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HEAD & SHOULDERS


Let's Play Devil's Advocate

09/16/11 08:49:38 AM
by Matt Blackman

When you put on a trade, it pays to see the opposite trade and become your own devil's advocate.

Security:   IYT
Position:   N/A

In my article, "Is It 'Make It or Break It' Time?" I showed some charts with potential bearish flag patterns. But the longer this zigzag between support and resistance lasts, the lower the probability that the pattern is in fact a bear flag.

According to Tom Bulkowski, author of "Encyclopedia Of Chart Patterns," "Encyclopedia Of Candlestick Patterns," and the host of http://thepatternsite.com/, a flag pattern lasts less than three weeks, although he admits that this limit is arbitrary. Potential flags on IYT, SPY, and DIA are now more than four weeks old. See Figure 1.

FIGURE 1: iSHARES DOW JONES TRANSPORTS ETF (IYT), DAILY. Here's another pattern that is looking more likely, except volume is not yet convincing.
Graphic provided by: Freestockcharts.com.
 
I asked Bulkowski about longer-term flag patterns or if the pattern could be a channel.

"I only studied flags with durations of three weeks or less, so I don't know how they perform over the longer term, nor do I know how common they are. I also haven't studied channels, other than rectangles [horizontal channels]," he replied.

There has been a steady stream of articles about all the troubles in Europe mixed with a litany of bad economic news on this side of the pond. But in spite of it all, stocks continue to march higher. Some sources claim this rally has been driven by short-covering. That may end up being true and the rally may run out of gas, but it's time to look at the alternative position. It may be a more sustainable rally.

This take was further prompted by a familiar pattern that popped up in the Dow transports, a frequent market leader showing a potential inverted head & shoulders pattern building with a neckline sitting around 87. If it is confirmed, which would occur if the neckline is broken convincingly on increasing volume, it would be bullish indeed.

This possibility is further strengthened by the positive divergence between price and the relative strength index (RSI), which is showing accumulation.

This lesson is that whenever a position is considered, it pays to automatically play devil's advocate. And this habit should not cease once a trade has been entered. Remaining short in the face of growing, at least in the short term, evidence to the contrary could end up being a very costly mistake.



Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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