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By Jason Pearce

If You Can’t Beat ‘Em…

In the first post on Profiting From Failure, we discussed how one of the first classic charting patterns that traders learn about – double tops and double bottoms- often fail to materialize like the trading books and blogs tell us they will.  Markets often surpass prior highs and lows, picking off the stop orders of those playing for a reversal.  So much for the easy money that we were all promised…

Furthermore, I noted that the alternative to double tops and bottoms – the breakout move- can go awry as well.  Traders place stop orders to buy a breakout above a previous high or sell a breakdown below a prior low, only to see the market run out of gas soon after and reverse sharply.

It’s easy to take that sort of behavior personally.  Betting on a reversal off the highs/lows didn’t work and betting on a breakout from the highs/lows didn’t work either!  Damned if you do, damned if you don’t.  Can anyone actually win at this game?

It’s important to keep in mind that the markets don’t know who you are.  They’re like the waves in the ocean; they don’t care if you’re having the time of your life and spending all day out there surfing or if you’re getting battered by the waves and on the verge of drowning.  The waves will do what they’re gonna do.  It’s your response and interaction with the waves that will determine your personal outcome.  It’s the exact same thing in the markets.

The fact that these classic pattern failures occur often is good news for traders with the right perspective.  Instead of simply avoiding these patterns, a trader can potentially profit by trading off the failure of these patterns.

We have dubbed these classic chart pattern failures the Wash & Rinse pattern.  Quite simply, when a market surpasses a prior high or low, the trader looks to get positioned if and when the market reverses back in the other direction.  These reversals are often the start of a tradable trend reversal.  I showed you several examples of this pattern at work in the prior post.

All in the Details

Let’s say that you see a market clip a prior high or crack a prior low.  It then runs all the stop orders.  Then shortly after that, the market it starts to reverse.  You might just have yourself a real live Wash & Rinse pattern trade in the making.  It’s a trading opportunity!

Now comes the tricky part: Where do you get in the market when it reverses course?

There are multiple answers that can apply here.  A trader can use an intraday trade back under the old high to get short.  Or for additional confirmation, he might wait for a close back under the old high to get a bona-fide sell signal.

Perhaps one would want to see a trade below the low of the bar where the breakout occurred before getting involved.  This would better negate the breakout and give you the greenlight to get short.

If you want to smooth things out a bit more, you can also apply these ideas to the weekly bar chart instead of the daily bar chart.  Your probabilities of success on the weekly timeframe might increase.  But the tradeoff is that waiting for the weekly bar signal might get you in later and at a much worse price than the daily bar signal.

Here’s one more idea to explore: Set a price band around the old high that the market is pivoting off of and wait for the market to trade back under price band (above the price band if it’s a trade on the long side) before getting in.  The price band could be a derivative of the Average True Range (ATR) to account for the market’s volatility.

These are just a few ideas that a trader can use to initiate a trade off a Wash & Rinse pattern.  I’m sure there are plenty of other ways for you to throw your hat in the ring.  I urge you to roll up your sleeves and do some deeper research on your own.  Discover what sort of parameters and triggers work best for your own trading style.  Then you can make this trading pattern one of your own weapons of choice.

Charting the Futures

Since futures contracts are always expiring and being replaced by the next delivery contract, it presents a unique charting wrinkle that does not occur with stocks, ETFs, and cash currencies.

Most longer-term futures charts are created by splicing together the prices of the closest-delivery contracts and rolling them over based on either the expiration of the nearest contract or a change in leadership where the trading volume and/or open interest in the nearest delivery shifts to the next delivery contract.

Due to carry-charges, interest rates, seasonal pricings, price squeezes, etc. the futures prices can sometimes vary noticeably from one delivery contract to the next.  So the rollover on the long-term charts can potentially create a chart pattern –like a Wash & Rinse pattern– that does not necessarily occur on the specific delivery contract being traded.

From my experience, this has not really been an issue.  The pattern still holds up.

But for traders who are concerned that it may be problematic, a filter could be added to the Wash & Rinse pattern by making sure the price on the specific delivery contract that they are trading is in agreement with the Wash & Rinse pattern that they are seeing on the larger timeframe.  Something simple, like a trend line break, a moving average crossover, a breakout signal, etc. should do the job.

Failure of a Failure

Question: What should a trader do if a Wash & Rinse pattern fails and the market hits new highs for the move (or lows for the move in a downtrend)?

