Long Tail StrategyTHE CMC MARKETS TRADING SMART SERIES

CMC Markets | Long Tail Strategy 2

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.

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CMC Markets | Long Tail Strategy 3

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.

What are we looking for?

Chart 1

CMC Markets | Long Tail Strategy 4

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 long-

tailed 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 5

In chart 3 you can see the early signs of what may become a double-

bottom 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.

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.

SummaryIf 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.

Chart 3

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