It's When the Patterns Don't Work

So you read a book once that explained a bunch of different price patterns and you figured that looking for these would make you money in the market. But then time has passes and you only remember the patterns with the silly names: head and shoulders, cup and handle, etc. You're constantly looking for these things in all of your charts, but since these are the only ones you know, you find yourself calling them out when they're either not there or not yet confirmed. Then you start to get mad at technical analysis because your "patterns" aren't making you money.

Am I close?

Okay, in all seriousness, I get people coming up to me on occasion questioning the validity of technical analysis, yet they haven't really taken the time to understand what it even is. "I bet if you go back, you'll find that a lot of the times those patterns don't work out like they're supposed to". EXACTLY!

Ladies and gentlemen, some of you are missing the point. The big money isn't made when a traditional technical pattern works out the way it's supposed to and everyone and their brother sees it and makes money from it. Life doesn't work that way. It's when they DON'T work out that the big money is made. A head and shoulders pattern is the perfect example. Everyone knows what this is because it has a ridiculous, easy-to-remember name. But truthfully they are pretty rare. Remember, markets trend. And if those Celebrex commercials have taught us anything, it's that a body in motion tends to stay in motion. But head and shoulders patterns are reversal patterns, by definition. So spending time looking for them is counter-productive in the first place. When you see a higher high, followed by another higher high, followed by a lower high about the same height as the first higher high: Head and Shoulders!!! Easy money right? Stock's going to crash?

Everyone sees it. Technical Analysis is so easy. It's a self-fulfilling prophecy. Anyone can do this.

The book says to sell the stock if it breaks the "neckline", which is another ridiculous and easy-to-remember name. This neckline refers to the lows put in after the "left shoulder" and the "Head". Once the "right shoulder" breaks this level, you were told it's supposed to sell off hard.

So then the price does exactly that; it breaks the dreaded neckline. Reporters come on the TV telling everyone about the big head and shoulders pattern in the S&P500. The twitterati is full of technicians all of a sudden. But then the next day, or two days later the price of the stock (or commodity, or currency, or bond) starts to creep back above that neckline. Now what?

Well I bet the people on the TV or on your social network of choice won't be updating you on the "obvious head and shoulders pattern" that had developed and was so clear to everyone. As it turns out, it wasn't a head and shoulders at all. This was just a sideways correction within a larger uptrend. So what happens? Rip-your-face-off rally.....and technical analysis doesn't work.

So is it technical analysis that doesn't work? Or was it your analysis that didn't work?

The market is here to make you look like a fool. That is the number one job of Mr. Market. Do you really think it's that simple to do this correctly? You read something silly in some book and that's it, you'll make money forever?

Things don't work that way. As much as supply and demand might be a science, the interpretation of it is more of an art form. These "failed" patterns are the best trades out there. Think about it. All of those sellers below the neckline now need to buy it back. This creates additional buyers on top of the natural buyers that were already present. What about the short-sellers? The only way to unwind that position is to buy it back. This brings in more buyers. Now the momentum players get excited from the action. So you've now got the natural buyers, the sellers missing out out that need to buy it back, the short-sellers unwinding their positions, and the momentum guys jumping on board. This squeeze, if you will, causes more shorts to cover, brings in more momo guys, brings more attention from people into this name. And that's why it becomes such a powerful trade.

And a head and shoulders pattern is just one example of many failed patterns. So it's not that technical analysis doesn't work. It's that you didn't see it or trade it correctly.

Friends....It's when some of these patterns don't work, and reverse course, that I believe you can make the most money. So let's try to stay open-minded no matter how clear that pattern might be.