Answer: Get out!

It is important to keep in mind that this pattern does not work every time.  Nothing does.  Sometimes you win, sometimes you lose.  The trick is to minimize the damage when you lose and exploit the opportunity when you win.

As far as losing goes, you should immediately place protective stop orders as soon as you get into a trade position.  The protective stops are set to liquidate your position automatically if there’s a reversal.

Logically, a new high after initiating a short position or a new low after initiating a long position means you are wrong.  You need to abandon the trade ASAP.  Even the Top Gun pilots use the ejection seat when the situation calls for it.

But Wait, There’s More!

Here’s a bonus second answer to the above question: If you have the stomach for it, you can even get positioned back in the direction of the initial breakout.

The Wash & Rinse pattern is a pattern based off of a failure of another pattern.  Yet, there are times that this failure pattern will also fail!  Hey, nobody ever promised that trading is easy…

Sometimes a market will breakout, experience a pullback that knocks out the weak-handed players and triggers the Wash & Rinse pattern, and then turn right back around to continue on with the initial breakout move.

This means the Wash & Rinse pattern didn’t work.  It also means that the initial breakout, while initially sloppy, is still in effect.  There’s still plenty of demand for the market so the path of least resistance remains in the direction of the initial breakout.  If you are going to get back on this horse, you better be going in the same direction that it’s running.

As an added benefit of the second breakout attempt, the reaction low of the pullback that immediately precedes it creates an obvious line in the sand for strong near-term support.  Placing sell stop orders below this level provides you with a logical bailout point and defines your risk on the trade.

Current Market Setups

One you have a grasp on how the Wash & Rinse pattern works and you have worked out the details for your own entry and exit criteria, it’s time to take it for a test drive.

You can do this by ‘paper trading’ the markets as they unfold.  It’s important to keep honest records.  That’s the only way that you can make real progress.

Now, if you really want to shorten the learning curve and make the emotional connection that comes from having real money on the line, you can do trade these in real-time with small positions.

In the prior post, we showed several examples of how some Wash & Rinse trades played out.  Now we’ll take a look at a few markets that have recently staged a breakout or are getting close enough to prior highs/lows to warrant attention.  Put these on your watch list as they have the potential to turn into Wash & Rinse pattern trades.

In mid-February, the ETF for the Brazil Index (EWZ) closed above the 2016 high of $38.50.  The following week, it closed back below the 2016 high and a Wash & Rinse pattern went into effect.

After bouncing off the March low, EWZ tagged the 2016 high again.  It reversed sharply before the day was over.  This keeps the Wash & Rinse pattern in play.

Aflac (AFL) set a record high at $74.50 late last summer.  It was actually made by way of a Wash & Rinse sell signal off the daily chart high that was set six weeks prior.

This week, the stock surpassed the August 31, 2016 and posted a new record.  Initially, this is very bullish.  But keep a close eye on it.  A failed breakout attempt up here could pave the way for another short sale opportunity in AFL.

Back in February, Continental Building Products (CBPX) surpassed the 2016 high of $24.78.  The stock advanced for a few more weeks, indicating a legitimate breakout.

At the end of March, however, CBPX closed back under the 2016 top.  This negated the breakout and triggered a sell signal as per the Wash & Rinse pattern.  Since the stock is still just a stone’s throw from the 2016 pivot price, traders still have opportunity to get short.

Genesco (GCO) traded a little over two dollars away from the September 2016 multi-month low of $47.66.  This level marked the start of a three-month advance that boosted the stock by 51%.  Watch this stock carefully to see what transpires.

Moody’s Corp (MCO) topped at a record high of $113.87 in the summer of 2015 and then surrendered nearly one-third of its value over the following six and a half months.

The stock finally recovered and blasted to a new high just last week.  The fun continues this week with another gap higher.  But should it fail to continue its trek, you’ll have a Wash & Rinse sell signal in the works.

Revlon (REV) has been in a nosedive since the start of March.  It is fast approaching the January 2016 low of $24.20, which was the lowest traded price in nearly two years.

As you know by now, a drop below the 2016 low, followed by a reversal higher, would be a Wash & Rinse buy signal.

It appears that Regis Corp (RGS) is reaching a do-or-die level.  The stock is right on the doorstep of the September 2015 multi-year low of $10.60.  After that, the last stop is the 2008 Financial Crisis low of $8.21.

