Published on February 12, 2014
THE CMC MARKETS TRADING SMART SERIES Long Tail Strategy
In recent years, the expression long tail event has become quite commonly used. It refers to occurrences that are on the further out regions of a distribution (or bell) curve. Essentially, these are events that are considered unlikely to occur – but this doesn’t mean that they are not extreme when they do. This guide is about a different type of long tail, but one that is likely to be of much greater interest to traders: the tail that occurs in candlestick charts. In this case, we are interested in tails that are long relative to recent trading activity, and also to the body of whatever candle we are looking at right now. Proudly No. 1 for FX education Results from Investment Trends September 2011 Singapore FX & CFD Report, based on ratings given by 12,000 investors CMC Markets | Long Tail Strategy 2
What are we looking for? The first thing we need to consider in depth is why long tails on certain candlestick charts are of interest. They are a common occurrence, so it shouldn’t be considered all that remarkable in itself. Annoyingly, like virtually everything trading related, the interesting setups take a lot of sifting and often a lot of waiting to ensure that they are exactly what you are seeking. What we want here is a setup that comes at the end of a sharp movement in price, and we will be looking to trade a price reversal if it occurs. This isn’t a trend reversal setup, however. If there is a trend in place we will be looking to find reversals that put us in a position where we are moving in line with the trend. Alternative means of utilising long tails will be when they highlight the failure of a breakout, which is more likely to occur in range-bound markets. This is what we will look at first. To begin with, let’s take a look at how these long tail events and the trade setups they generate fit in with the way in which we view the market. Possibly the best known of all trader adages is the idea that ‘the trend is your friend’. Quite simply, this suggests that the trader determines which way the trend is heading and then looks to take a trade that aligns them in the correct direction. What we want to examine are ways of determining potential setups, but they will not necessarily always be in the direction of the trend. The issue that people face when entering into a trending position is where the stop loss order should be placed. If you simply take an approach where you enter a trend at ‘anytime’ then some of the time you will be entering a long way away from an ideal stop loss level. You will notice that many trending movements that occur will see price oscillating around a reasonably central level as the price trend continues. This means that sometimes the price will moving higher and sometimes lower but overall it moves in the direction of the trend (until the trend breaks down of course – but that’s more an issue associated with the stop loss anyway). What you should start to derive from this is that isolating the trend is one thing but the entry point that we use to join this trend is also of crucial importance. In nearly every case the trader will be keen to place their stop very close to their entry point. This doesn’t mean that you can always put your stop very close (because that will not have much basis in sound technical reasoning) but instead means that you need to time your entry carefully at a point close to where your stop loss order will be placed. Chart 1 illustrates this point. The take-out from this is that although this is a chart where the trend is clearly upward, a careless entry can still be very costly. This costliness is seen when a cavalier approach is taken to the entry point into the market. The trader decides that because there is an uptrend they can get in at any point, and so they buy when the price is a huge distance away from the trendline. Of course, it doesn’t have to be a trendline: a long-term moving average would be a good alternative. Just make sure you know that if the exuberance of the market starts to cool then you aren’t too far away from your stop loss point. Chart 1 CMC Markets | Long Tail Strategy 3
If you look at a candlestick with a long tail then you should start to consider what has happened in the market that has made it happen. Essentially, the market has opened and price has been driven strongly one way, and then at some stage over the life of the candle the price has been driven back towards the opening level, which leaves a long tail on the chart. Even from the description of this type of candle, you can see that price has moved strongly in one direction and then there has been a dramatic shift in the sentiment that exists in the market. This in itself may or may not be a significant event but if we add some qualifying factors we can ascertain whether or not the move is of great interest to us. One of the strategies we generally suggest when dealing with price breakouts is to wait until there has been at least one close outside of the pattern before entering. The rationale in this case is to try and avoid being whipsawed on the trade and entering based on what turns out to be a false signal. These false signals are of great interest to us if they form up as part of a long-tailed candle, because it shows that there has been an initial breakout (possibly because it has cleaned out a lot of the stops placed just on the far side of the breakout point) that has lost its momentum and changed direction. You may then start to think that this failure points to genuine direction of the market rather than the false one that the breakout initially appeared to be pointing towards. This now presents an interesting trading opportunity in itself, because although the breakout failed it is likely to give a new lease on life to the support/resistance level. This is one of the best outcomes that the trader can look for, because it not only allows them to determine a new security in the S/R level, but more importantly allows them to take a trade with a relatively tight stop loss which is a good outcome to begin with. It would seem reasonable to suggest that this course of events highlights exactly where market momentum is moving, and even though this destroys the breakout trade it gives the trader an opportunity in the opposite direction. In this type of situation, if you had already entered the breakout phase of the trade and there was a long-tailed candle subsequently setting up, this would likely cause you a great level of concern for the outlook for the trade. Even if your stop level is not reached, you may end up considering discretion to be the better part of valour and exit the trade. The reason for this is that when breakouts occur it is best when they happen on high levels of volume and high levels of price movement. If, instead, the price moves quickly one way and then sharply back the other way, it raises questions about the validity of the setup. Keep in mind that the breakout should be explosive in nature, so if it isn’t then you may well be trading something much more disappointing. Looking for the tails on their own – or with a couple of friends Thus far we have looked at long tails that occur as part of a breakout formation signalling that there may be problems with the breakout. You can find all sorts of other setups involving long tails, but the common element is the fact that the tail shows the market has rapidly changed its opinion of the direction of the market. Another good example may occur on a retracement to a trendline. One of the things you will likely hear quite commonly is that you should wait for price to ‘respect’ the trendline before making any trade based upon it. Happily, this type of candle may be just the type of thing you are after in order to get that requirement satisfied. Remember that a trendline is essentially in place as a region where, based on the broad direction of the instrument previously, you would expect price to start rallying again (or declining in the case of a downtrend). If price hits on or near the trendline, and then sharply reverses direction forming a longtailed candle, then this may dictate both your signal for entry and the placement of your stop loss level below the lowest point of the candle. Chart 2 CMC Markets | Long Tail Strategy 4
Chart 3 In chart 3 you can see the early signs of what may become a doublebottom formation on the S&P500 index in the US. The final candle is very interesting though, because, as you can see, the price has moved below the previous major low but has then bounced back and actually moved higher. By looking at this, the trader will likely feel that the initial move lower will have triggered many stop loss orders which have then quickly driven the price lower. However, at the lows great support has been built, and this has actually quickly changed the momentum of the market. Some may suggest that the double bottom pattern has not been respected, but because of the long tail on the candle you may be inclined to give the pattern the benefit of the doubt. This would not always be the case though, and would apply to candles that have long tails relative to their body only. Summary As you can see, by looking at the construction of a chart pattern, a support and resistance level or even an individual candle, you may be able to gain a new insight into the underlying psychology of the market. This in particular is demonstrated by the sudden triggering of supply or demand once price trades within a specific region. This underlines why we need to be careful around important price levels, because as we have seen price can move quickly in one direction (implying that there has been a successful price breakout) only to see it move rapidly in another direction. If nothing else, the appearance of long tails may cause us to be extra careful about the assumptions that we have made regarding price movements, and realise that there may be a large number of buyers and sellers just under the surface that may be able to swing price direction in a way we can either take advantage of or, alternatively, get out of the way of. CMC Markets | Long Tail Strategy 5
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