By Jason Pearce
Charting 101
One of the first patterns that technical traders learn about is double tops and double bottoms. The belief is that history will repeat itself as a market peaks at a prior high or bottoms at a prior low. Supply/demand exhausted at these same points the last time around, so they’re likely to do so again. The idea is to get positioned for a major reversal from this level.
Additionally, a breakout above a prior high or break below a prior low indicates a major breach of support/resistance. Something has changed. The move should now be traded in the direction of the breakout as support/resistance has been conquered and the trend is expected to continue.
In the real world, however, these patterns are not usually as neat and clean as traders have read about in a trading book. Otherwise, every rookie trader out there would be a multi-millionaire in just a few short months.
Sometimes a market will bottom out and turn around before it tags the prior low of a move or peak out before returning to the prior top. That’s frustrating. The trader who was patiently waiting for the perfect setup will miss out on the reversal.
It gets even worse…
Markets will often surpass the prior high or break the prior low and signal a breakout. Then the traders looking for the double top/double bottom get stopped out. At the same time, other traders pile into the market on the breakout signal in anticipation of a continuation of the trend.
Murphy’s Law is then swiftly enforced as the market reverses shortly thereafter. Suddenly, it seems as if everyone loses on the trade attempt. So much for the idea of playing a zero sum game…
Bad News Is Good News
Chart patterns often fail. These failures often lead to sizable moves in the opposite direction. In particular, attempted breakouts above prior tops or below prior bottoms can lay the groundwork for some pretty big retracements that turn into trends.
Most importantly, the pattern failures can lead to tradable moves. This means that these initial pattern failures will often sow the seeds for new profit opportunities that follow immediately afterward. As traders, profit opportunities are exactly what we’re looking for!
While running a trade desk for over two decades, I have witnessed and participated in literally thousands of these failed breakouts. Waves of buy stop orders get triggered soon after the market clears a prior top and even bigger waves of sell stop orders get triggered shortly after the market turns back over. It didn’t matter if one was trading stocks, commodities, currencies, or bonds; this pattern was replicated across sectors.
We referred to this event as a Wash & Rinse pattern because the market seemed to knock everyone out of their positions before reversing.
Because the pattern failure initially racked up losses for both the bottom and top pickers and the trend followers, very few of the traders would get right back into the market to take advantage of the powerful move that started right after the reversal.
Most of the traders did not want to pull the trigger right after a losing trade because of Recency Bias. This was tragic because the move that followed the pattern failure ended up being the one that was the real money-maker.
Widely-Know Secret
Admittedly, the Wash & Rinse pattern is not my own unique observation. I’ve worked with other professional traders and even money managers who profited greatly from this pattern failure. They had other names for it (pivot reversal, specialists’ trap, the shakeout, etc.) but it was all the same thing.
The important thing here is that this pattern has worked, it does work, and it will continue to work. You can go back over several decades or price history and see this pattern in play on all sorts of markets. You can also look at some recent charts and see the same thing. The Wash & Rinse is a robust pattern and has longevity.
Despite the fact that many great traders have profited from this pattern, it doesn’t seem to get nearly as much attention as a classic double top or double bottom pattern. It doesn’t even get the same coverage as a breakout trade. But quality trumps quantity here.
The traders that do trade with this pattern seem to be the minority. They are members of the winner’s circle; the ones that profit consistently when the other participants are accumulating losses. I observed this phenomenon during my time at the trade desk. Once the failed breakouts above the prior highs (or breakouts under the prior lows) happened, the majority of traders did not go back in to trade the reversal…but a small group of the professional traders did.
Why It Works
The reason this Wash & Rinse pattern works is two-fold. First, traders who bought on the breakout get stopped out after the market returnd below the prior high. Some of the buyers were initiating positions and some were adding to positions they had already established on the way up.
The mass liquidations orders that hit right after the market broke back down below the prior high caused the sellers to overwhelm demand. As a result, the market sinks like a stone.
Secondly, the traders who were positioned on the short side in anticipation of a double top initially got their buy stops picked off on the breakout. Since they were already bearish, it’s a safe bet to say that most of them weren’t looking to immediately reverse course and start buying on the pullback right after the breakout failed. So we won’t see any demand for the market coming from this crowd, either.
Furthermore, if this second group of traders did decide to take another shot at the market, it was only to get short again. Adding that on top of the orders that are simultaneously coming in to liquidate the long positions and you have even more selling pressure put on the market. This can create a sustained move in the opposite direction of the initial breakout.