 

Although this stock currently looks like a dumpster fire you should stay away from, a Wash & Rinse pattern might still give you a technical reason to take a shot at the long side.  The last time it traded down here, a 71% rally followed in just nine weeks.

If you want to see a stock that has bucked the trend of the bull market, you need to look no further than Twitter (TWTR).  This one has been a complete train wreck.

As traders, though, we are not looking for a company to buy.  We are looking for a setup to pull some money out of the markets.

The record low for TWTR was set at $13.72 on May 24, 2016.  The stock dropped as low as $14.12 this week.  It’s getting close.

Don’t forget that TWTR rallied as much as 85% off the lows last year and it only took a little over three months.  Should the 2016 low get breached, followed by a reversal, a Wash & Rinse buy signal might be worth trading.

The recent drop in industrial metals has hit the stock prices of the producers pretty hard.  Olympic Steel (ZEUS) is one of those companies currently feeling the pain.

ZEUS bottomed out with the main market during the Presidential election.  The low of the correction was established at $17.14 on November 8th.

ZEUS recently cracked the November low and traded to a new one-year low.  The correction could continue, of course.  However, a reversal from here could create a Wash & Rinse buy signal.

The currency markets seem to be in limbo.  On the one hand, the late 2016 breakout to new multi-year highs in the US dollar index and new multi-year lows in the Euro currency stalled out and triggered Wash & Rinse pattern signals right after 2017 began.

On the other hand, there has not been any follow through on the reversal patterns.  The greenback and the Euro are just a stone’s throw from the multi-year levels that were posted during the first week of 2017.

Theoretically, the currencies could decide to stay range-bound at these multi-year levels for the rest of the year.  In reality, however, they are worth monitoring on the weekly and monthly timeframes to see which way things will resolve.

Changes in economic data trends, stock market corrections, Tweets from the Commander In Chief, further rate hikes and/or changes in the expectations of further rate hike expectations, etc. all have the potential to be catalysts for the next move in forex.  Currencies are currently a slow moving train, but they may be one worth boarding soon.

Speaking of rates, take a look at Ishares 20-Year Bond (TLT).  It triggered a small Wash & Rinse buy signal back in March when it undercut the December low of 116.80 and then immediately reversed higher.  This may have been the low of the year, so traders could consider buying pullbacks in TLT.

But

If TLT breaks down again and breaches the current low of 116.49 it will negate the Wash & Rinse pattern.  It would be a blessing in disguise as it may allow the ETF a chance at testing the June 2015 low –which also marked the low for the year- at 114.88.  A Wash & Rinse buy signal off this low would certainly be worth taking a shot at.

Deutsche Bank offers an easy way to own a basket of agricultural markets via an ETF.  Of course, “easy” doesn’t always mean “profitable”.  Anyone holding the DB Agriculture Fund (DBA) as a long-term investment has racked up losses in five of the last six years.  The +2.6% gain in 2014 offered little consolation –and very little profit- to the Buy & Hold crowd.

From a trading perspective, however, a buying opportunity may be setting up.  DBA recently clipped the February 2016 record low of $19.55.  Depending on how it unfolds from here, a Wash & Rinse buy signal could potentially materialize.

Also in the commodity sector, the cocoa futures market looks really interesting right now.  The 2011 low on the nearest-futures chart was $1,898.  Cocoa clipped this low in February and immediately bounced, triggering a Wash & Rinse buy signal.

The bounce faded and cocoa dropped back under the 2011 low.  In addition, the market traded below the February low.  This constitutes as Wash & Rinse pattern failure.  It’s a sell signal.

However, cocoa has now cracked price support at the 2008 Financial Crisis low of $1,867.  A reversal higher could trigger yet another Wash & Rinse buy signal.   If you like chocolate, watch this one carefully!


More Articles by Jason Pearce:

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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trading butterfly spreads

Trading Option Butterfly Strategies


Butterflies fit into the class of “non-directional” strategies. In terms of market opinion they are similar to straddles and strangles in that one is not primarily guessing a particular direction in the market, but rather the size of that movement.

• Long butterflies should be used when one is predicting little or no directional movement or a “trading range” in the underlying, and the trader seeks to profit from an increase in the value of the position due to time decay or falling implied volatility.

• Short butterflies should be used when one is predicting a large magnitude move in either direction, and the trader pursues profit from a decrease in the value of the overall position due to an increase in implied volatility or a move away from your long strikes.

