"Study the past if you would divine the future." | Confucius

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Backtracking: Unlocking Patterns in Price Action

by Charting Wealth in Training Updates




by in Training Updates

Backtracking is a valuable practice that involves reviewing past price action of stocks/ETFs to identify discernible patterns. Not all stocks/ETFs can be charted. Some don’t move enough (i.e., low volatility) to be worth the trouble. Others are too erratic in price movement with which to bother. To determine if a stock/ETF is worth our time and energy, we must spend a few minutes looking back in time at prior price movement.

To begin the process, go to your weekly chart and zoom out in time to approximately one year in the past. Count the number of reversals where the candles shifted clearly in price movement from red to green and green to red.

Now you can begin your analysis:

First, do reversals in price movement (weekly candles going from red to green and green to red) occur at least four or more times a year? If not, leave the stock/ETF alone. There is not enough volatility for the time investment to monitor the equity.

Second, how many fake-outs occur? A fake-out is when the weekly candle turns a new color, but only for a short period of time and the wick of the starting candle and ending candle end are near the same price level. If the price run is too short and price movement is not adequate to capture a profit, you are wasting your time.

Third, what is the difference between the bid and the ask? The best rule of thumb to always remember is that you will pay the higher price when buying and the lower price when selling. The wider the difference between the two, the more illiquid the stock/ETF. You want to stay away from illiquid stocks/ETFs. Such equities are lightly traded, and low volume means the stock/ETF is more subject to price manipulation since fewer shares are necessary to buy or sell to artificially drive the price up or down.

Note: When a significant price difference exists between the bid and ask, we call this an “illiquidity gap.” It means that you have a significant hurdle to overcome upon entering a trade just in order to break even. Before you can make anything, you must at least have the price of the stock/EFT rise enough to cover the difference between what you paid for the stock/ETF trades and what it is worth. If the difference between the bid and ask is a couple of cents, no big deal. If it’s two dollars and the stock/ETF trades at $20, you must make a 10 percent gain before you can even cover the illiquidity gap. Stay away from such equities.

Fourth, does the stock ETF pay a dividend? Be aware of the typical size of the dividend and the price action around the date it is paid.

Fifth, is the stock ETF optionable? Just because options are available on an equity does not mean they have any potential trading value to you. If options are available, find a quote sheet and take a quick look. If the options are lightly traded, you will immediately discover this fact by seeing a great difference between the bid and ask prices (illiquidity gaps). Additionally, strike prices and option offerings will be limited. If you like to trade options and the options are illiquid in this particular stock/ETF, you may wish to pass on this candidate.

After you gather all this data, you can begin to sort out whether a particular stock/ETF is a potential candidate for future trading. You do not need a positive vote on each and every category. The most important of all considerations is whether or not the stock/ETF has clean, long-running crossovers, going from green to red and red to green. Next, can you clearly enter and find a profitable exit point? Don’t cheat yourself as you analyze the candidate. Find the entry candle at the worst price point at which you would realistically purchase the stock/ETF. Now, use the Always Winning Formula and apply the two-day ATR from that time period to set your profit and loss bands at a 1 to 1 risk-to-reward ratio (1x ATR). Does the trade work? If not, don’t give up yet. Can you clearly see exit points where the candles change direction, but not so sharply that you can still get out of the trade with a decent profit or no loss? If you consistently see entry and exit points, you may wish to further consider the candidate.

The next most important consideration is how many fake-outs occur with the stock/ETF throughout the year and how traumatic are the fake-outs? Multiple fake crossovers that pull you into bad trades, only to crush you, are never good. Even if you have a few good runs of profit, but many fake-out entries and traumatic losses, you need to pick a better candidate for trading.

Never forget that what happened in the past is no guarantee of what will happen in the future. To quote Mark Twain: “History does not repeat itself, but it rhymes.” We are looking for these potential rhymes. By qualifying candidates and practicing trading them, you will learn that trading is both a technical skill and an art. Through patience and hard work, you will learn to pick and choose candidates based on a multiplicity of factors.

Over time, your skills will improve, and you will hone your own guidelines and rules. Never forget, by properly qualifying candidates and with the Always Winning formula on your side, you only need a win every now and then to move ahead and profit. The better you get, regarding the number of wins, coupled with more and more trades, the greater success you will see. Now, get out there, find candidates, and start honing your skills by practice trading!

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