Continuing on from our last article, I know that many out there would have looked at the exercises which I left you with last time and thought to themselves that – “this does not apply to me”, or “I already know how to identify consolidations”, or “I am not going to participate in childish exercises” or some of many other thoughts which constantly appear when faced with this type of exercise.

I have, over many years of being involved in education in this industry come across all of these thoughts, in fact I thought some of them myself when I was first learning, including “Let’s get over this crap, show me the real stuff”;

When I first embarked upon the education route in this industry, my mentor Rob Lennox told me that I needed to ignore these comments and attitudes as they appear, because it probably means that you (meaning I as the ecducator) had failed to effectively communicate the importance of these exercises to all of the people in front of me, and that when hearing these things, I should re examine how I have presented these thoughts and do what I can to improve the communication.

So for all of you who did not understand the importance of identifying some of the nuances which help identify the differences between consolidations and retracements, I do apologise for my inadequate communication, if that was the issue.

What everyone reading this series of articles needs to keep in mind is that these are based on my own personal experiences, study, input from others I respect in the industry, not the least of which are from Rob Lennox and Leon Wilson. They are all of this, followed by thousands of hours of my own refinement of the techniques, identification criteria which have had to be adapted as the market changes character, and identifying some very specific criteria which can help to make these trading techniques very highly reliable.

A favourite quote of mine is a quote from a book called Good to Great, by Jim Collins. When he was at university, his favourite professor told the group of students – “The best students are those who never quite believe their professors, but they should not reject the data merely because they do not like what the data implies”;

So with that in mind, I would urge you all to take whatever you can from these articles, not just mine – but all in the publication and try to prove them wrong, but while keeping in mind the need to accept what the data is telling you.  

Why would I say that? Because if you approach any exercise like this with the mindset of trying to prove it wrong, you are not just blindly following, as many do. You are approaching the subject with an open mind, willing to look at data from different angles and in this state, you are more likely to develop your own consistent trading style and refine techniques to suit your own methodologies.

Harvey Norman

With Harvey Norman we can clearly see that a directional change occurred in May 2005 and an uptrend, which was confirmed in September 2005 by breaking through the resistance level to give us a higher high, in addition to the higher low already in place, has been in place since.

While this was technically an uptrend, it is clearly not a strong one and the price action really seems to be wallowing along sideways. The resistance levels are not very far apart, however an interesting thing occurring here is the significant rises in the low turning points, during this period.

This sort of price action demonstrates a compression effect within the action and prepares the way for a possible consolidation.

Another observation we can make from here is that within last the compression, the average range of movement (distance between the high and low of each bar) is getting smaller or is also compressing. This is also another indicator we can use to assist in identifying consolidations, and therefore potential trading patterns.

With Coles Myer Limited, we also have a directional change occurring in August 1999, followed by a significant fall in price action, with a significant support level occurring at around $7.63; It wasn’t until January 2000 however, that the down trend was confirmed by the lower low during the week ending 7th January.

Coles Myer Limited

The lower highs which occurred merely confirmed that price action was compressing, indicating a possible consolidation. But it wasn’t until January that we were able to confirm that the average range of movement had definitely decreased and that this was more likely to develop into a probable consolidation, for the purpose of trading.

I probably need to pause here for a moment and make what I believe to be an important point. There are many patterns and formations which have been identified by a large number of people over the last 50 or so years, many by theoretical Technical Analysts who do not actually trade, but study Technical Analysis. 

As a result, many of these formations have not been tested in the rigourous environment of trading, by traders who have their hard earned money on the line,
where mistakes can, and frequently do, cost the trader money, sometimes serious amounts of money.

I am not putting down these patterns or their credence as a theoretical subject, but when looking to learn from anyone, the major question you need to ask yourself is – “Do I want to learn from someone who has only studied the theory, or from someone who has taken the theory, applied it in real time to the markets and through continuous testing and refinement, proven them to work?”.

There are also many patterns which have been developed by traders and the developers of these patterns apply a great deal of credence to them, such as V-Top, V-Bottom, Cup & Saucer, and many others. 

Many of these, I have not been able to make work to the same degree of probability that I have with the patterns I am covering in this series of articles. This is not to say that the patterns do not work, it may be as simple as myself not being able to correctly identify them, may not have devoted enough time to testing, or not being able to develop a set of acceptable risk parameters to apply which could give them the same level of reliability as the ones I use.

Hence my use of the term for the purpose of trading, as opposed to the term, for the purpose of study.

Again I urge you to do your own testing and development. Don’t take what I, or indeed any other author, have to say and blindly follow it. Please have a healthy measure of scepticism and be prepared to try to prove it wrong.

