Failure Confirmation 1

Introduction to my
“Failure Confirmation” Concept
This PDF is one in a series that I am writing about the base concepts of my trading
style. This document provides some detailed analysis about what I am referring to
when I talk about waiting for a “Failure Confirmation” before taking a trade set-up. The
Failure Confirmation concept applies to both intra-day trades and longer-horizon trade
set-ups – it doesn’t matter the time frame, it only matters that you have a certain
sequence of candles before you enter a trade.

“If It Can’t Go Higher, then It Must Go Lower …”

Price is continually undergoing a process of price discovery in the marketplace (i.e.,
supply and demand driving price higher and lower). If you accept this as a market
truism, then if price can no longer go higher, it must go lower (and vice versa).

The above statement is, in a phrase, what I am referring to when I talk about Failure
Confirmation. If I am looking to trade a particular stock, I have found that my best trade
entries have always been when I am able to identify candle action that “proves” to me
that price refuses to go in the opposite direction of my intended trade. I put quotation
marks around the word “proves” because in trading there are no guarantees.

If for example, I am looking for a bullish long swing trade in a particular stock that is
trading bearishly intra-day, I will generally look to enter the trade using my 15-minute

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chart when I see a confirmed reversal candle set-up i.e. when price proved to me that it
could no longer go lower.

If the stock was actually acting more bullishly intra-day, I will look for a bullish rejection
of the bottom of the intra-day trading range as my trigger to get long.

Before I go into illustrative examples of Failure Confirmations, I want to talk a bit more
about the process of price discovery, as well as some general trading truisms that will
help readers better understand why I am often looking for a Failure Confirmation at a
certain level.

Price Discovery
Veteran traders understand that no matter what the time frame being analyzed, prices
for stocks and ETFs continually search out a level that is considered fair by the majority
of both buyers and sellers. In other words, supply and demand will determine at which
price a security will trade. This is what is meant when you hear someone mention the
concept of Price Discovery in the stock market.

What is fair value, and how is it determined? Well, you could write a number of
investment tombs on this topic alone, but suffice to say that fair value is in the eye of the
beholder. That is another way of saying that each buyer and seller will have differing
motivations and time horizons with respect to their investments in a particular
stock/ETF. For example, when I look to intra-day trade IBM’s common stock long off of
the prior day’s low, I would hazard to guess that Warren Buffet will not be thinking the
same thing – his idea of a good buying range may be 10% below yesterday’s low in part
because his horizon for an exit on this trade is likely to be a minimum of 5 – 10 years.

So when you combine all of the varying investor time frames with all of the differing
ideas of fair market value, you arrive at a process of price constantly going back and
forth.

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Technically Driven Fair Market Values

My idea of fair value is probably more technically driven than fundamentally derived at.
I’m not really going to explain all of the technical levels I watch or trade against with this
PDF, but I do want to talk a bit about a couple of what I think are market truisms when
talking about the price action / discovery process around technical levels of resistance
and support.

1. Always Look to Your Left.

Traders often fail to take advantage of one of the simplest directional filters when
trading … by this, I am referring to the fact that traders should expect the direction and
strength of any recent stronger than normal price action to reassert itself if it has started
to pause or begun to pull-back.

For example, if price made a strong bounce off of the morning low and trended higher
for the past 60-minutes, traders should be looking at any short-term weakness off of that
last pivot high to be just a pull-back consolidation and not a new trend lower.

When you look to the left of the current price action, what you see is price acting
strongly. If you suspect or are anticipating a move lower from current levels for other
reasons, at a minimum you need to wait for price to fail to bounce and take out the pivot
high of that earlier strength. If it did fail to take out the pivot high, your most recent
evidence would be one of weakening price action and therefore, an acceptable
backdrop to try a short trade.

The biggest and most common mistake that retail traders make is that they think a stock
is too strong or too weak and that the recent price action can’t continue … that is wrong
almost 100% of the time. Wait for price to show you that it cannot make new highs or
lows before trying a trade in the opposite direction.

