Many references were made yesterday in financial media about a key reversal in Russell 2000 after a new record on Monday. But how reliable is this pattern?
The key reversal pattern in Russell 2000 is shown in the chart below:
According to classical technical analysis, there are bullish and bearish key reversals. The current one in RUT is bearish because it is formed at the top of an uptrend and all-time high. These patterns are rare mainly because of the condition of a closing price below the previous day’s low. In RUT there have been only two such patterns formed at all-time highs since the inception of the index. If we relax the condition of an all-time high, then there are about 20 but the conclusions of the analysis having to do with the random nature of this pattern do not change.
Due to small samples in RUT we will test this pattern in all current components of DJIA with data since 01/2000 or later. We use an exit of 5 bars but as it turns out the conclusions do not differ much for longer exits. Below is the equity curve.
The above equity curve depicts a random result. The end value is close to the starting value after about 18 years and 62 trades. Win rate is 49%, close to coin toss.
We also tested this bearish reversal pattern in all current QQQ ETF constituent stocks with data starting on 01/2000 or later. Below are the results.
In this case, possible due to the high growth of tech market, the key reversal bearish pattern loses about 50% of initial equity after 152 trades. Win rate is 46%.
Note that there are some variation of this pattern and also regarding its exits after an entry but the idea and conclusions are similar.
Most classical technical analysis patterns were the result of wishful thinking. Why do so many people still make references to these and related unreliable patterns in 2018 when algos dominate trading? During the times when these patterns were conceived as potential indicators of price action, there were no easy ways of testing them. But nowadays any reference to them as some kind of an indicator is inexcusable. But why is this constantly happening? I’m not a psychologists but it must have to do with cognitive biases, such as the availability cascade for example: simple explanation of complex problems are popular because others have adopted them. Often these “others” appear as “gurus” or experts when in fact they are poor souls lost in randomness that try to appear smart or successful. They teach these simple explanations because they are easy to convey. But essentially they teach people ways of redistributing their money.
For more information about the reasons classical technical analysis does not work you may read my interview in Forbes and visit our Trader’s Education section.
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Charting and backtesting program: Amibroker
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