From the February 01, 2010 issue of Futures Magazine • Subscribe!

Failed setups: Inverse predictive power

CLASSIC SETUPS

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.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day trade his own account. His Web site is www.DayTradingWithLinesInTheSky.com . E-mail him at richardmue@yahoo.com .

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