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Profiting From Failure: The Wash & Rinse Trade, Part II

Jason Pearce

Jason Pearce

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.
Jason Pearce

Latest posts by Jason Pearce (see all)

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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