Butterfly Spread Explained

The classic long butterfly consists of two longs and two shorts. Typically a long at one strike, two shorts at a strike greater than the long and then another long at a strike greater yet than your short strike. These three strikes are usually equidistant from each other and they are usually all calls or all puts in the same expiry (of course on the same underlying).

Example: Long Butterfly

IBM January 95 calls +1
IBM January 100 calls -2
IBM January 105 calls +1

This gives you, a long vertical spread and a short vertical spread.

Depending whether you sold the middle strike (the body) or sold the lowest and highest strikes (the wings), determines whether you are long the butterfly or short it. Whatever you do with the wings is what you have done with the spread. Long butterfly spreads are safer when you construct them with a lot of time left until expiry (they are usually very inexpensive) and get more expensive as one gets closer to expiry with the spread still near the money.

Since you are selling the center and buying wings, you have a chance of making a maximum of the difference between the two strikes, less your cost of the butterfly.

The most you can lose is the amount you paid for the butterfly, giving most typical butterflies a 5:1 up to a 10:1 risk/reward ratio. Expanding out to skip a strike and do butterflies with a larger span, to say 10-point butterflies, increases the cost, but also increases the range of payout and the risk/reward stays high.

I want you to think of these now, because they are a safer way to sell premium than just selling premium naked. As the volatilities climb, butterfly spreads should get “cheaper” and this is a fine time to put
some elongated butterflies or butterflies that skip strikes in the middle (called Condors) on in the May through August expirations.

The Long Butterfly


Think of a long butterfly as containing an embedded short straddle wrapped within a synthetic long strangle. This type of structure allows the properly positioned long butterfly to capitalize from time decay and/or falling implied volatility just as a short straddle would. The big difference is that the long strangle “wrap” of the long butterfly severely limits the risk in the position, making it an appealing “directionless” strategy for risk-adjusted return traders.

Butterflies are ideally suited for trading in directionless markets: The foundational reason to put on a butterfly is to target a well-defined price range within which the stock will trade at expiration.

This statement begs the question, “What is a directionless market?” A directionless, or “sideways” market is one that shows no definite or sustained direction in price movement. Although the price of the underlying may fluctuate, it tends to trade within a certain well-defined range, i.e. it doesn’t penetrate either the defined support level or the defined resistance level.

It should be noted that directionless markets are the most common markets a trader encounters; more so than either a bull or a bear market! The adept trader will develop the ability to identify such a market by recognizing when a stock is consolidating. An adept studying of charts (technical analysis) is important here

Why do we say that the long Butterfly is a “limited risk” strategy? That’s simple: if you put on a long Butterfly, you can never lose more than the initial debit paid out. The Butterfly is constituted so that it is “exposed” to losses on either side of its “body”, but this exposure is hedged by the location of the “wings”.

Why do we say that the Butterfly is a “limited reward” strategy? Well, at expiration the long Butterfly will always have a value between zero and the width between each strike price (5 points here). In other words, the price of a 5-point Butterfly will never exceed $5.

Note that the spread will be worth its maximum value if it closes right at the strike of the shorts. If this happens, the long OTM (out of the money) option as well as the two shorts will expire worthless. The long ITM (in the money) option, however, will expire worth its full value of $5. So we know that the greater the chance of it closing at the middle strike on expiration, the more expensive it will be.

Any movement away from the middle strike will cause the spread to lose value. The worst-case scenario occurs if it closes either below the lowest strike long option, or above the highest strike long option. In our example above, the call Butterfly will lose value below $100, because as stock drops below $100 the ITM 95 call will begin to lose value. The call Butterfly loses value above $105 because the loss from the two short 100 calls will be twice as much as the gain from the 95 call.

Greek Values and the Butterfly

The price of the butterfly spread becomes increasingly more sensitive to changes in the underlying with thirty days or less to go until expiration. The greeks of the butterfly respond the same way, in that they can also change dramatically and exponentially with less time to expiration.

But for all of the greek values, keep in mind that the delta, gamma, theta, or vega is not of much interest if the contracts in the spread are ninety days or more away from expiration. Far away from expiration, the greek values are minor factors; they become noteworthy only when the contracts are within thirty days of expiring.

