Sometimes you may look into the night sky and see patterns in the stars.
The Big Dipper, Ursa Major, Orion… These patterns were defined by our ancestors thousands of years ago.
People have always tried to see order in disorder. I understand this desire. It’s natural to want to make sense of the world around us, and hope that there is some larger force guiding it all.
Since this is Technical Tuesday, you may know where this is headed.
For hundreds of years, traders have seen orderly patterns in charts. They’ve identified heads and shoulders, cups with saucers, dojis, and hundreds of other patterns.
I understand this desire, too. Price action has a high degree of randomness. Looking for patterns helps traders cling to order in the chaos of short-term price action.
But I’ve never been comfortable with that. I always want more than a diamond pattern or rising wedge to justify a trade…
Because I know our eyes can play tricks on us, and the pattern might just reflect what we hope to see.
To overcome this problem, I do my best to describe any pattern I notice with precise rules.
Last week’s price action is a great example…
Let’s Find a Pattern in Last Week’s Rally
Last week, the SPDR S&P 500 ETF (SPY) gained more than 5% in five trading days.
That’s easy to program as a trading system. I can assume I buy SPY the day after it gains 5% in five days. Then, I’ll sell a set number of days after the buy. This shows me how well the signal performs.
While that 5% gain in one week seems unusual, we actually see a gain like that an average of three times a year. The table below summarizes the performance of SPY after those moves.
(Click here to view larger image.)
This test looks at performance over the next week, over the next month (20 trading days), the next two months, three months (65 days), six months, and one year.
For context, I included performance data for a random entry. This is the second section of the table. For this test, I just set the system to buy on a random day and hold for the same number of days as in the first test.
These two tests allow for a comparison of performance after a one-week gain of 5% compared to a random entry. This results in the Trade Edge section.
The Win% in this column is based on the ratio of other two sections. For the day after the big gain, there is an 8.8% lower probability of a gain than at random times. This makes sense. We’d expect some sort of pullback after a quick rally.
The Average Trade in the Edge section is the difference between the trades in the other section. We immediately see why context is important.
Over the next year, our big gain pattern is followed by additional gains 75% of the time. The average gain is 8.62%. Both sound good.
But neither number beats a random entry. In fact, the percentage of winning trades almost always lags a random entry.
From the table, we see that this pattern doesn’t offer a significant edge. There is some outperformance at two months and six months, but the other time frames don’t show that.
Trust the Price Action, But Verify
Based on data, last week’s big gain isn’t a tradable signal by itself. It does alert us to the fact that there could be a new bull underway, and we need to be watching that.
I ran this test because it’s hard not to get excited about a stock market recovery after a performance like last week. I understand you might be feeling this excitement, and want to chase last week’s move.
But sober minds are what make great traders. It’s possible that what we saw this week is the beginning of a “baby bull market”, or it could be a classic bear market rally.
Testing like this often shows that the patterns we think we see don’t beat the markets. The truth is that many of the patterns traders see on charts are exactly like the constellations in the sky. They are nice in theory, but don’t add value.
This is an important lesson in technical analysis. As Ronald Reagan liked to say, “trust, but verify.” To do that, always consider the data, in context, when reviewing a trading signal.
Regards,Michael Carr, CMT, CFTe Editor, One Trade
Chart of the Day:DOGE About to Break?
By Mike Merson, Managing Editor, True Options Masters
(Click here to view larger image.)
The irony of trying to follow Mike’s insight today with a Chart of the Day — which isn’t far off from spotting constellations on price charts — isn’t lost on me.
Nevertheless, DOGE looks bullish. And it has proven to us many a time before that sometimes the most obvious trade is a profitable one.
I couldn’t help but give DOGE another look after watching Chris Cimorelli’s recent video on it. It’s hard to deny that it looks great here.
We’re beginning to break up out of a falling wedge pattern into several months of positive divergence on the RSI and MACD. This comes as ETH and BTC just put in new local highs this morning, and may be returning to an uptrend.
If crypto does take off again, DOGE will at the very least follow it. I doubt it will become the Meme Trade of the Year twice in a row — so keep those expectations tempered. But if you’re not averse to some belligerent speculation, DOGE should be on your radar.
Regards,Mike Merson Managing Editor, True Options Masters