CMC Markets Trading Smart Series: Long tail strategy
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.
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CMC Markets | Long Tail Strategy
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.
CMC Markets | Long Tail Strategy
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.
CMC Markets | Long Tail Strategy
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.
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