Option Butterfly Spreads & Delta

For a long butterfly, such as the $150/$155/$160 spread in the example, the delta will be as follows:

• Positive when the underlying share price falls below the inside strike price ($155)
• Neutral when it matches the inside strike price
• Negative when it climbs above the inside strike price

The butterfly reaches its greatest value when the price of the underlying equals the inside strike price. Therefore, if the share price falls below the middle strike, that share price must rise for the butterfly to make money—hence the positive deltas. If the price of the underlying asset is above the middle strike price, it must fall for the butterfly to make money. That leads to a negative delta value.

Option Butterfly Spreads & Gamma

The gamma value of a long butterfly flows from positive to negative, or vice versa. When the underlying price reaches the outer strike prices of the butterfly, the gamma is positive. This shows that the butterfly would produce positive deltas if the underlying share price rises, and negative deltas if that share price falls, albeit to the extent that the underlying is close to a long strike. This matches the behavior of the delta of the long butterfly as shown in Figure 9.

Meanwhile, the gamma of the long butterfly is negative when the underlying share price matches the inside strike price (see Figure 9). This shows that the butterfly will create negative deltas if the underlying share price rises and positive deltas if the share price falls. But you want your delta to be neutral; you want the share price to match the inside strike price and stay there.

Option Butterfly Spreads & Theta

Think of theta as the opposite of gamma. If a long butterfly is negative gamma, the theta will be positive; if a short butterfly is positive gamma, it will have a negative theta. For any butterfly, the theta will be positive if the stock price approaches the inside strike price.

As the expiration date approaches, a positive theta is good for a long butterfly and bad for a short butterfly. If, however, the underlying price trades either high or low, and thus near one of the outer strike prices, the theta is positive for a short butterfly and negative for a long butterfly (see Figure 10).

That is, if the underlying price is close to one of the outer strike prices, it benefits the holder of the short butterfly, because the theta will be positive, but the theta will be negative for the long butterfly. With the short butterfly, remember, you sold the contracts with the outside strike prices (say, $60 and $50), bought two contracts with inside strike prices ($55 each), and earned a net premium in the transaction.

With a short butterfly, you make a profit if the share prices climb toward the highest strike price ($60) or fall toward the lowest strike price ($50). The short butterfly profits if the market is active, and the theta tends to reflect that.

This is an excerpt from Managing Expectations by Tony Saliba.

Tony is going to teach an Options Master Class.

Register for the Options Master Class.

More Excerpts from Tony’s Book

What the Pro Options Traders Know About Vega

What the Pro Options Traders Know about Delta

Free Audiobook Chapter: Options Gamma

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forex trading

By Cornelius Luca

The appetite for risk is surging following the lack of surprises from the first round of France’s presidential elections. This means buy continental Europe, at least in the short term.

In FX, the models are long on all euro pairs, particularly euro/dollars and euro/yen. The pound is the exception to this rule, as the UK is struggling with its own complex, political meanders.

Outside the euro space, the commodity dollars show limited interest. While there is some demand for them, the commodity dollars were pushed to the back burner.

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In Asia, short dollar/Singapore dollar seems to be the safest bet.

In LatAm, the model remains short dollar/Mexican peso.

All East European currencies benefited from the strength of the euro; on this milieu, the Russian ruble seems attractive. 

Get the full report

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By Jason Pearce

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 during my time at the trade desk.  Once the failed breakouts above the prior highs (or breakouts under the prior lows) happened, the majority of traders did not go back in to trade the reversal…but a small group of the professional traders did.

Why It Works

The reason this Wash & Rinse pattern works is two-fold.  First, traders who bought on the breakout get stopped out after the market returnd below the prior high.  Some of the buyers were initiating positions and some were adding to positions they had already established on the way up.

The mass liquidations orders that hit right after the market broke back down below the prior high caused the sellers to overwhelm demand.  As a result, the market sinks like a stone.

Secondly, the traders who were positioned on the short side in anticipation of a double top initially got their buy stops picked off on the breakout.  Since they were already bearish, it’s a safe bet to say that most of them weren’t looking to immediately reverse course and start buying on the pullback right after the breakout failed.  So we won’t see any demand for the market coming from this crowd, either.

Furthermore, if this second group of traders did decide to take another shot at the market, it was only to get short again.  Adding that on top of the orders that are simultaneously coming in to liquidate the long positions and you have even more selling pressure put on the market.  This can create a sustained move in the opposite direction of the initial breakout.

A Few Examples

Take a look at a few examples of the Wash & Rinse pattern in action.  You’ll see that it works across all sorts of different markets.  It doesn’t matter if you’re trading stocks, treasuries, currencies, or even commodities.  This is the sort of robustness that a trader hopes for!