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2. The Stronger and Quicker the Move, the Greater the Likelihood of a Break-Out
Failure or Consolidation.
When you have an obvious technical level of price support or resistance, I always
remind myself to pay attention to how quickly and how far price has traveled into that
resistance/support level. This applies to all time frames.

For example, if a stock makes a strong quick intra-day move from a lower area of range
trading up into the level of the prior day’s high, I would always trade this stock assuming
that this initial test was not going to see price make a sustainable break-out without first
pulling back or consolidating sideways.

There are times when prices will run or gap through smaller time frame resistance or
support levels without much of a pause, but that type of price action is generally news
driven and not what I am referring to. Most normal trading conditions will see price
respect this truism.

3. The First Test of an Obvious Level will Typically Fail.

Now, this may sound exactly like what I was saying in truism #2 above … it is but it
refers to all types of first moves into an obvious level of support/resistance – not just
ones where price makes stronger / larger-type moves.

Experienced traders understand the idea of obvious levels of support/resistance and

how traders from around the world will be watching these levels. For example, a retail
trader trying to momentum trade AAPL may use the high of yesterday’s trading as their
level to go long AAPL. Better capitalized, and often computerized algorithm trading
programs know many retail traders will be getting long at the prior day’s high playing
and praying for a break-out … they also know that these traders will have a tight stop on
their long trades as they do not want to get whipsawed like they have in the past when a
breakout fails.

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So, in essence, you have one group of traders trying to play a break-out move of a
stock (with a tight stop-loss) and another group of traders willing to fade that break-out
attempt. If the amount of traders playing the break-out is limited to generally just retail
traders, this break-out will almost always fail on the first attempt as the better-capitalized
fader sells more stock than retail traders and small institutions can absorb. The fader’s
goal is to overwhelm the break-out buyers in the short-term thereby causing the tight
stop loss orders to get triggered and for price to then move back below the obvious
break-out level. Once in a profitable position, these faders will cover their shorts and
price will often but not always, retest that obvious break-out level.

If price attracts more and more buyers as it pulls back and trades around the obvious
level of resistance, the stock will eventually be able to break that resistance level. That
first test though is generally “known” by experienced traders as likely to fail.

4. Wait for a Candle in the Direction of Your Intended Trade

Again, one of the easiest trade filters for traders to take advantage of is to wait for at
least one closed candle that is in the direction of your intended trade. Some traders will
aggressively trade based purely on a level being hit … I think waiting for the partial
confirmation of a directional candle will increase the winning percentage of your trades
and increase your overall profitability.

5. Higher Time Frame Buyers and Sellers

Traders have to understand who is in command of the buying and selling of a stock on
any given day. For example, corporate or industry news may cause a fundamental
change in the attractiveness of a given stocks’ current price. Good (or bad) news may
cause a shift in bigger institutional demand for a stock, and once a decision to buy or
sell is made, there may be a large difference in the amount of stock to buy versus the
amount for sale.

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That imbalance will often cause the stock to be constantly bid for (or sold) in the
marketplace … this level of new additional demand (supply) does not care about price
levels that intra-day traders normally trade against – they want to build (or sell) large
positions and they understand that this may take several days to accumulate/distribute.

If shorter-time frame traders do not recognize when price is being affected by bigger
institutional accounts, they are likely to get caught trying to fade normal range day
support and resistance levels during an actual trend day of trading. That can be painful!

Ok … let’s look at two examples of a Failure to Confirm.

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Alibaba Group (BABA) – April 2, 2015

BABA Daily Chart – as of April 1, 2015

(double click on any chart to bring up a separate copy)

BABA has been a disappointing stock for bulls since the mid-November 2014 highs
were put in ($120.00). Price has been trading in a range for the past 4 weeks, but if you
look at the last three daily candles coming into April 2, 2015, you will see that they were
all bearish red candles that not only ended lower than the prior day’s low, but actually
closed near the lows of the day.

So the bias for traders coming into the day would be to trade BABA to the downside …

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BABA 3-Minute Chart – April 2, 2015

So coming into the day, your bias for BABA was to the downside … that meant any sign
of weakness at the open would require traders to wait for Failure Confirmation of a
consolidation range of that first move lower.

