Buyers enter trades expecting to win: they expect prices to rise. Sellers also enter trades expecting to win: they expect prices to fall. Each buyer and seller in a trade expects to win and, therefore, expects his counter party to lose. While many futures market participants may be hedging a position and therefore don’t care about the ultimate direction, they certainly are trying to execute that hedge at the best possible price. These mutually exclusive expectations are one of trading’s most fundamental concepts: You cannot enter a trade until you find someone who thinks you are wrong.
In trading, expectation and reality collide at high speed and high frequency. How you cope during these collisions determines your long-term success as a trader.
You cannot buy until you find a seller. You cannot sell until you find a buyer. Sometimes you will be right. Sometimes your counterparty will be right. Perhaps sometimes you both are right, but one of you is off on your timing.
When your counterparty is right, join him. When reality counters your expectation, go with reality. If your trading approach says price should go up, but price goes down, sell. If your trading approach says price should go down, but price goes up, buy. When your analysis says one thing, and reality says another, reality is right every time. The best traders are able to switch from offense (taking a position) to defense (taking a loss) and back to offense (reversing your original position) without hesitation.
A good defense includes risking a small predetermined percentage of your account and using stop losses. If you fear leaving standing stops in the market you should have a mental stop loss and use it when that level is hit. If you are wrong about a trade, these tactics ensure loss control.
Another tactic is to restrict your trading to specific price setups. Until you see one of your selected setups, stay in cash. This limits your exposure to situations you already have studied and experienced. Trade only on ground of your choosing. Wait for price to trigger one of your setups; enter the market accordingly and take your profit.
When a price setup succeeds, it will condition you to trade during that setup. Depending on your strengths, expand the number of setups you follow. If a setup fails, then proper risk controls will cushion the loss. You will have a moneymaking machine that balances expectation and reality.
The time will come, however, when even your best setup will fail. Whenever something you have come to depend on turns on you, it can be emotionally and financially traumatic. Built-in safeties can limit the pain, but when a trusted setup fails, it can throw you off balance for days, weeks or months.
One way to cope with a failed setup is to change your perspective. When everything you know says a market should go up but it goes down, that is a setup, too. In other words, for every setup that you follow there is a corollary setup. If you follow a single setup then you are in effect following two setups. The first is when the setup succeeds and price follows through in the predicted direction. The second is when the setup fails and price moves in the opposite direction. A follow through has predictive power and its corollary, a failure, has predictive power.
Say a setup succeeds. You run with price. You make money. Say a setup fails. Price runs in the opposite direction. You limit your loss. If price continues to run in the opposite direction, you reverse your original position and you run with price. You need to train your brain to recognize that a failed setup is an inverse setup with inverse predictive power.
Many price setups have long been in the public domain. These more popular setups tend to present the most information. These classic setups are effective for demonstrating the hypothesis of inverse predictive power.
Head-and-shoulders bottom: This setup is characterized by a new price low followed by a rally followed by a break to a deeper low, followed by a rally, followed by a break to a low that is on a level with the first low. The middle, deepest low is called the head. The first low and third low are called the shoulders.
• Predictive power: After setting the third low, price should stage a significant rally.
• Inverse predictive power: After setting the third low, if price pushes lower, price could move significantly lower.
Double and triple bottom: Price sets a new low, followed by a rally, followed by a break to the first low, followed by a rally, followed by a break to a level that is in line with the first and second lows.
• Predictive power: After setting the second or third low, price should stage a significant rally.
• Inverse predictive power: After setting the second/third low, if price pushes lower, it could move significantly lower.
Rounded (saucer) bottom: Similar to a head-and-shoulders bottom except price sets a series of lows that form a gradual saucer-like arc.
• Predictive power: After the arc is completed, price should stage a significant rally.
• Inverse predictive power: After the arc is completed, if price pushes lower, price could move significantly lower.
Bull flag: This setup happens during an established uptrend. After a significant move higher, price begins to trade in a tight range, forming a series of lower highs and lower lows in the shape of a parallelogram. (A bull pennant is similar to a bull flag except price will trade in a tight range forming a series of lower highs and higher lows.)
• Predictive power: Price should soon stage a significant extension of its move higher.
• Inverse predictive power: If price breaks below the flag it could retrace lower.
Symmetrical triangle: This setup can happen at any time. Price trades in a broad range forming a series of lower highs and higher lows.
• Predictive power: If price rallies off the tip of the triangle, it should move significantly higher, or if it breaks it should move significantly lower.
• Inverse predictive power: If the initial rally or break reverses (fails), price could move significantly in the direction of the failure.
Each one of these bullish and bearish setups — head-and-shoulders tops, double tops, rounded (saucer) tops, bear flags, and bear pennants — is the mirror image of its counterpart.
THE LAST WORD: PRICE
When a price setup follows through as expected, flow with the follow through. When a price setup fails, flow with the failure. Said another way: When what you expect to happen does happen, good; when what you expect to happen does not happen, good — if you know how to recognize the failure and adjust your behavior accordingly.
The key in using inverse predictive power is to see all failures as having some degree of power. In “Liar, liar” (page 43), the October action in a December 2009 gold futures chart starts strong then sets up a seemingly perfect bull pennant predicting a significant extension of the rally. The setup failed. Inverse predictive power handed bears a quick profit.
“Wrong way” zooms in on the October gold action. You can see how the highs and lows formed a perfect bull pennant setup. This chart drives home the message that complacency can be dangerous. Even a perfect setup can fail.
Inverse predictive power teaches you to be mentally flexible and to come out on top regardless of how a market moves. You still, however, have to stay on your toes. “Twister I” shows what happened after gold’s October bull pennant failed. Bears made a quick profit if they were wise enough to take it. Gold exploded higher in a double-whammy demonstration of inverse predictive power. First, the October bull pennant failed, then the failure itself failed. Price action is a perpetual duel between buying pressure and selling pressure. Trading is a world of dueling setups.
“Twister II” (right) shows a six-month chart for USO, the crude oil exchange-traded fund. August/September shows a failed symmetrical triangle followed by a failed failure. Price pushed significantly higher after the failed failure, showing once again the dynamic nature of inverse predictive power. During November, USO traced a bull flag. Expectation was high that USO would follow through to the upside. Instead, the November bull flag failed.
Good traders trust the predictive power of their trading models. They also are disciplined to take losses when those models fail. Instead of simply waiting for your next set up, there may be opportunity in that failure. If a setup fails, trust the inverse predictive power of the failed setup. Many models zero in important pivot areas and that is why they work. Consequently, when they don’t work it often sets up a move in the opposite direction. Combining the predictive power of price setups and the inverse predictive power of failed setups can make you a stronger trader.