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Failure Swing PatternsIdentifying trend reversals at an early stage

In my last article published in FX Trader Magazine, ‘‘Trend Following – One more Step to Success’’, I shared my trading strategy. The article explained that it is absolutely imperative to have a trading strategy as it will allow you to better manage your trading expectations, as well as help you to develop your trading plan. We also said that even though traders using this trading strategy will often

enter the market after a trend is well established, we took a step further and tried to spot new developing trends in their early stage. We underlined the fact that one of the methods to identify a weakness in the trend, as well as the possibility of the selected instrument to get into a consolidation phase, or even to reverse the current trend, is by using the Failure Swing patterns.

What is a Failure Swing Pattern

Failure swing patterns go back to the work of Charles H. Dow and his partner Edward Jones (Dow Jones & Company since 1882) back in the end of 19th century. The last tenet of the Dow Theory states that ‘Trend Remains In Effect Until Clear Reversal Occurs’. In that tenet, the

by Efthivoulos Grigoriou

This article shows how to use Failure Swing Patterns in a Trend Following strategy and explains why these technical analysis patterns are among the most reliable graphical tools to identify trend reversals at an early stage.

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Dow Theory discusses how Dow Theorists search for “failure swings” and confirmations to give definite signals of a trend exhaustion or trend reversal. The idea behind any pattern – ie. a continuation pattern like a Flag Formation, or a reversal pattern like Head & Shoulders – is that they repeat themselves over and over again throughout time. The same with the failure swings patterns. In a failure swing, a primary trend fails to meet new highs in an uptrend or record new lows in a downtrend.

The Secret Behind The Failure Swing Pattern

Let’s analyse why the market fails to record a higher high in an uptrend and lower low in a downtrend. First of all, let’s define what moves the

market. We have two basic types of orders, the buy action and the sell action. When someone is buying an instrument, it will help the selected instrument value to increase; thus the price to go up. On the other hand, when someone is selling, it will help the market price move downwards. When there is more buying pressure, meaning that more traders are buying the selected instrument, they are more chances for the instrument to move upwards or vice versa. Therefore, when buying orders (bulls) exceed selling orders (bears) then the market will move upwards and when selling pressure exceeds buying pressure the market will likely move downwards. When the market is moving, someone is winning, and at the same time someone is losing.

When the market fails to record a new high in an uptrend, or vice versa, it could be translated in two ways: the buyers took profits and were unwilling to buy again, or a huge group of sellers (bears) entered the market where it forced the price to go down. A lot of different reasons could cause these actions.

From a technical point of view, we can assume that a significant technical level coincided slightly below the previous top, where the buyers predicted that the price could struggle to break above it, alongside with a combination of a bearish moving average cross or an indication or a bearish cross from a technical indicator/oscillator. Another reason which could force the market to move down at this point could be an economic event or release which came out and affected the selected instrument. Following the economic event, a huge group of sellers probably entered the market while at the same time some stops were triggered as the price was falling, adding to the downward momentum. In both cases, if the group of sellers exceeds the group of buyers then the odds for the market to move lower are very high.

At that phase, the bears took control as there were only bears in the market since the buyers were forced to liquidate. And we are now at point D (figure 1), where a battle takes place most of the time. One of the reasons is that most of the pro-traders, as well as the swing traders, observed that a

Fig.1. Failure Swing Top & Failure Swing Bottom Source: JFD Brokers

In a failure swing, a primary trend fails to meet new highs in an uptrend or record

new lows in a downtrend

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failure swing was in place and they would like to join the movement. Thereby, some of them will go short at the current price while others will wait for the price to break below point D – as a confirmation. At this point, bulls would be waiting for much stronger evidence before buying again and shorts would be adding on believing that any blind up would be temporary or fake. But since a huge group of sellers - swing traders and pro-traders – have entered the market, as a result to trap the bulls, this further helped the market to fall below point D. The bears will continue to sell as the market drops. This will result in a sharp move to the downside, below point D, as most of the buyers’ stops were triggered, forcing them out of the market.