If price were to gap higher or move higher at the open, traders need to wait for Failure
Confirmation of a second attempt to move higher after the first pull-back in price.

Point #1 shows that price pushed higher at the open … therefore, our bias would
require us to wait for a Failure Confirmation of this opening bullishness before trying to
short BABA. Price pulled back from the opening gap higher and then bounced higher
into Point #2 after the opening 15-minute range was closed.

The bounce from the Opening Range low found resistance at the typical level I like to
utilize when fading a stock near the open (the 50% Opening Range level). Now you

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needed a trigger … The first filter when looking for a trigger is a reversal candle or in
this case, since I will often use the actual 50% level to fade, a bearish red candle at or
near that level that points in the direction of a short trade lower.

Inside candles are viewed by some traders as a form of reversal candle … I generally
only view hammers and shooting stars as possible reversal candles. If you take inside
candles as reversal candles you can use the break of this candle’s low as your trigger
short. To me, the more conservative trade that gives you higher odds of not getting
whipsawed is to wait for another candle to close below the first red candle’s low and
then use as a trigger the low of that second candle. In BABA’s case here today that
would only make a difference of $0.09/share … not a big amount for some extra
confirmation of what price may end up doing.

The next level to watch price action at would be Point #3 … the purple dash line tells me
that was the low of the day from the prior day April 1 st. If price wants to keep going
lower, we should not see any signs of price rejecting this level. There was an inside
candle here but price did not break the high of that bullish inside candle. Remember
one of the truisms that I mentioned earlier … if you look to your left as price pushed into
Point #3’s low, what you saw was weakness for the whole day so far – that tells you to
assume that price is still heading lower until proven that it can’t head lower. A small
bounce in price is just that, a bounce … until price bounces and starts to give signs of
more strength over a longer period of time, you still have good odds that price is going
to continue lower.

Price did go lower to a new low and actually made a possible bullish reversal hammer
candle at Point #4 … again, traders need to look to their left – traders have seen
nothing so far today that tells them to expect a bottom near this level yet.

Price pushed down to another new low at Point #5 … again, look to your left and traders
can see only weakness so far today. The one difference here though was that you were
beginning to see some signs from the chart indicators that the push lower was running
out of steam – the VZO had made a higher low, the red DI- line (Direction Indicators)

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had made a lower high, the trend strength histogram was near the extreme warning
zone and the relative strength momentum indicator was showing divergences as well.
Time wise, it was about 11am so in theory there was still time for another push lower
during the Morning Trading Session.

In reality, a conservative approach would have been to take a partial profit on this trade
and to move your stop lower to a level that you were comfortable with … an obvious
level would have been just above the pivot high after Point #4’s bounce. That would
have stopped you out on the bounce into Area #6.

If you were aggressive and played for another attempt at a push into a new minor low
(and you weren’t stopped out), you would have noted the strength in the price action
during the bounce into area #6 and how different that was relative to the earlier
bounces. That price action and the chart indicators should have had you looking to
cover your short on any possible reversal signal at any potential double bottom move or
on any push down to a new minor low.

Point #7 was that push down to a new minor low – this was also right at 12pm and
made sense as the conclusion to the Morning Trading Session. The bullish quasi-
outside candle at Point #7 was a good signal for traders to cover their short.

Many aggressive traders may look at Point #7 as a possible long entry, but to me, all
you have here is the start to a possible counter trend bounce that may only last over the
lunch hour. I could see a trader arguing that the bounce up to Point #6 was evidence
that a lunch hour bounce could be large enough for a scalp trade and in fact may mark
the end of the move lower today.

If you took that aggressive trade at Point #7, you would be watching with interest at
Point #8 … this level was right at the prior level of overlapping candles at Point #6
earlier and a logical spot for resistance. A conservative trader would take profits here
and look for a Failure Confirmation of price rolling lower to re-enter a long trade. That is
what happened … the 12:51pm candle was a large bullish candle that took out both of

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the consolidation candles, and your new entry would be the high of this large range
candle or on the break of the high of the first candle to break the large range candle’s
high.

Point #9 came at a point where the chart indicators were pointing to a possible top to
this expansion off of the low of the day … time for all traders to take profits (1:15pm).

