Sunday, March 12, 2017

Retests or Bull Traps?

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:

CLF Weekly 

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.