One core flaw traders make is when they use support and resistance levels, trend lines or Elliott waves alone – in other words, only “Context type” of ideas. Others traders fancy near term price action or candlesticks analysis alone, and they miss the forest for the trees by relying totally on the right side of the price chart (i.e. only using “Signals” or timing ideas.). We must always seek for the two bedrocks together, “context and signal” as we call it here at TraderSkillset. Those who master only one of these two might have hard time to trade consistently profitable as they miss out on an essential edge that is otherwise lies right in front of them.
On the most basic level we would like to initiate long trades on bullish signals in a bullish environment and vice versa. This comes at a cost of patience as we have to wait until structure and prices line up together.
People are often bragging about picking the exact bottom, or top, but these are mostly just urban legends echoing in the background noise of a casino. You are simply not a hero if you happened to trade successfully a bull signal in a strong bear trend. Either because you won scalping for more risk than your reward, or your risk to reward ratio was all right, but such a countertrend position won’t close in a profit often enough to be part of robust trading success over the long term.
One might ask: would it be just pure luck to win with a sole bull reversal bar in hostile bear context? As a trader you don’t want luck to be part of your trading method. Luck in trading is something like being away from your desk for your 10-minute break when a setup forms that otherwise sitting in front of your screen you would have taken. And that very trade would have failed you if you had taken it. You are lucky that you missed the entry. But no. Next time you are going to skip a winner the same way balancing out your previous “lucky miss.” Conclusion: there is no long term luck in trading. Good, consistent trading builds upon facts, impartial and even-handed math only.
To get to the point I cite a great question, and a good call, from a Wolf’s Prey reader regarding the 240-minutes NZDUSD closing bar of Friday, May 31. He was asking about an inside bar preceded by a bull reversal bar in a strong bear trend, and as far as my systematic thinking goes, his bearish bias was fully justified. In that specific situation the weak bull reversal bar was more interesting to me therefore I’ll write more about it here.
The reversal signal had some good attributes, like braking significantly below the previous bar and still closing above the middle of the total span of the bar. More about signal attributes in this post: “Ideal reversal and continuation signals”. When you see something like this candle, you can assume that many traders would fall into the trap of buying above the high of the bar hoping for hitting the jackpot by buying at the lowest bar in the trend.
But, in reality, they have a very slim chance for success – because of the context. Here’s an example of bar traders needing to incorporate context type analysis.
“It is very subjective to define the context”, one might say. Or “Ah, context is not tangible enough, it is just an expression of our mood.” I hear you. But, what if I tell you that there is an actual parameter that can filter out reversal signals that have a low probability to succeed?
Reversal signals that are formed in the lower gray area on our RSI charts tend to fail within 4-6 bars without racing significantly higher than the height of the initial signal bar added to the maximum point of the reversal bar. With this condition, it fails the early momentum bulls almost 70% of the time.
It does not get any easier than this; simply observe that the RSI(14) momentum indicator is at 26.5 when the bull reversal bar closes. That does not make the cut as a quality bull signal. I might have thought about a bullish scenario, if the corresponding RSI indicator value would have been above 35, or 40, would be even better.
The basic measurement method based on the height of the bar pointed to 0.7155 as
a benchmark, and I suggested that the signal might reverse back into the otherwise sustainable bear trend by Monday morning ET (i.e. 4-6 bars). You can check out the live conversation in the “Most hated currency” post.
This second chart shows that is exactly what happened. Most of the countertrend bulls were not able to get out of their long scalps because the market only reached as high as 0.7151 before resuming its slide. In other words, the setup was not able to provide a reward equal to the risk.
Taking bull reversals in a sustainable bear trend is a losing strategy, but there is another moral that you may have not noticed yet. And, it is another type of loss. It is the loss of profit due to the loss of your directional focus. When one starts to concentrate on an early, shaky countertrend trade then that trader can’t pay enough attention to the with-trend signals and misses some lucrative bearish setups. The last chart today exactly illustrates just that, as the situation has been followed by two swift bear legs (i.e. profitable sell setups).
If you want to read more about a similar case study, we have already referenced a similar case back in November when a EURUSD signal had an identical context: “The quality of the EURUSD signal.” Remember, there’s a reason our trading process is Context – Momentum – Signal. First, we pay attention to the Context (Elliott, support/resistance, etc). Then, we ensure Momentum concurs with our Context ideas. Only then do we begin the search for Signals in order to enter trades. Hopefully, this case study will help you avoid only considering context (or signals), which is one big mistake we see many traders make.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.