Something we always need to watch out for are when bullish
patterns go through their inevitable pullback/retests; we want to watch that
the pattern formation doesn’t fail. Pullbacks and retests are very normal price
behavior following breakouts and rallies. They are normal so long as the
pattern doesn’t break and set a lower low.
When bullish patterns trigger we expect price to remain firm
and hold the higher swing low created by the new breakout. If the pattern is to
stay intact price will resume higher after the period of consolidation.
Take a look at CLF as an example of this:
Since the trend reversal in early 2016 the stock has been in
a steady trend of higher highs and higher lows. The stock pulls back into the
rising 20 Week SMA and then resumes higher with a strong reaction breakout.
Each pullback forms a higher swing low compared to the prior low
keeping the pattern valid.
Currently we are seeing the fourth such pullback since 2016.
What we need to watch for is does CLF hold the prior low near 8.25 and
resume higher with another breakout (as it has done each time in this rally) OR
does this pattern fail by breaking through the prior
low?
Unfortunately, we don’t have a crystal ball so
we can’t know with certainty whether this is the time the pattern fails or if it
just resumes back higher like the previous instances. What we can do is identify character change in the market. For more than a year CLF has
rallied, tripling from the first bull flag signal in April 2016 ($4 to a high
of over $12), the trend of higher highs and higher lows has remained intact
this whole time. If this trend were to change and price makes a lower low, we
will have proof that something is changing. Maybe it’s a temporary change or
maybe it completely reverses the new positive trend, we can’t know that either.
It is our job as risk
managers to avoid the situations where no pattern exists and to stick with
those that do. As long as CLF can maintain its recent higher low the pattern
will be intact and we will stick with the bullish pattern. If it fails we will
stop out and take our gains.
Keeping the signals and strategy simple is what gives us our edge;
being able to identify with clarity what the situation is at any given time
helps align us with the market. We need to be watchful of these changes in
character. The individual stocks will give us the early indication of the
overall intentions. When we begin to see many bullish trends fail we know that
the underlying support for the market is weakening. Until the patterns break
however it means we need to stick with the market as the overall trend remains intact.
