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Profiting From Failure: The Wash & Rinse Trade, Part I

Charting 101

One of the first patterns that technical traders learn about is double tops and double bottoms. The belief is that history will repeat itself as a market peaks at a prior high or bottoms at a prior low. Supply/demand exhausted at these same points the last time around, so they’re likely to do so again. The idea is to get positioned for a major reversal from this level.

Additionally, a breakout above a prior high or break below a prior low indicates a major breach of support/resistance. Something has changed. The move should now be traded in the direction of the breakout as support/resistance has been conquered and the trend is expected to continue.

In the real world, however, these patterns are not usually as neat and clean as traders have read about in a trading book. Otherwise, every rookie trader out there would be a multi-millionaire in just a few short months.

Sometimes a market will bottom out and turn around before it tags the prior low of a move or peak out before returning to the prior top. That’s frustrating. The trader who was patiently waiting for the perfect setup will miss out on the reversal.

It gets even worse…

Markets will often surpass the prior high or break the prior low and signal a breakout. Then the traders looking for the double top/double bottom get stopped out. At the same time, other traders pile into the market on the breakout signal in anticipation of a continuation of the trend.

Murphy’s Law is then swiftly enforced as the market reverses shortly thereafter. Suddenly, it seems as if everyone loses on the trade attempt. So much for the idea of playing a zero sum game

Bad News Is Good News

Chart patterns often fail. These failures often lead to sizable moves in the opposite direction. In particular, attempted breakouts above prior tops or below prior bottoms can lay the groundwork for some pretty big retracements that turn into trends.

Most importantly, the pattern failures can lead to tradable moves. This means that these initial pattern failures will often sow the seeds for new profit opportunities that follow immediately afterward. As traders, profit opportunities are exactly what we’re looking for!

While running a trade desk for over two decades, I have witnessed and participated in literally thousands of these failed breakouts. Waves of buy stop orders get triggered soon after the market clears a prior top and even bigger waves of sell stop orders get triggered shortly after the market turns back over. It didn’t matter if one was trading stocks, commodities, currencies, or bonds; this pattern was replicated across sectors.

We referred to this event as a Wash & Rinse pattern because the market seemed to knock everyone out of their positions before reversing.

Because the pattern failure initially racked up losses for both the bottom and top pickers and the trend followers, very few of the traders would get right back into the market to take advantage of the powerful move that started right after the reversal.

Most of the traders did not want to pull the trigger right after a losing trade because of Recency Bias. This was tragic because the move that followed the pattern failure ended up being the one that was the real money-maker.

Widely-Know Secret

Admittedly, the Wash & Rinse pattern is not my own unique observation. I’ve worked with other professional traders and even money managers who profited greatly from this pattern failure. They had other names for it (pivot reversal, specialists’ trap, the shakeout, etc.) but it was all the same thing.

The important thing here is that this pattern has worked, it does work, and it will continue to work. You can go back over several decades or price history and see this pattern in play on all sorts of markets. You can also look at some recent charts and see the same thing. The Wash & Rinse is a robust pattern and has longevity.

Despite the fact that many great traders have profited from this pattern, it doesn’t seem to get nearly as much attention as a classic double top or double bottom pattern. It doesn’t even get the same coverage as a breakout trade. But quality trumps quantity here.

The traders that do trade with this pattern seem to be the minority. They are members of the winner’s circle; the ones that profit consistently when the other participants are accumulating losses. I observed this phenomenon...