A few years back, precious metals and mining shares were running hot and the Gold Miners ETF (GDX) reached a record high of $64.62 in the last month of 2010.

After a pullback of a few weeks, GDX recovered and nearly returned to the 2010 high in April 2011.  Alas, it peaked just shy of the 2010 high and rolled over again.

In September, however, mining shares were red-hot again and GDX broke out to new record territory.

The fourth week after the breakout, GDX had a meltdown as it went from a record price to a multi-week low.  This Wash & Rinse sell signal was just the beginning of a multi-year bear market that knocked GDX off as much as 81% from the peak.

In the spring of 2012, things in Europe looked pretty bleak.  So much so that the Spanish stock market (EWP) dropped below the 2009 Financial Crisis low of $24.33.

Spain’s market dropped nearly 19% below the 2009 low, but reversed sharply higher in the summer and closed back above it.  This Wash & Rinse pattern marked the start of a two-year bull market that added 125% to the value of the Spain Index MSCI Ishares (EWP).

In November 2013, the nearest-futures coffee contract clipped the 2009 Financial Crisis low of 101.60.  The market recovered before the week was over.

Little did anyone know that the Wash & Rinse buy signal off the November 2013 bottom would precede a weather market that would cause coffee prices to more than double over the next five and a half months!  Using the leverage of a futures contract could have made this the Trade of the Year.

In the summer of 2015, the Japanese yen (cash) undercut the 2007 low of .8059.  Traders were waiting for the multi-year bear market to accelerate on this break.

Instead, the yen flip-flopped for several weeks and then resolved higher.  This bullish Wash & Rinse pattern was actually one of the reasons that I became so bullish on the Japanese yen at the start of 2016.  The 26% rise from the 2015 low into the summer of 2016 is a great example of just how powerful this pattern can be.

Netflix (NFLX) posted a record high of $129.29 in the summer of 2015 and then took a breather for several weeks.

In early December, NFLX blasted to new record highs again.  But the very next week, it went from a record high to a three-week low by the end of the week.  This Wash & Rinse sell signal was the start of a vicious two-month, 40% correction.

Remember the 2014-2015 bear market that killed the oil industry?  Well, it ended with a nice Wash & Rinse pattern that signaled loud and clear for traders to get long again.

The nearest-futures crude oil contract established a bear market low at $33.20 in January 2009.  This price was undercut in January 2016 and a final bear market low was put in place five weeks later at $26.05.

Crude oil closed back above the 2009 low by late February 2016 -triggering Wash & Rinse buy signals on daily, weekly and monthly charts- and black gold prices nearly doubled from the lows by June.

Apple (AAPL) experienced a spike low in the summer of 2015 that marked its low for the year at $92.00.  The stock neared this price again in January of 2016, but reversed higher before the low was breached.

Finally, support cracked in May 2016 when AAPL plunged to a nearly two-year low of $89.47.

The break didn’t last long, though.  AAPL turned around the very next week and began an advance that is still under way today as the stock is trading at record highs.

Cerner Corp (CERN) is an interesting case, as it experienced a failed Wash & Rinse pattern, followed quickly by a successful Wash & Rinse pattern.

The March 2016 multi-month low of $49.59 was the first line in the sand for CERN.  The stock breached this support level in early November and then bounced above it two weeks later.  A Wash & Rinse buy signal was triggered.

The very next week, CERN dropped to a new correction low and negated the initial buy pattern.  It also ended the week below the 2014 low of $48.39.  Two weeks after that, the stock blasted higher and closed back above the 2014 low.  This was the second Wash & Rinse buy signal.

After the buy signal, CERN backed down again.  But this time it did not make a new correction low.  It merely bided its time in a trading range for several days as the end of 2016 trading was wrapped up.

After the new year began the stock really took off and rewarded anyone who got long.  So far, CERN has rallied over 27% from the December low.

Terrific Trades for Treasuries

Now let’s shift gears and look at a widely-followed Treasury ETF: The Ishares 20-Year Bond (TLT).  This ETF is notorious for failed breakout attempts beyond prior highs and lows.

But that’s good news for traders looking to capitalize on the Wash & Rinse pattern!  Opportunities abound on both the long side and the short side of this market.

