BarroMetrics View:Pattern Recognition in Trading
It’s quite rightly said that for the most part trading technically boils down to pattern recognition; but since the days of Richard Wyckoff and perhaps prior to that, technical analysis has split into two camps:
- Those who follow Wyckoff’s dictum that understanding the principles behind a pattern and the context in which a pattern appears is more important than the pattern itself. In Wyckoff’s view by understanding ‘principle and context’, we traders make room for any variation that the market may throw at us.
- The alternate view is that of Richard Schabacker: the key to a successful methodology lies in the classification of as many as possible of the patterns and their variations.
I belong to the Wyckoff camp simply because of the fact that I believe that markets rhyme but not repeat. This means trying to classify all the permutations the market will exhibit is a dauntless task.
Let’s look at an example.
In the Nature of Trends, I identify four patterns that reliably identify a trend change in the next higher timeframe. One of these I call the Horizontal Terminal. The S&P (cash) shows a variation of the pattern.
Figure 1 shows the normal variation - what can be expected to happen 80% of the time. What occurs is a breakout on low volume with no acceptance above the maximum extension. The idea is at the end of a trend, the ’smart money distributes to the dumb money’ at the highs and when their supply is off loaded, the ’selling begins’.
Figure 2 shows the current situation. The question is: do we still have a Horizontal Terminal?
If you understand the principles behind the Horizontal Terminal, then you’d know the answer is yes:
- The volume in the current upmove has been decreasing as the market has headed higher.
- The sentiment (dumb money) has been increasing as the market has moved higher.
- The smart money (commercials) have been reducing their positions since the break up above 940 (basis cash).
- The price action last night - kick to new highs, and a return to the 1-day swing congestion - may mark the end of the congestion.
- If we see a strong downside move in terms of volume and range, that would signal the end of the smart money off-load.
Figure 3 shows a similar pattern in context and principle. Crude Oil was trading in a 1-day congestion between 132 to 138. It then broke up but note that on the up move, volume went down. Given that this pattern was coming at the end of a sustained trend, I said on TV that ‘Crude had a better chance of breaking down to $100 - $110 than breaking up to $150 to $200′.
Crude did then break down on increasing volume to $134. But then broke up on good volume. It looked like I was wrong. But then the break-up failed to follow-through. The inside day on July 14 marked the day the commercial off-load ended. Of course we did not know this until July 15’s price action.
You can view the S&P’s price action since the break up above 940 (the price action in the magenta rectangle in Figure 2) akin to the Crude Oil inside day. A sharp break to the downside would signal that the market correction (or restart of the bear market) has begun (metaphorically, this would be the July 15 move in Crude).
Once that occurs what sort of correction can we expect? History suggests we’ll see mean correction of about 75% even if the move from 666 to 956 was the start of a move to 1550.And there is always a chance the rally from 666 has been a bear market rally, in which case we’ll see lows below 666.
FIGURE 1 3-day Horizontal Terminal Ideal
FIGURE 2 3-day Horizontal Terminal Current
FIGURE 3 Crude Oil
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) which then intensifies.
