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I know that many Stocks & Commodities readers are interested in learning how to interpret charts as part of your investment or trading education. Toward this end, I want to discuss some exercises that I believe will aid you in that endeavor. The obvious first step to train yourself as a chartist is to gain a working knowledge of the various patterns. To do this, review historical charts by covering up a section with a folded piece of paper or a bit of cardboard, and move the paper one bar at a time to see how the market unfolds after a particular pattern has been completed. This kind of hands-on exercise is useful for two reasons. One, it is difficult to write a computer program for some formations, such as a head-and-shoulders top or bottom, so you cannot always rely on the computer to search out the patterns for you. Two, it's very easy to visually analyze your charts and only see the patterns that work, ignoring the failures, and ultimately missing out on a prime opportunity to take yourself to a new level of trading.
So what is that prime opportunity, you ask? It's the failed signal, and you may not realize it, but learning how to trade it can be both valuable and profitable. How can failed signals be of value? Analyst and author Jack Schwager, in his Schwager on Futures: Technical Analysis, published by John Wiley & Sons, devotes an entire chapter to the failed technical signal. In fact, Schwager titles that chapter "The most important rule in chart analysis" (italics mine).
Schwager avers that when a market forms a chart pattern, including a legitimate trading signal, the failure of that signal strongly suggests the market will trend in the opposite direction. Stop and think about that for a moment. Who hasn't experienced the heartbreak of taking a signal, then getting stopped out of the trade, only to find yourself staring in disbelief as the market continues in the new trend, with you only showing a loss for your troubles? Ouch!
With 20/20 hindsight, of course, reversing positions was the move to make. However, the willingness to reverse positions at such a point requires a keen understanding of the way traders and investors react to price movement. For example, say you've taken a loss in the above scenario, and it may sting, but think of the others who may have reacted to the same entry signal. They might not have had your discipline to abandon the trade; they would have ended up on the wrong side of the trend. Do you think the market would simply back up and let them out even? I sincerely doubt it and therein lies your opportunity.
To fully understand this opportunity requires research. Spend time reviewing your charts and qualifying the patterns that work and the patterns that don't. Determine the outcome of the two scenarios so you'll have a working knowledge that can be turned into a set of rules. Use the rules and the outcomes as your system. You really can't do too much research! The more research you do, the greater the confidence you will have in following either of the two scenarios presented to you.
In his work, Schwager concludes, "It takes great discipline to capitalize on the failed signals, but such flexibility is essential to the effective synthesis of chart analysis and trading." I certainly concur. And certainly, it's something for you to think about in your own trading.