2011 – TLT surpassed the 2008 top of $123.15 in late September/early October.  The market never did make a weekly close above this price.  Instead, it turned over and dropped a little more than fifteen points over a three-week period.  TLT finally bounced and then settled into a multi-month trading range.

2012 – At the end of May, TLT finally gapped up and cleared the October 2011 top at $125.03.  On week later, this ETF pulled back and spent nearly a month trading either side of the 2011 high.  Had a trader gone short on this pullback and Wash & Rinse sell signal, he would have likely been stopped out when TLT raced back up to a new high in the second half of June.

However…

A new Wash & Rinse pattern setup materialized.  You see, TLT posted a high of $130.38 on June 1st and then pulled back.  On July 23rd, the ETF closed above the June 1st high and stayed above for four days.  But on July 27th, TLT dropped back under the June top and stated to decline in earnest.

By mid-September, TLT had dropped over fourteen full points from the July top.  As a matter of fact, the bear market decline carried on for nearly a year and a half and dropped thirty-one points from high.

2013/2014 – In August of 2013, TLT posted a two-year low of $102.11 and bounced.  The bounce eventually faded and this ETF traded to a new low of $101.17 on New Year’s Eve.

TLT blasted higher the very next week and started a thirteen-month run that boosted the price of the ETF by over thirty-seven points.

2015 – Soon after the New Year started, TLT surpassed the 2012 record high of $132.22.  One week after the initial breakout, TLT pulled back to the 2012 high and immediately bounced.  This solidified the breakout.

After posting a new record high of $138.50 on January 30th, the ETF started to weaken.  One week later, TLT closed back under the 2012 top.  Ultimately, TLT declined roughly twenty-three and a half points in about five months.

2016 – In late June, TLT gapped higher and surpassed the 2015 high.  It peaked out at a new record price of $143.62 on July 8th and then sunk for a week.  The market then went into a tight trading range until just after Labor Day.  Interestingly, the bottom of the trading range was either side of the 2015 high.

TLT finally left the trading range on September 9th, but a bounce into late September soon followed.  Coincidentally, the bounced ended right around the same level as the 2015 high point!

TLT rolled over at the end of September and started another descent that finally bottomed out in mid-December at 116.80.  At this price, TLT had dropped nearly twenty-seven points in a five month period.

Worth a Look

At first glance, the new trader may be discouraged by the fact that double tops and double bottoms don’t appear as frequently or as perfectly as they were led to believe.  Worse yet, the breakout trades often fail as well.  But don’t throw the baby out with the bathwater.

As you saw in this post, the classic pattern “failures” can actually be one of your best opportunities for profit.  I know professional traders who rely on this pattern and use it as one of their main trading tools.

In the next post, we will further discuss the Wash & Rinse pattern and how you can make it yours.  In addition, we will also take a look at some markets that are currently setting up for potential reversal trades.  You don’t want to miss this!


More Articles by Jason Pearce:

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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It’s easy to get caught up in the daily grind of price action and market sentiment.  Sometimes it’s good to take a step back and look at the week in review to bolster your conviction for the week ahead.

Key Points:

  • Weekly gasoline build – an anomaly or a sign of a trend?
  • Increase in overall inventories since the export ban was lifted is tracking with the growth of US working storage capacity keeping contango at bay.
  • Spreads between crude grades globally that have been supportive of US exports are narrowing (keep an eye on the WTI/Dubai spread)
  • Front-month gasoline cracks held relatively stable given the bearish interpretation of this week’s gas build.

Weekly Oil Inventories post a net DRAW of 1.5 for the week ending April 14, 2017; Gasoline build the outlier (Figure 1):

Refinery Utilization Comparison by Year

However, given the move lower in prices, let’s take a closer look at the past Two week stock changes.  Below you can see that total inventories have declined by 9.5 (thousand bbls/day) this year, yet we saw builds in inventories those same 2 weeks in 2016 and 2015.

EIA 2 week stock changes tell a different story

The sticking point for the market is clearly the build this week in gasoline.  Looking at absolute gasoline inventory levels below, I don’t believe this weeks’ data point ALONE is enough to solidify a trend of oversupply this early in the summer season.

Another way to keep storage levels in perspective is to look at the growth in storage capacity.

