PATTERN
FAILURE
Figure 10, the Standard &
Poor's 500 December 1994 contract, illustrates a failed pattern. Consider the
selloff period in Figure 10 during the July 30th to August 9th time frame. Instead of plunging, the
stochastic sank, resembling a camel in quicksand — a muddled and congested
technical sight. But market momentum and prices began to rise again within a
few days. The pattern failed, even though the short-term selloff did occur on
the anticipated second peak of the 10-day cycle.
The resolution for
completion of the pattern had to be immediate — at worst within 10 trading periods.
As can be seen from the other examples, if the pattern does not develop quickly
after the position is established, the likelihood of a false signal increases
greatly. All of the successful examples display market resolution that is
powerful and decisive.
A typical sign of
pattern failure will be a stochastic upswing crossover after the stochastics
have already turned down, as revealed by Figure 10. In addition, if the market begins
to trade in a range and is slow to impair technical support such as trendlines,
moving averages and relative strength index (RSI) support, the pattern
is very likely to be a failure.
Because the stochastic
pattern recognition system trades near price extremes, the wisest course at
this point is to liquidate the position before the market hits a new high.
Taking the other course of placing a stop-loss exit at the new market highs
would entail a kind of casino risk with only a bingo reward. There are two
reasons for this. First, whenever you are able to sell a market near contract
highs and stay with the position for several trading periods, the chances are
good that other traders are also pointing to the obvious top in prices. A top
in prices rarely gives the timid a second chance to participate or liquidate.
Now the second reason:
With so many traders looking for a top and prices beginning to churn higher,
the adage of what is obvious to most is obviously wrong suddenly becomes very
apropos. The old high in the market suddenly acts like a powerful trading
vacuum. If prices trade through the resistance at the old market highs, the
slippage suffered by stop-loss orders can be very substantial. I have found
that it is usually more profitable to pivot to a long position when the market
threatens to retest highs from the pattern. However, pivoting from signal
failure is beyond the scope of this article.
Stochastic & RSI
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