Trading Patterns

There are some patterns that can be used for effective trading with known profit/loss scenarios.

Trading Hypothesis

Retail traders are the unaware cohort that serves as unwilling liquidity providers to the market. The true players are the institutional investors, hedge funds and other funds, large corporations and banks and the government.

The movement of most large investors cannot be determined since they either trickle their purchases and sales, or they buy through dark pools that are untraceable to individual investors. Insitutional traders leave a significant footprint as they need to generate liquidity for entries and exits, often at the cost and expense of retail traders.

Take for example a retail trader who buys when a breakout occurs. A strong momentum occurs and a lot of traders attempt to capitalise on the signal by entering long. This is the perfect position for institutional investors to get their large sell order in by taking the opposite position against the retail horde. The momentum wanes and the stock falls fast allowing the institutional investor to quickly profit.

An institutional trader also needs liquidity engineering for the perfect exit to minimise slippage. They can engineer a scenario to fill their orders, by creating a large sell order at a certain level, or an iceberg sell order that “encourages” retail traders or those that read the order book to take a short position. Once they reach a certain liquidity zone, the institutional trader can then trigger the stop losses and then distribute their large short to the retail longs, hence creating a swing failure pattern.

Swing Failure Pattern (False Breakout)

Actionable for both long and short.

Take the counter trade when momentum is lost following a liquidity grab and retraces into the pre-breakout zone. Take profits at or near liquidity levels.

In this chart, a large green candle formed a potential breakout of the previous liquidity zone of $61,235. This large green candle could either be due to a lack of orders or because of significant buying interest. The breakout fails and retreats to the previous liquidity zone, where we can enter a trade expecting a complete retracement. Place stop loss at new highs for risk management.

A similar long setup is shown above.

Another example of perfect liquidity engineering by institutional investors to get the long fill.

Reason: During consolidation periods where price stagnates, institutions would attempt to hunt liquidity zones to get better fills on their positions. They will set an iceberg order or other mechanism to drive prices towards a certain liquidity zone, and then trigger all the stop losses there to fill their own orders. Take profit is set to the next liquidity zone that the market approaches, as likely buying/selling presence will be significantly diminished as the stock will be considered over/undervalued.

Intermediate Zone Liquidity Sweep

Actionable during a breakout and strong trend.

Take a trade in the direction of the breakout when previous liquidity built during the intermediate range is swept. We must see a willingness to go higher with strong demand.

There must be a willingness to buy - either through strong and rapid price movement to break above the liquidity zone, or through the formation of a strong pattern like a flag or pennant formation.

Reason: Flags are created as liquidity is constantly swept, as institutions and early traders take their initial profits. They will often leave runners which allow for a second impulse move. If enough liquidity is swept this will encourage the completion of the move.

Inverse Head and Shoulders (Right Shoulder Formation)

Actionable when two impulses are absorbed, the second impulse retraces significantly, and the third impulse (right shoulder) should form.

Take a trade in the direction of the inverse head and shoulder pattern and take profit at the next liquidity zone.

Reason: The first impulse indicates a slowing down in selling momentum, the second impulse completes the selling momentum, and the third impulse should fail to break the lows of the second impulse to indicate a momentum shift. If we break the lows, or if the right shoulder becomes too steep it will indicate a failure in this pattern.

We must anticipate the formation of the right shoulder and not the breakout because often times this pattern in unreliable during the breakout and if momentum shifts again at least we had an early entry to take partial profits.

Intermediate Untapped Liquidity Sweep

Actionable by noticing a build up of choppy movement - this indicates an area of liquidity build up that needs to be resolved.

Take a trade that cleans up the untapped liquidity zones. No entry is provided here as it may take a long time for these liquidity zones to be cleaned up.

Reason: An accumulation of buyers and sellers failed to make a decision here, leaving untapped liquidity in the form of potential stop losses. Institutions can leverage this trapped liquidity to add to their positions.

Double Tops and Double Bottoms (Unfinished Business)

Actionable by noticing an incomplete market auction around the highs (double tops) or lows (double bottoms). Markets are saving this liquidity so they can be taken out significantly at a later stage. Traders that are long from there will have stop losses below the lows, and if price triggers these stop losses, it will cause longs to liquidate, creating strong selling momentum for a continuation past the lows.

If we have an existing short position that is nearing these imperfect lows, we can expect these to be eventually taken out.