BABA 5-Minute Chart – April 2, 2015

The last push higher into Point #10 was not the area for starting new trades, and it was
at best, the last area where traders may have been hanging on for a more definitive sign
of a possible reversal lower.

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Macy’s Inc. (M) – April 2, 2015

M Daily Chart – as of April 1, 2015

M’s daily chart was starting to show signs of bullishness that the whole retail sector had
been showing as of late. I highlighted an area of previous resistance with the blue
rectangular box and that level would be important for traders to respect because price
had faded that area in the past … however, M had made a higher low off of the last
bullish looking push higher/retest.

To me, this daily chart looked like it was going to try and break higher … the question
was when would it do it and how would the break occur? Would price make a clean
break or would it be a smallish candle consolidation around the prior resistance level?

The indicators were not all screaming the start to a possible expansion phase so traders
needed to be aware of a breakout trade. Be looking long, but look for a Failure
Confirmation of price not be able to go lower.

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M 15-Minute Chart – April 2, 2015

I wanted to show a bigger time frame chart here with the M example to better show how
a bigger time frame intra-day chart also could be used to give you a Failure
Confirmation.

M broke above the 15-min ATR resistance right out of the box first thing … any break of
an ATR resistance/support level needs to be respected as a possible expansion signal.
In this example, the 60-min ATR was in a position of support so, traders should have
been willing to go long on either a bullish sideways consolidation near the break level or
on a smallish controlled pull-back from the break level. When price pushes strongly
higher through the break level like it did here with M, then you need to wait for the first
bullish consolidation move after the initial push/break.

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Having to wait for the first bullish consolidation after a strong push/break is sometimes
frustrating, but it actually shouldn’t be. After the strong break and bullish consolidation,
you actually have more proof of a bullish acting stock, and the odds of follow-through
and a winning trade set-up are greater than if price had pulled back or moved sideways.

So price pushed into Point #2 … that was the first 15-min candle that showed signs of
an exhaustion/pause Again, look to your left … nothing to see but strength, so traders
need to expect a continuation move after a period of rest/consolidation.

If possible, I like to see some sort of two-legged pull-back and if you look at M’s
consolidation here, you had that – the second push‘s low was seen with candle #1
which actually was a bullish hammer candle. My preference is to have a candle break
that hammer high and then I would trigger on the break of that second candle’s high.

Candle #2 was actually an inside candle so it did not trigger the hammer candle high yet
… candle #3 actually broke the hammer high and closed above it as well. So an
aggressive entry would have been on the break higher while a more conservative entry
would have been on the break of candle #3’s high.

Candle #4 was an inside candle and then candle #5 finally broke out of the
consolidation and closed above all of the other candles being analyzed.

The next area of consolidation was at Point #3 … the chart indicators were beginning to
warn traders of an extended push higher so it would make sense to monitor the candles
to see when/if we could see a Failure Confirmation for price pushing higher. Candles 6
and 7 were both inside candles and then candle 8 pushed higher – some traders would
have liked to now put their stop just below the low of this break candle (#8) but I like to
place it just below the low of the two combined inside candles (candles 6 and 7).

Candle #9 broke either of these stop candles’ lows so most traders would have been
stopped out here – the chart indicators were warning of an extended move so taking
profits here around 2:30pm is perfectly fine.

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Summary
One of the trickiest parts to entering good trade set-ups is the actual timing of that buy
or short … many good set-ups end up leaving traders frustrated and sitting on the
sidelines when they enter the trade at an inopportune time (i.e., price is not quite ready
to start its expansion phase). By entering at a time when price is not quite ready to start
expanding, traders can find themselves doubting the set-up as price continues to chop,
or even worse, they could get stopped out with a small loss by having too tight of a stop.

On average, I have found that the best time to enter a directional trade is when price
proves to me that it cannot go in the opposite direction. When price tries but cannot
sustain an attempted move in the direction opposite of my intended trade, price has
made what I refer to as a “Failure Confirmation”. If price can’t go one way, it is going to
try and go in the opposite direction …

Cheers … Leaf_West

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