Patterns are important in trading; you might even say that trading is basically a game of recognizing the right patterns and doing the right thing when they happen. Most of you who have read my blog or my book, or have seen the research I write every day, know that I focus heavily on trading pullbacks in most market environments–pullbacks in trends, after breakouts, before breakouts, at the end of trends, at turning points in trends–even a simple pattern offers many ways to trade the market’s action.
One of the more useful variations of the pullback theme is something I have called a “nested pullback.” As always, terminology can be confusing, so it’s important to realize that the “nested” part of the term means that the nested pullback is a smaller structure that is “nested” within the larger pullback’s drive to resolution. It is not nested within the larger pullback itself, but, rather, within the thrust that happens when the bigger pullback begins to turn into another trend leg. Another way to think about it is that it is a pause: the bigger pullback starts to go into another trend leg, and that move stalls into a small consolidation which is the nested pullback. (I wrote a longer post about a year ago here.)
Take a look at this recent example in natural gas futures:
Identifying the bigger pullback at 1) was easy if you were able to let go of preconceptions, concerns about sentiment/COT data, and other nonsense that always encourages us to fade trends. So many times, the right thing to do is to simply align ourselves with the dominant group in the market until the market makes it clear that something has changed. The market is in a downtrend so we want to short bear flags–that sentence is the essence of one pretty successful trading plan.
The nested pullback provided additional confirmation. We obviously would prefer if every trade would move immediately and cleanly to its target, but things don’t often work like that. It’s more common for a move to stall or pause, but we can then often find additional information in the character of that pause. In this case, the nested pullback showed that there was a good probability that this market would break lower. (For instance, a pause that had a lot of sharp rallies would be more likely to suggest that factors were beginning to align against the trade.)
This is a good pattern to add to your toolkit because it can do at least three things for you: 1) it gives you some insight into how to manage the trade and how to tighten stops. 2) It can provide a secondary entry if you miss the initial spot to get into the trade, and 3) it can be a good spot to add, if you do that within your trading plan. Spend some time looking for this pattern and see if it can enhance the way you view market trends.
I’m very suspicious of “after the fact” analysis, and you should be too. Anyone can find any pattern on an old chart, but this is another example that we identified in real time: I signaled the initial short to my research clients and identified the nested pullback as it was developing. We took partial profits into the decline, and are still short for today’s meltdown. Obviously, not every trade works like this, but this is a clean example of the pattern, and a good example to commit to memory.