Avoiding Wrong Signals In Price Channels

Posted by barkand on November 19, 2010 under Bollinger bands, Price trends | Be the First to Comment

Many people dismiss technical analysis as an investing tool, and there are some valid reasons why they would have that opinion. Sometimes the benefits are overpromised by those selling books or other advisory services, only to leave their readers/clients disappointed. But another reason is that technical analysis is often poorly practiced.

Let’s take this weekly chart of Net 1 UEPS Technologies (UEPS) as an example.

One interpretation by many chart readers is that a price channel has formed (green parallelogram on the chart). And a common tactic would be to buy at the low end of the channel and sell at the high end. There are two problems with this approach:

1. It can take a long time for the price channel to reveal itself.
2. The trader’s last trade – selling at the upper boundary – will be potentially  terribly wrong when the trend is finished.

Relying only on pretty geometric patterns can get a trader in trouble. 

In my view, I would like to see two things to tell me the trend is reversing, or at least stopping. I would want to see a low made safely above the lower Bollinger band along with a decline in ADX from a high level – a number above 40 is preferred but 35 might be good enough. These two criteria tell me that selling pressure is abating and serve as an early warning that the downtrend could be over. Those looking to go long might want to start buying shares at this point, with a final green light being two closes above the 20-day moving average.

In early July, the shares did make a low within the Bollinger bands. But ADX was only around 25 — middle-aged for a trend. So the stock rallied about 10% in the coming weeks and then got smacked down again when it reached the 20-day MA.