by Tommy Lackey
Technicians use price patterns to gauge the supply and demand of the markets. Pattern recognition is a skill that is vital to chart reading, but often seen as one of the more subjective tools in a technicians toolbox. This is because patterns are like clouds, when we look at them often two people can see a very different picture in the same cloud. Neither is right or wrong, just different interpretation. As technicians it is also normal to see our patterns morph into another pattern before we see the big picture. Price patterns add a certain level of subjectivity to the technical process, so it is the rules we employ with each pattern that really that brings out decision making process back to the land of objectivity.
Recently one that has been on my mind is the pattern we see in Crude Oil $USO. This one happened to be an Inverse Head and Shoulders pattern that was forming (near the apex of a rather large triangle, but that is a different story). Many on the stream recognized the pattern and were waiting patiently for the break, but it wasn’t until after the break out that it really got interesting. Many were quick to abandon the break out as soon as the first sign of weakness showed. Granted, it did gap down and formed a new Island Reversal Pattern, but does that negate the larger Inverse Head and Shoulders? My rules said no.
In fact, I wrote it in my weekly notes on the chart (under last weeks notes above) that the pattern had not been negated and needed to be watched closely. Then this week I added it had held and reversed higher. This was a net positive. This is a rule I learned from John Murphy’s books early in my career. This told me to hang in there and not overreact even if the new pattern looked ominous. Now we see the chart today $USO runs back higher blowing the shorts out along the way.
So now we know the pattern wasn’t negated, but this morning Dr Phil @ppearlman suggested we also discuss how we know if it has confirmed. There are a few different strategies here. The most common is moving beyond the neckline by 3%. This is a conservative confirmation for most. Some add 3 days to the 3% to give a little more comfort. Others may use the B/O and close above the neckline for their signal, this is aggressive, but if they know their risk is the right shoulder, it may fit their parameters. Finally, there are some traders that even wait for the back test to be successful. This provides the tightest risk parameters because you are closer to your stop point, but can miss many moves if you don’t get the back test at all. None of these are right or wrong and results will vary depending on the market action at the time. As Mark Douglas constantly reminds us in Trading in the Zone, “…every trade is a unique experience, even if the pattern looks and measures the same.” It is more about your trade plan; it is in that plan where you identify and accept your risk before ever entering the trade.