Classical charting has suffered a few major blows during the last couple of years with flagship patterns failing at an alarming rate for those few that are still rely solely on this old method of establishing positions in the market. The most notable example from this year is the failure of the complex top in bond prices or bottom in yields. Another possible failure this year of a textbook case of a head & shoulders pattern in Russell 2000 may finally provide a very strong indication that this old method of trading has faded.
I actually thought that the head & shoulders top in Russell 2000 was a good short-term signal but I never believed it indicated a significant down move.
The price action after the penetration of the neckline at the 783 level to the downside was so volatile that only very experienced short-term traders could profit from it depending on their profit target and stop-loss objectives. As it may be seen, the price action formed a skewed W with the right bottom lower than the left, a vicious type of pattern that basically facilitates the wealth transfer for naive technical traders to the vaults of HFT robots, which according to my opinion stated in a post during this past weekend, flock to maximize their gain as a group.
It may also be seen that the low of this skewed W pattern was about 10 points higher than the target classical chart pattern analysis calculates around 719 – 720. Thus, this is what happened with the price action:
(1) The penetration of the neckline to the downside starts the accumulation of short positions from chartists with target near 720 but also from short-term trades with various targets and stop-loss levels.
(2) The price action that follows is choppy enough to squeeze out most of the short-term traders at a loss. But the start of the second half part of the W formation gives hopes to chartists that the pattern may work out, luring in the last of them.
(3) The final formation of the second half part of the W is starting to cause panic to chartists and short-term traders are now reversing and going long to recoup their losses, propelling the market higher. The RSI(14) and the MEI(14) show good momentum buildup away from overbought levels.
Given the boost of a temporary solution to the huge Spanish debt problem, this market may attempt to squeeze out chartists at this point, essentially invalidating the head & shoulder formation by breaking above the neckline and rallying. That will be another major blow to pure chart analysis, a methodology that is based on techniques and procedures developed during the 1950s and 1960s and popularized during the 1980s with the advent of the personal computer. Before the recent stampede of chartists after shorting bonds, I warned them to be very careful. The outcome is well known. Now, this is another warning about another possible massive failure that will basically, as far as I am concerned, settle the case about the effectiveness of pure chart analysis in this new market environment that has emerged in the past few years. I hope I will be shown wrong this time around and chartists will get some room to breath. I have nothing against the people who use just classical charts to analyze and trade the markets and I hope everyone has the brain to understand this. It is the method I am criticizing and I hope this is clear. Also, my criticism has a good intention to warn people using that method about its pitfalls. As I have said in the past, I do not discount the possibility that some are using classical chart analysis in ways that increase its effectiveness. Here I only talk about chart patterns in the context of the classical method and my writings do not constitute advice but only express my personal experience and my opinions about this method.
Disclosure: no relevant positions.