Gaps (Unfinished Business)

Actionable by noticing gaps in the price action for certain markets (for indices ETFs, it is not expected for all gaps to fill, however 70% of gaps do eventually fill). Therefore, gap entrances and gap fills serve as support and resistance levels, and also potential levels for SFP.

A trader can long and expect to take profit around the gap fill, and conversely a trader can look for a swing failure pattern to enter short after the gap is filled.

Reason: Gaps are liquidity voids where no market auction has taken place at these price levels. This violates efficient market theory which suggests that every price historically should be auctioned at all prices.

ChatGPT: According to the Efficient Market Hypothesis (EMH), all available information should be reflected in the asset’s price, and every price should have been tested by the market, ensuring that there are no untraded or untested price levels. Similarly, Auction Market Theory suggests that the market seeks to find a balance between supply and demand by auctioning prices at various levels until an equilibrium is reached.

Horizontal Bull Flag

Actionable by recognising a strong period of horizontal consolidation after an initial upward thrust. This indicates that there might be more favourable price action to come.

Horizontal bull flags are rare, but offer a unique opportunity since we can assign a stop loss right beneath the bottom of the consolidation anticipating a breakout that yields high R:R.

False Breakdown (Avoid Trading)

A false breakdown is a rapid movement during the consolidation phase to sweep liquidity that was built early after market open. A strong and violent movement against the prevailing trend occurs that is usually dissipated after a 5-20 minute move. This is standard liquidity engineering to get large orders to fill by hunting and absorbing as much liquidity as possible in the early market phase.

The white lines represent all the potential liquidity zones that have been absorbed. As these lows are repaired, the market can now go higher.

Support and Resistance Zone Reactions

When the price of an asset reaches a certain level of interest, such as Fibonacci Extension/Retracement levels, key volume levels such as HVN, LVN, VAH, POC and VAL, or traditional support and resistance areas, we expect or anticipate a certain reaction from that level. The following reactions can be expected:

• Continuation of prevailing trend, ignoring the level of interest.
• Consolidation at level, as traders reach take profit targets.
• Swing Failure Pattern (SFP), as institutional traders engineer a liquidity capture to set their own positions.
• Reversal, due to patient traders waiting for the confluence level.

However, how are we able to determine what to expect? The truth is we are unable to, however we can improve our chances of a success trade by determining the type and strength of the reaction to provide us an edge. As always however, this must be accomplished with strict risk management.

Immediate Reversal (Engulfing)

The price prior to reaching the resistance level had been continuing for a long time, eventually exhausting buyers. The surge in interest in sellers caused supply to overwhelm demand, resulting in the complete engulfing of the previous candle. We can expect to take a short position, knowing that the trade is invalidated if buyers return and trap the sellers in the engulfing candle.

Immediate Reversal (Look Above and Fail)

This is similar to the engulfing candle reversal, however in this circumstance price trades above prior resistance for a short duration before falling back and ultimately collapsing. The reasons are similar to the engulfing, but in this circumstance more sellers are waiting for the level to hit before entering heavily to fail the breakout. This ensuing move could be weak or strong, so be careful when scaling profits.

Delayed Reversal (Double Top, Head and Shoulders)

Expect pain and drawdown if this occurs - a moderate reversal to form the first top, but then a sharp green reversal to almost stop the seller out before consolidation and the ultimate selloff. This is difficult to trade because of a few reasons:

• The sharp green reversal to form the second head could be the ultimate continuation move to stop us out.
• A requirement of mental fortitude if highly leveraged since the move would go from profit to drawdown.
• Even take profit is difficult, since the first liquidity area is less than 1.0 R:R, so we need to wait until the second liquidity area for better returns.
• This strong reversal continues to sell for 8 more hours, which is great for swing trading, less so for scalping. This is why we always leave runners and set stop loss to break even!

Delayed Continuation (Equal Highs and Lows)

When buyers or sellers create an equal high or low, this means that the final auction price is exactly or near the same as the previous level of support or resistance. This is an example of a failed auction. This is because of the following:

• There is little interest for buyers/sellers to continue the move.
• There is a significant order block that was only partially absorbed in the first move, and has now retraced to the same order block.

Equal highs and lows create a significant liquidity zone because there is a lot of stop losses placed underneath it. This could either be used for institutions to liquidity engineer to enter a large position, or be used as a firestarter to create a significant continuation move when all the stop losses trigger.

