Trading should be as simple as possible and the tailing pattern is one of those simple tools that is easy to spot and, once mastered, is likely to become your new best friend.
The tail pattern can be one of the best indicators of tops or bottoms because they show where the balance of power shifts from the bears to bulls or bulls to bears. They show where fear runs out and greed takes over or where greed runs out and fear takes over.
Like a key reversal bar, the bottoming tail indicates a price low where professionals are beginning to accumulate the stock. It is formed by a strong move to the downside that suddenly reverses and has a nice rally.
The topping tail is, of course, just the reverse. It signals a dramatic move to the upside and just when the general public starts to take notice the professionals start dumping. The result is a sharp move to the downside.
I have summarized the characteristics needed to form the perfect tail. We, of course, usually dont have a perfect world in the stock market, so we try for as close as we can.
Lets look at some examples.
Here is a daily chart of the Crude Oil futures contract (QM on most charting platforms). I have marked the bottoming tail with a red arrow. Lets review each of the criteria for a bottoming tail:
1. Most powerful when it occurs after a multi-bar drop this bottoming tail formed after an 11 day drop.
2. Best ones are wider in range than the last three bars The range on the day this tail formed was 53.35 51.43 = $1.92, which was wider in range than the previous three bars.
3. The open and close are very close together. As you can see this criteria has been satisfied because the body is a very small.
4. Closes in the top 1/2 of the daily range. QM closed at 52.41 which is about the 50% of the daily range.
The next day look to go long at the high of the bottoming tail which would be 1 tick above 53.35 and look for a 3 to 5 bar advance.
Ok, so you are now in this trade, you are now long the Crude Oil futures. The easy stuff is done. We all know the market will do just what it wants to do not what you want it to do. Just because it formed a bottoming tail doesnt mean it will reverse. Although there is a good probability that it will, what if it doesnt? How do you protect yourself? Where do we draw the line in the sand, say adios, exit stage left? Well you can put a stop at the bottom of the tail, which would be 51.42, and risk 1.94 points. If that fits your money management plan sounds like a good idea. Bottom line is that everyones exit point will be different depending on ones pain level (size of account), level of aggressiveness or style of trading - day trader or short-term investor. A number of things go into a persons exit strategy and Im not here to tell you what your exit strategy should or shouldnt be but just to say HAVE ONE!!
Next lets look at an example of a topping tail.
Here is a daily chart of 10-year treasury notes. I have marked the topping tail with a blue arrow. Lets review each of the criteria for a topping tail:
1. Most powerful when it occurs after a multi-bar climb this topping tail formed after an 11 day climb.
2. Best ones are wider in range than the last three bars The range on the day this tail formed was 11410 11354 = 20/64, which was not wider in range than the previous three bars.
3. The open and close are very close together. As you can see this criteria has been satisfied because the body of the candle is a very small.
4. Closes in the bottom 1/2 of the daily range. TY closed at 11357 which is in the bottom 25% of the daily range.
The next day look to go short at the low of the topping tail which would be 1 tick below 11354 and look for a 3 to 5 bar drop. For 3 days the drop was straight down.
When a topping or bottoming tail is spotted, successful traders not only know what to do, they know when to do it and where. These three Ws are crucial ingredients in a proper trading plan, and are key items that typically separate the haves from the have-nots in the market.
You may have noticed this discussion is just a discussion of candlesticks. We are talking about the candlestick formations called the umbrella (or a reverse umbrella) and doji which are the simplest reversal pattern. Umbrellas can be either bullish or bearish depending on where they appear in a trend. If they occur during a downtrend, they are called hammers (bottom tail) and are bullish, as in "the market is 'hammering out' a base." If an umbrella appears in an uptrend it is bearish, and is referred to as a hanging man (topping tail). The latter's ominous name is derived from its look of a hanging man with dangling legs.
Picking tops and bottoms with tails and using the method above to profit from them in one of those simple trading methods. But dont mistake its simplicity for lack of power. This single tool, once mastered, is sure to give the old Wall Street axiom, buy low and sell high a brand new meaning.
Remember trade your plan and plan your trade.