Figure 2 below highlights that the growth in total inventory levels is tracking slightly below the growth in working storage capacity (from the most recent EIA data through September, 2016).  I understand that this is not a 1:1 comparison, however, it’s still relevant to the narrative.   Growing capacity tends to reduce overall price volatility (as long as that capacity is used), but for short-term disruptions in the system.  Risks to going long here hinge on whether a real trend is developing in gasoline withdrawals and the upcoming OPEC meeting.

Oil Working Storage Capacity Increases

The lifting of the export ban at the end of 2015 brought with it a tank storage boom.  The market seized the opportunity to build pipeline, storage and dock logistics to capture favorable arbitrage economics and keep the export flow going.  The most significant build-out of crude oil offloading and storage facilities has been along the Gulf Coast.  Then in January, 2017 OPEC cut production of mostly heavy crude oil which opened up the arbitrage opportunities for exports.  Going forward, crude oil production levels, the relative price of crude oil in North America to other markets, the market price structure and the cost of transportation will determine whether exports will continue to grow and if even more infrastructure is needed.

A key consideration in the build-out was the need to address the mismatch between the light sweet quality of most of the new crude now being delivered to the Gulf Coast from areas like the Bakken, and the heavier crudes that many refineries are configured to process.  The Gulf Coast system has continued to add capacity in anticipation of increased throughput.  See discussion in the next section regarding WTI’s discount to Dubai and other Middle Eastern heavier crudes which makes WTI more attractive for Asia.

Futures prices across the Petroleum complex fall roughly 4.75% week/ week in response to Inventory report:

Figure 3 below details the price declines of the key benchmark crude oils and spreads. Overall, calendar spreads moved in a bearish direction along with the outright price declines.

1 Week Change in Crude Oil Prices, Calendar Spreads, Location Spreads and Quality Spreads

That being said, the June/Dec contango for US crude grades widened by less than $0.20 while the same spread for benchmark European and Asian crudes widened by more than $0.40.  Spreads across crude grades were largely unchanged with a slight narrowing of the WTI/Brent and LLS/Brent spreads by a marginal $0.17 for the balance of the year.  The narrower these spreads, the more economically enticing it is for US refiners to import foreign grades.  In general, crude spreads have been tight enough this year that logistical ‘arbs’ (moving oil from one market to another) require a lot of creativity.  The WTI/Dubai spread is the one to watch.  When WTI trades at a discount to Dubai, the US export ‘arb’ to Asia is open.  WTI’s discount to Dubai narrowed by roughly $0.15 yesterday for the balance of 2017 to around ($0.80).  Looking out into 2018 however, the WTI discount to Dubai narrows to around ($0.25).

Except for the initial market adjustments to the Light/Heavy crude spreads due to OPEC cuts there aren’t many overall price differences to pull crude significantly from one market to another (absent specific refinery requirements).  Will this be the impetus that slowly backs up crude inventories in specific regional markets?  The US Net Import number will be key to watch.

Speaking of Net Imports, Figure 4 below shows a high-level comparison of total supply, net imports and futures prices for the last 3 years.  Clearly, the reduction in Net Imports has been a key balancing factor.

Net Imports and Production changes compared to Price changes

Product prices decline slightly less crude, dropping just over 4% for the week (Figure 5 below).

**One thing to keep in mind when looking at settlement prices is the fact that different market closing times across the globe lead to a mismatch of settlement prices.  This is evident in Gasoil prices in Figure 5.  European oil markets settle at 11:30 EST.  Meaning large afternoon price swings in the US aren’t reflected well in spread settlements.

Petroleum and related product futures prices in $/Bbl

While the product markets seemed to key off of an unexpected build in gasoline inventories, the decline in front month gasoline cracks was relatively muted as was the front month (June/Dec) backwardation.  In general, this would favor pulling barrels OUT of storage, not building.   Typically, if the Market is fearful of excess inventory levels such as gasoline, there would be big moves lower in cracks to discourage production.  Instead, the entire complex moved lower in unison without much change in spreads.  We shall see.

Week Ahead – Expectations and Wild Cards:

As noted above, the key items to watch in the upcoming week are:

  • Signs that this week’s gasoline build was a trend or an anomaly. Look for front month gasoline cracks or backwardation to collapse further to indicate a trend vs. anomaly.
  • WTI/Dubai Spread movements that would be problematic for US exports.
  • Increases in storage capacity seem to be accommodating current production and inventory levels without widening the contango in the front of the curve.

There is nothing wrong with pre-positioning based on the expectation that the above conditions will change.  Just make sure you know what you’re looking for! 

 

 

 

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