Real World Examples

Micro S&P500 LTF Short (13/08/24 Pre-market Open)

The price of the MES took out the previous daily high, which serves as a resistance and a place to look for an SFP trade. We took an initial short position after the breakdown, which is incorrect - it is better to wait for a consolidation or retrace first. This is because a real change of direction requires a certain amount of distribution. The second short was successful and price went down for over half an hour.

Due to time restrictions it was not possible to monitor the price after profit was taken, but the price made a subsequent retracement to the 0.618 Fibonacci retracement level, which opened up another potential short after the first breakdown red candle. Take profit would be the -0.618 and -1 expansion levels.

Micro S&P500 LTF Short (13/08/24 Lunch)

Another potential resistance level + SFP opportunity arose, as this level was the high of a previous liquidity area during a sell-off. Price usually stagnates around here with a potential to retrace to digest the upward movement from earlier in the day. A cautious short was taken, but do take note that this is risky because the market was in full bullish mode during the day. During bullish days keep longs long and shorts short.

A consolidation occurred which resembled a bull flag, this lowered the probability of success significantly and stop loss was almost imminent. However, there was a rapid bull flag breakdown which allowed hitting the take profit target before strong buying demand resumed. Again, the lesson here is that an immediate SFP is often a poor decision, and we should wait for a distribution pattern to form before taking the appropriate position.

Determine Price Capituation

The following chart accurate depicts and shows the stages of price movement, from initial insitutional involvement, to liquidity sweeping, to retailer interest and then finally price capituation and a return to the normal.

The NQ (Nasdaq) was trading in a bullish environment on all timeframes and quickly approaching an important intermediate level, therefore we expect a potential bearish reaction to take advantage of this. A lot of liquidity has been accumulating for a day and a half, and judging by the small, incremental and gradual climb we can determine that this is just retail interest driving the market up. During London session we observe an intial selloff from 19,680 to 19,610 to take out the support line A, before to 19,640. This is the first signal for a potential bearish change of structure, and a H&S pattern is formed to indicate strong bearish momentum.

All of this to a keen-eyed chartist is quite straight forward. After all, change of structure and H&S are common patterns to take advantage of. But where will the bearish momentum end? If we take a standard head to shoulder distance and place that below the shoulder, we will miss out on potentially a lot more to gain.

A useful indication for where price will capitulate to can be to locate the intermediate support lines (depicted from B to G), and determine the momentum of the bearish move in each sector. We realise quickly that the movement from A –> B was rapid, and the majority of the volume was built to closer to B in a bearish structure, thus there is further to fall. From B –> C the momentum escalated, and barely any 5 minute green candles could be observed. C –> D, D –> E and E –> F were complete capitulations, where stop losses were triggered from the earlier liquidity buildup, and retail traders take advantage of the heightened volatility.

Finally price arrives between F –> G. We notice that the distance between F and G is much larger due to the strong impulse move prior. To reach the liquidity zone at G would require immense selling, which might not be reasonable in an uptrend. The volume hovers just slightly below F for many minutes, which indicate that the momentum has completely shifted. Therefore, this serves as the perfect level for a take profit for shorting, and a potential long entry with a stop loss below the F lows.

Here is another example of a bearish impulse move that can be broken down into sectors:

This is a classic double top formation, and a break led to the initial move from B to halfway between C –> D. This would allow early traders to exit. However, a keen observer would realise that when price retraced, it failed to hold at the resistance of A, also the neckline of the double top structure, leading to a further impulse move from A –> E. This would then break the bear flag formation, driving more retail involvement for the subsequent moves. Ultimately, price fails during the H –> I sector, leading to a rebound and bullish regain.

As an unaware trader who can only make decisions based on the limited data we receive, determining price capituation is another piece of the puzzle to help minimize risk and maximize reward. It is not possible to predict the decisions of the market, but at least assist in making more correct decisions than not. Thus, the following rules should stand:

• If we observe a strong momentum shifting structure (H&S, double top, three drive), we can attempt to trade with strong conviction after the break and retrace, with an eventual flexible take profit where we fail to move to the next liquidity zone. Alternatively, we take partial profits at every major liquidity zone.
• If the momentum shifts suddenly, it is unlikely that this is due to insitututional participation, because there would be no opportunity for them to engineer liquidity. As such, it is likely to be a shorter impulse move.