Bowtie Pattern: in the previous articles, it was discussed that only short-term market forecasts are viable. However, through proper money and position management positions can be held for weeks, months, and even years should the trend continue. This proper money management involved the use of stops, taking partial proﬁts, and the slowly widening of trailing stops as the positions became more and more proﬁtable. After that we looked at how to get onboard established trends with Trend Knockouts (TRADERS´ 29/2014) and Persistent Pullbacks (TRADERS´ 10/2014). And, in the last article we looked at how to get onboard emerging trends with the First Thrust Pattern (TRADERS´ 11/2014). In this article we will keep with the theme of getting on board emerging trends, this time with the Bowtie Pattern.
» When the Trend Ends a New One Often Begins
Trends do not last forever. Eventually they exhaust themselves and quite often, a new trend in the opposite direction emerges. However, established trends can often last much longer and go much further than most anticipate. Trying to buy a market because it is low or sell short a market because it is high is a loser’s game. The good news is that the market will leave clues that a trend is turning and will usually have a minor correction before resuming its new trend. Looking to enter after that minor correction and only if the new trend shows signs of resuming is the goal of the author’s transitional patterns. This is illustrated in Figure 1.
Emerging Trends: Sometimes an Event, Sometimes a Process As discussed in the last article, markets in major trend transitions often begin with a sharp thrust in the new direction. This often catches participants off guard. Sometimes though, the trend change can be more of a process than an event. This can still catch participants off guard. They assume that the market is just resting before it mounts another leg higher (or lower for shorts). Just like the First Thrust as the new trend begins to emerge, they find themselves trapped on the wrong side of the market, waiting for the market to reverse so they can get off the hook. Bottom pickers and top pickers who missed the top or bottom and do not want to pay up are also waiting for some sort of meaningful correction. Unfortunately for these traders, the meaningful correction may never come. Often, once markets begin to roll over, they only pull back very brieﬂy before resuming their new trend. The old market participants will soon be forced out at adverse prices and the bottom/top pickers must pay up or risk being left behind. By waiting for the market to have an obvious rollover as evidenced by the Bowtie moving averages, you avoid the pitfalls associated with picking tops/bottoms. By looking to enter at the ﬁrst signs of a correction rather than waiting for something more substantial, there is the potential for your position to be helped along by the predicament of the aforementioned traders.
Indicators vs. Illustrators
Before we look at the rules and an example, keep in mind that all price indicators have lag. Therefore, the world “indicator” is a misnomer. It simply shows what is happening with price, an “illustrator” if you will. So, the Bowtie moving averages crossing over (read further) suggests that the trend has changed. A quick glance at the price bars will usually confirm that it has.
The Moving Averages
For this pattern, a 10-day simple moving average, a 20-day exponential moving average, and a 30-day exponential moving average are used. The author likes the 10-day simple moving average since it gives a true average price of the stock for the past two weeks (ten trading days). For longer-term moving averages, the exponential moving averages are preferred since they front weight the data. Therefore, although they take into consideration the longer-term trend, they are faster to catch up with price, since more credence is given to more current data. Do not worry about the math. Moving averages are available in the even the most basic charting packages.
The goal of the Bowtie setup is to get on a new trend early. You wait for the market to show signs that it has changed direction of its longer-term trend and then enter on the slightest correction. Entering new trends is risky, but the payoff can be tremendous if you catch a new trend early.
Through the use of multiple moving averages, it was discovered that they would often come together and spread out in the opposite direction as the market was making a major transition. That is, they would go from proper downtrend order – the faster moving averages (shorter periods) below the slower moving averages (longer periods) – to proper uptrend order – the faster moving averages above the slower moving averages (Figure 2).
When this happens over a short period of time, it gives the appearance of a Bowtie. After the Bowtie forms, it suggests that the market has made a major trend shift. However, it is still prone to correct. Therefore, you seek to enter after a minor correction.
Here are the rules for buys, short sales are reversed:
1. The market should make a significant low. Longer-term or ideally all-time lows are the best. This helps to ensure that the most amount of people are on the wrong side of the market when the new trend begins to emerge.
2. Referring to Figure 3, the moving averages should converge and
spread out again, shifting from proper downtrend order (10 SMA < 20 EMA < 30 EMA) to proper uptrend order (10 SMA > 20 EMA > 30 EMA). Ideally, this should happen over a period of three to four days. This creates the appearance of a Bowtie in the averages.
3. The market must make a lower low and a lower high.
In other words, it must make at least a one-bar pullback. Note, in some cases, markets that only make a lower high (vs. a lower low and a lower high) may be considered. This is especially true when previous day is a wide- range bar and/or when the trend is turning fast.
4. Once qualiﬁcations for (2) have been met, go long above the high of (2).
Let’s take a look at an example (Figure 4). Kodiak (KOG) makes an all-time high (1). Everyone who owns the stock is at a profit. However, the momentum has slowed as evidenced by the fact that the stock hasn’t made much forward progress on a “net net” basis for over a month. It also has formed a double top. Classical technical analysis used with a setup as trigger usually makes for more powerful trades. The moving averages come together and spread out going from uptrend proper order (10 SMA > 20 EMA > 30 EMA) to downtrend proper order (10 SMA < 20 EMA < 30 EMA) over
a short period of time (2), giving the appearance of a “Bowtie.” The stock makes a higher high and a higher low (3). This is actually part of a pullback that is already in progress. The stock triggers an entry (4) as the low of (3) is taken out decisively. The new trend begins to emerge.
Bowtie Pattern: One Caveat Look for First Thrust First
The Bowtie moving averages are great for catching gradual changes in trend. They help to illustrate a trend change that might not be initially obvious by looking at the chart alone. As discussed in the previous article, sometimes the trend change can happen more abruptly. It is an event vs. a process. Therefore, when analysing a market, always look for First Thrusts first. Notice in Figure 5 that the First Thrust has already triggered while the Bowtie is still forming.
Gold or Arrows?
Keep in mind when trading emerging trends that there is a chance that what appears to be an emerging new trend might just be a correction in the longer-term trend. You’re a bit of a “pioneer.” And, like the American Pioneers, you’re either going to get the gold or arrows in your back. The good news is that all major tops or major bottoms will have a First Thrust or other emerging trend patterns. Therefore, the chance of the gold makes it all worthwhile.
With just a little experience, you will ﬁnd Bowties very easy to recognise. Paying attention to the Bowtie moving averages in the indices will help keep you on the right side of the market. Through the use of multiple moving averages, Bowties often catch gradual changes in trends early. Because they are visually easy to recognise, they are a great pattern for those new to trading emerging.
Now that established and emerging trends have been discovered, in the next article we will look at the third phase of trends, accelerating trends. We look at how to recognise and get aboard these trends using the author’s Accelerating Momentum Strategy. Then, we will discuss how to pick the best stocks and other markets to trade. Without a plan and moneymanagementthe bestsetups inthe worldare useless. Therefore, we will discuss money and position management in more details. Without the discipline to follow a plan, your trading results will be random at best. So last, but certainly not least, we will discuss trading psychology. «