With Challenger, we can clearly see that directional change occurred in August 2006 and a strong drive up resulted in this change. We then clearly see that price seemed to change direction in September of 2006, we have a Low Turning Point late in September, followed by a rise in price, then a fall again beginning mid October.

Challenger Financial Group

The question we need to ask here is: “Is this formation a consolidation, or a retracement? Therefore will it possibly form a pattern which I can reliably identify and trade?”.

There is no doubt that there is strong support at around $3.30, there have been 1 Low Turning Point and 2 lows at that level, during which time, price formed a new high turning point. So we can assume that price action is compressing, is it forming a consolidation?

It could be argued that the ROM (Range Of Movement) has reduced, but if we look at volume during this period, it has sustained or possibly increased. 

Remembering that most retracements seem to be volume driven with sustained or increased volume
during the formation, is this more likely to be a retracement or a consolidation, when looked at in conjunction with the fact that ROM has not reduced a great deal?

A price compression does not necessarily equal a consolidation, therefore, every compression we identify needs to be looked at in the context that is can be a precursor, but is not always an identifiable consolidation or pattern.

With cab charge we can clearly see that there was an existing uptrend in place until the end of December 2005, and then the price action proceeded to drift sideways incorporating a series of lower highs and higher lows as has been illustrated. This price action is definitely forming into a compression, but will it form a tradeable pattern, is it a consolidation?

Cabcharge

We can also see that while there has been a reduction in the range of movement, it did not occur until late in the compression and when we look at volume, it also has remained high until late in the compression. 

Atlas Iron 

This late reduction in ROM and volume is a common trait for triangular patterns, which we will go into in more detail when we start into individual pattern identification. But bearing in mind this is a common trait, we can keep this formation on our watchlist a little longer.

With Atlas Iron, we can clearly see an uptrend in place from the Low Turning Point in January 2008 until the peak of price in early May 2008. Apart from the 2 weeks leading into the peak of week ending 9th
 May, the ROM of the weekly  bars was quite small compared to all that came after the week ending 25th April 2008.

Aristocrat Leisure

What is also apparent from the price action is that the price has changed direction and has formed a downtrend, as is evidenced by the successive low highs and lower lows.

This price action is neither a consolidation nor a retracement, it is a directional or trend change which is heavily supported by volume. There is no way that this is a pattern of the type we are discussing here, for the purposes of trading and making a profit.

Australia and New Zealand Banking Group

With Aristocrat Leisure, we can see an extended run up in price to the peak in May 2006. But what happened after this is a retracement or pull back in price, the price has just driven down, and this is supported by sustained volume during this period.

There is no pause in price action, there is no compression of price action, there is just a change of direction, and therefore cannot be considered as a continuation pattern or Mid move consolidation.
ANZ is a relatively easy retracement to identify, a very clear change of direction, a significant drive down in price and when we look at volume this was also sustained.

While the range of movement has actually decreased during the fall in price, this is a straight drive down in price and is not a consolidation nor even a compression. A classic retracement.

National Australia Bank 

With NAB, we have an obvious strong uptrend from late 2004 until April 2006, when price changed direction again.

When we look at the price action, the peak was at the end of April, the range of movement increased as the price fell, and the volume sustained its previous rate, again a classic retracement.

Conclusion:

Price compressions can be a prelude to a consolidation forming, but a compression does not mean that there will be a consolidation, it is an alert indicator and no more.

Consolidations generally show a reduction in ROM as well as volume, whereas retracements don’t normally
show a decrease, they normally sustain or increase either or both.

However, as we saw with the ANZ example, retracements can show a decrease in 1 of the ROM or vol and still be a retracement.

Pattern identification, I believe, is a bit like driving a car. When you first start out you misjudge distances, speed, closing rates and it all seems overwhelming. However when you have enough experience, you develop a feel for these things and your driving is much more relaxed and precise. So I have found with learning pattern identification, you do develop a feel for it and they do start to jump off the
screen at you and sing “here I am, take me”;

If you are having difficulty in this at the beginning, please persist, as the markets do change character, and it is advisable to learn several strategies which will enable you to adapt to changing markets and continuously make profits from whatever the market throws at you.

I do trust this exercise has proven advantageous for many of the readers of this publication, and that it has added some ideas for further testing and development of techniques.

I also trust that we have assisted in clearing up some of the misconceptions involved in pattern trading. There are many out there who would keep it “mystical”, and I hope that we have progressed the learning of some of the subscribers in this highly profitable trading area.

I look forward to working with you further in subsequent publications, and look forward to any feedback from subscribers.

Have a great start to the year, and may the markets go with you.

Peter

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