It Needs A Lot of Effort But Keep It Simple

Having explained the structure and the move behind a failure swing, before we go through an example, I would like to address a specific point.

It needs a lot of effort, dedication, hard work, perseverance, self-denial, determination and sacrifice to accomplish or reach a goal; it’s a well-known fact. In our case, we speak about a trading system and some basic rules behind it. Try to simplify things and do not use a plethora of technical

tools, such as moving averages, indicators, oscillators, Fibonacci etc. It is very important to remember that each instrument has its own character and it will react differently in certain situations. Besides the process of trying to identify a bull market or a bear market from their early stages, you have to suffer and accept consecutive losses. Trend trading

needs discipline and emotional control. If you are not ready to accept these parameters or rules, then you are in danger of losing your money.

A Perfect Example: EUR/CAD

Let’s look at an example, which was one of my best trades back in mid-2013 to early-2015 period. As each i n s t r u m e n t has its own character, it doesn’t mean that if we use a 100-Simple Moving Average (SMA) and a 200-SMA for a trend reversal on the EUR/CAD pair this will also work and on the EUR/USD pair. Note, that this technique

will allow us to identify a failure swing pattern in the early stages and to enter the market before the trend develops.

Typically, we will look for a prior trend that has been reversed with the following confirmations:

• First, the market price to cross

Dow Theorists search for “failure swings” and confirmations to give definite signals of a trend exhaustion or trend reversal.

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above the daily 100-SMA and the 200-SMA.

• Second, as a confirmation I will need the 50-SMA to cross above both, the 100-SMA and the 200-SMA.

• Finally, a strict parameter I use is the price to retrace more than 70 percent

(76.4 percent Fibonacci Retracement) of the previous trend, which will confirm that it is not a secondary trend or a brief correction. Note, that a secondary trend is a move in the opposite direction of the primary trend that will not continue.

When all of these parameters are met,

then I consider that a trend reversal took place and that a new trend is born.

Then, from that point, we switch to a 4-hour chart and we use a combination of simple moving averages to identify a failure swing pattern in an early stage. We wait for the following confirmations:

Fig.2. Trend Reversal - New Born Trend

Fig.3. Failure Swing Top

• The price to cross below the 300-SMA.

• The 100-SMA to cross below both the 200-SMA and the 300-SMA.

Each time the above occurs, we take a short position. Note that we are trying to identify a failure swing formation from its early stage, so the best possible point would be at point C.

As you can see on figure 3, the EUR/CAD pair fell below both the 200-SMA and the 300-SMA in early-April 2014. In mid-April, the 100-SMA crossed below both the 100-SMA and the 200-SMA, alerting us – based on our parameters – that a failure swing formation might be in place. Even though we suffered some consecutive losses in early May, the 100-SMA remained below the 300-SMA and

continued its downward move. With that technique, we managed to spot a failure swing formation from point C, where we opened a short position, roughly around the 1.5250 area. Normally, the majority of the observant swing traders should have been fully aware that a failure swing pattern is under way. Most of them will enter the market after the price retraces below point D, whereas others will wait for a close below that level and before entering the market. In many cases, following the break and the close below point D, the price will come back to test point D from below, and sometimes it will slightly move above it – taking some stops – before it falls aggressively to the downside.

Then we switch back to the daily chart for the take-profit scenario.

Conclusion

Failure swing is perhaps one of the most reliable patterns that could help traders identify a trend reversal in an early stage. Understanding failure swing formations should not only provide you with a strong foundation in technical analysis but should also help you improve your own ability to find and execute profitable trades. Identifying a market trend from its early stages is a difficult skill to master. But the technique described above can help you add to a profitable strategy and with enough practice and consistent performance evaluation, you can greatly improve your chances of beating the odds.

Efthivoulos GrigoriouHead of Global Research and Analysis

JFD Brokers

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Fig.4. Failure Swing Top Completed