposed to be reversing. Sentiment was a bonus here.

And what about falling trends? Just flip the whole flipping thing upside down. Same rules apply.  We can that an inverted head-and-shoulders. Or, you can call it an upside down head-and-shoulders. Or, you can call it Ray, or you can call it Jay but you doesn't hasta call it Johnson (yeah, look up that pop culture reference). 

And now, for the pièce de résistance - the inverse or continuation head-and-shoulders. 

Nah, I lied. I'll save that for another day but here's a tip, the same rules apply in terms of price and time. 

Nothing is more bullish than a failed bearish signal.
- Mike Epstein

Friday, March 31, 2017

Unmasking the Voodoo - Cup with Handle

Anyone who ever discovered a relationship in the stock market and decided to go public with it probably created an indicator - which they named after themselves - or described a pattern or cycle and gave it a really catchy name. I want to focus on the latter in this post.

First of all, let's start with marketing. Ralph's OK Chart Pattern is not going to sell a lot of technical analysis books. It won't get a lot of page reads online. And it won't be worth anyone's while to publish it without the advertising potential. Forget about seeing it coded into TradeStation.

It does not matter if it works or not. Or even if it really works. I mean reeeaallllly works all the time and makes oodles of coin to impress the ladies (or gents, I don't judge).  The only way someone will care about Ralph's OK Chart Pattern is if they 1) find out about it at Ralph's OK workshop at Traders Expo or 2) find out about via a catchy headline such as "Ralph has unlocked the secret of the market with a chart pattern that works every time with no draw downs!"

OK, that's extreme. But what if Ralph's pattern had a better name? One that is easy to remember. And one that cuts through the clutter of every other Ralph out there with his own pattern?

To me, cup-with-handle is just a perfect name. First, you can visualize it even without a chart. Second, it actually describes what you see. And third, there is actual technical analysis behind it.

Of course, a lot of people seem to forget that last part.

There really is a some theory behind the picture but why let that get in the way of a good forecast?

Back in the day when William O'Neil concocted it, the cup-with-handle was a bullish continuation pattern that formed over a period of three-six months.

Let's dissect that definition. First, it is a bullish pattern in an uptrend. Nowhere does it say it works in a down trend although we technicians like to think every pattern works in all markets and in all time frames. For sure, some do but not all. In the stock market, and that is where the pattern was developed, up trend and down trends have very different personalities.

Next, nowhere does it say that the cup-with-handle is a reversal pattern. It says it is a consolidation in an uptrend. It did not say it was bullish no matter what.

Now, that does not mean there cannot be a similarly shaped pattern at the end of a bear trend that reverses the market to the upside. It's just not a cup-with-handle.

Now, I just pooh-poohed the notion that the pattern only works in a three to six month period. If you really understand what is going on then you will see that it does translate to other time frames - barely. The built in technicals of support, volume and consolidation do apply across time frames. But again, can we call it a true cup-with-handle?  Going by the definition handed down by the creator at the IBD alter it is not a true cup-with-handle.

OK, that's picky. But the part about it being a bullish consolidation pattern in an uptrend is untouchable.

Now it is time to get into the pattern so you know what you are talking about - in a way people can and want to understand - the next time you get interviewed on the Consumer News and Business Channel. Yeah, that's CNBC.
Nerd Note: Originally established on April 17, 1989 by a joint venture between NBC and Cablevision as the Consumer News and Business Channel, the network later acquired its main competitor, the Financial News Network, in 1991. Cablevision later sold its stake to NBC (Wikipedia).
Sorry, I am still kicking myself for turning down a gig with them back then.

Anyway, the cup-with-handle describes what happens after a rally. The stock eases back down on diminishing volume. Endures a period of low volume, low volatility trading. Starts to recover as volume picks up before finally erasing the whole decline.

If you want a chart, visit with my little friend Google. or be wild, try Lycos, Hotbot, Ask or Webcrawler. OK, you can try Yahoo, too.

Now, at resistance from the old high the stock pauses again.

Think about this for a moment. In any pattern, a pause at resistance gives bulls and bears a chance to think about life without having to trade. In most patterns, price action touches resistance or the upper border of the pattern a few times. Why? Supply overwhelmed demand at that relatively high price.

Sometimes a stock will slice right on through resistance immediately after bouncing off support. This sort of breakout - usually due to momentum - is not reliable. I'd rather see everyone calm down at resistance so that a breakout attempt results when there is a sea change of attitude. What was once relatively expensive suddenly becomes relatively cheap. That's a true breakout.

It could be a product launch, the CEO finally clearing that intestinal blockage or some other mood bending occurrence from the Fed, oil prices or Gollum. It does not matter why on the charts.

The charts tell us that something changed. Knowing exactly what does not make us any money. Taking action does (or should).

Picking up where we left off, we have a stock that rallied, pulled back in a defined manner to really allow all excesses to be wring out and then a pause back at the old high. Remember, we like pauses at resistance as good setups.

Then the stock eases back a bit. Aye, a bit. It's subjective but if it looks small relative to the overall pattern then that is ease-y enough for me.

What is that important? Because it tells us that bulls were mostly holding on to their shares. A lack of buying rather than heavy selling caused the small price decline. How do we know? Because volume eased back with it.

You might recognize that as a flag pattern elsewhere.

The fun comes when the small pullback is resolved to the upside. Another sea change towards the bullish side and away we go!

And if the pause keeps going and either a lot of time passes (like months) or price sags too much then there is no breakout and no buy signal.  Just as with any other technical chart pattern.

Sure, you can describe the pattern with what unfolds on the chart but the voodoo-less way would be to talk about why the ups and downs appear:
  1. A stock rallies
  2. It reaches a point where the price entices supply to appear and demand to wane.
  3. That creates a pullback as bulls lock in profits.
  4. Then the market loses interest and the stock languishes for a while.
  5. But since the stock was bullish only a few weeks ago some people decide to buy it on sale.
  6. They tell two friends and they tell two friends and before you know it the stock slowly recovered.
  7. That was not lost on the bears and the other nattering nabobs who see another chance to sell at the old highs.
  8. Once again, the stock eases back but not too much because not too much supply came out.
  9. Something sparks the next breakout and suddenly what was expensive is now considered cheap.
  10. Bulls pile in and volume increases.
  11. The stock rallies again. 
Note how some of that is silly for a stock in a down trend. The premise that the stock is generally a long-term winner is important in the intermediate-term gyrations.

When you know why a pattern forms you will understand what the market is telling you when it happens.

And one more thing - the cup portion has to look like a cup. It cannot be a sharp reversal with a champagne class. That leaves no time for the market to forget about it. And it cannot be an overly long period of malaise with a fancy soup dish. A quiet stock is not a dead stock.

It has to be a U-shaped cup with low volume in the middle.  It has to let the volume curve play out, too.

Let me live 'neath your spell
Do do that voodoo that you do so well
'Cause you do something to me
That nobody else could do
- Frank Sinatra