Despite being so simple — we buy or sell — trading is notoriously hard to do competently, and almost impossible to master. One reason for this difficulty is the human brain is not wired to be conducive to trading success. We seek comfort in everything we do. Thus, entering a position to obtain the most favorable risk/reward ratio collides with our desire to confirm that a move is going to play out the way we want.
We’ve learned that you succeed by buying when there’s blood in the streets. But after a huge drop and financial rout, fear is rampant and resources are tight. It’s hard to accept that moments such as these are when opportunity presents itself. We prefer to buy after the move is confirmed.
Although seemingly obvious, this scenario plays out on all time frames over and over again. On the daily scale, a condition that twists traders in knots is the wide-range candle power bar. A wide-range power bar is a candle that extends aggressively either up or down. Because we are wired for comfort, the wide-range bar has the potential to interrupt our goal of consistent profitability.
Power bars depend on context, and every power bar is a potential trap that could stop out a position and drain prior gains, but you can trade them, and trade them well if you know what to do.
No man’s land
Look at the territory covered by the wide-range power bar the same way a quarterback in a football game directs his team down the field. The power bar defines a certain territory on the chart. In instances where price stays within the range of the bar itself, action after the wide-range bar will be choppy as bulls and bears wrestle for the upper hand.
“Down day” (below) is a daily chart of the SPY exchange-traded fund (ETF). The chart shows a key bearish power bar on June 21, 2012. Price action could not break cleanly away from the bar for a full month until July 26, 2012. The territory became gridlocked until price could confirm its move above or below the range of the power bar.
In the zero sum game of trading, the mistakes of bulls fuel bear markets and the mistakes of bears fuel bull markets. In this post-financial crisis era, the tendency has been for bears to attempt to replicate the crash. They have to cover when they fail, and many times they’ve been squeezed out. Once price definitely clears a power bearish bar, a short squeeze materializes and prices tend to rise. This tendency is particularly pronounced in equities.
Another analogy is how a meteorologist describes a key attribute of the atmosphere. Viewers watch “The Weather Channel” and the satellite loop for the direction of the jet stream. Trading power bars can be similar. Consider this the jet stream trade. The U.S. Dollar Index showed a bearish power bar on June 29, 2012 (see “Weather vane,” below). That bar was retraced, causing a smaller-degree short covering phase that formed the top. Short covering can materialize anywhere on a chart. All you need is one group large enough to be wrong. In this case, bears may have been early. In any event, a top materialized.
If bears can succeed at taking down the price action in a specific territory, they can do it again. It’s much like a football team having a certain tendency in the final 20 yards before the goal line. This territory becomes a jet stream, and if price action revisits it, the results might be the same. In the case of a topping market that failed to go lower just prior to the top, post-top price action might freefall as it did before. In the case of the U.S. Dollar Index, once prices entered the range of the bearish power bar, the market collapsed.
Another example can be seen on the five-minute Nasdaq chart (see “Short-term slip,” below). In this case, we have bullish territory sitting atop a prior bearish range. Once the bullish territory is violated, the drop is bold and swift because of the prior success that bears had in claiming that particular territory.
The wide-range power bar also is useful during a downtrend. Often in the confines of a downtrend, a wide-range bullish power bar will materialize. It does so for a couple of reasons. If it’s early in a downtrend, it could be bulls attempting to buy a dip, not realizing the trend has changed. Or, it could be that some bears are covering to take early profits. In either case, we have consolidation in a bear move with a big bullish candle.
Consider what happens if these traders are wrong. Smart bears will put sell stop orders below the market because the mistakes of the bulls could provide fuel for a bigger move south. On the euro chart, this is exactly what happens (see “Hard drop,” below). You must be careful with such a trade because there’s always the potential for a squeeze.
This is an advanced play that has a better chance of working on the back of a bullish power bar; once the long play doesn’t work, the bulls will be stopped out, but new bears will enter to fuel the drop. The power bar adds to the bearish pressure. This also means that if the power bar is absent, chances are lower that such a trade will work out. Don’t attempt to sell a low without the bullish power bar being present. Similarly, both conditions should be in place, so don’t short below a bullish power bar if the trend is up.
Other pitfalls are buying the high end of a bullish power bar or selling the low end of a bearish power bar. We’ve discussed the jet stream, but in a tighter range or breakout situation, a power bar in one direction will be met by several bars going the other way. The breakout point is particularly risky because of a natural tendency to buy when the move is confirming. But markets don’t work that way. Observe bullish power bars that break above a ridge. Do they tend to sustain?
“Defending the line” (below) shows a sequence on an intraday heating oil chart. Starting on the left side, which is the breakout bar, whenever a larger-than-average bullish bar tries to break higher, it is met with resistance. In each case, the push higher is rejected before the move commences.
Does it make good sense to buy the bullish spike? Or is it a better strategy to wait and see if the bar is defended? Waiting for confirmation is not easy. It requires patience and asks the trader possibly to abandon a profitable outcome. The train could leave the station without us. Nevertheless, the greater likelihood is the level will be defended. Of course, there will be missed breakouts, but the best that traders can hope for is to manage uncertainty. With a wide-range power bar, even one sequence where a stop loss is triggered far from the entry point can hurt.
There are many applications of the wide-range power bar, but the recurring theme in all of them is not to treat it as trend confirmation. In financial markets, just when something looks obvious, it probably isn’t. Reliable opportunities to sell lows only materialize occasionally, but extremes develop because of power bars all the time. Exploiting this frequency can keep a trader in the black.