A Few Examples
Take a look at a few examples of the Wash & Rinse pattern in action. You’ll see that it works across all sorts of different markets. It doesn’t matter if you’re trading stocks, treasuries, currencies, or even commodities. This is the sort of robustness that a trader hopes for!
A few years back, precious metals and mining shares were running hot and the Gold Miners ETF (GDX) reached a record high of $64.62 in the last month of 2010.
After a pullback of a few weeks, GDX recovered and nearly returned to the 2010 high in April 2011. Alas, it peaked just shy of the 2010 high and rolled over again.
In September, however, mining shares were red-hot again and GDX broke out to new record territory.
The fourth week after the breakout, GDX had a meltdown as it went from a record price to a multi-week low. This Wash & Rinse sell signal was just the beginning of a multi-year bear market that knocked GDX off as much as 81% from the peak.
In the spring of 2012, things in Europe looked pretty bleak. So much so that the Spanish stock market (EWP) dropped below the 2009 Financial Crisis low of $24.33.
Spain’s market dropped nearly 19% below the 2009 low, but reversed sharply higher in the summer and closed back above it. This Wash & Rinse pattern marked the start of a two-year bull market that added 125% to the value of the Spain Index MSCI Ishares (EWP).
In November 2013, the nearest-futures coffee contract clipped the 2009 Financial Crisis low of 101.60. The market recovered before the week was over.
Little did anyone know that the Wash & Rinse buy signal off the November 2013 bottom would precede a weather market that would cause coffee prices to more than double over the next five and a half months! Using the leverage of a futures contract could have made this the Trade of the Year.
In the summer of 2015, the Japanese yen (cash) undercut the 2007 low of .8059. Traders were waiting for the multi-year bear market to accelerate on this break.
Instead, the yen flip-flopped for several weeks and then resolved higher. This bullish Wash & Rinse pattern was actually one of the reasons that I became so bullish on the Japanese yen at the start of 2016. The 26% rise from the 2015 low into the summer of 2016 is a great example of just how powerful this pattern can be.
Netflix (NFLX) posted a record high of $129.29 in the summer of 2015 and then took a breather for several weeks.
In early December, NFLX blasted to new record highs again. But the very next week, it went from a record high to a three-week low by the end of the week. This Wash & Rinse sell signal was the start of a vicious two-month, 40% correction.
Remember the 2014-2015 bear market that killed the oil industry? Well, it ended with a nice Wash & Rinse pattern that signaled loud and clear for traders to get long again.
The nearest-futures crude oil contract established a bear market low at $33.20 in January 2009. This price was undercut in January 2016 and a final bear market low was put in place five weeks later at $26.05.
Crude oil closed back above the 2009 low by late February 2016 -triggering Wash & Rinse buy signals on daily, weekly and monthly charts- and black gold prices nearly doubled from the lows by June.
Apple (AAPL) experienced a spike low in the summer of 2015 that marked its low for the year at $92.00. The stock neared this price again in January of 2016, but reversed higher before the low was breached.
Finally, support cracked in May 2016 when AAPL plunged to a nearly two-year low of $89.47.
The break didn’t last long, though. AAPL turned around the very next week and began an advance that is still under way today as the stock is trading at record highs.
Cerner Corp (CERN) is an interesting case, as it experienced a failed Wash & Rinse pattern, followed quickly by a successful Wash & Rinse pattern.
The March 2016 multi-month low of $49.59 was the first line in the sand for CERN. The stock breached this support level in early November and then bounced above it two weeks later. A Wash & Rinse buy signal was triggered.
The very next week, CERN dropped to a new correction low and negated the initial buy pattern. It also ended the week below the 2014 low of $48.39. Two weeks after that, the stock blasted higher and closed back above the 2014 low. This was the second Wash & Rinse buy signal.
After the buy signal, CERN backed down again. But this time it did not make a new correction low. It merely bided its time in a trading range for several days as the end of 2016 trading was wrapped up.
After the new year began the stock really took off and rewarded anyone who got long. So far, CERN has rallied over 27% from the December low.
Terrific Trades for Treasuries
Now let’s shift gears and look at a widely-followed Treasury ETF: The Ishares 20-Year Bond (TLT). This ETF is notorious for failed breakout attempts beyond prior highs and lows.
But that’s good news for traders looking to capitalize on the Wash & Rinse pattern! Opportunities abound on both the long side and the short side of this market.
2011 – TLT surpassed the 2008 top of $123.15 in late September/early October. The market never did make a weekly close above this price. Instead, it turned over and dropped a little more than fifteen points over a three-week period. TLT finally bounced and then settled into a multi-month trading range.
2012 – At the end of May, TLT finally gapped up and cleared the October 2011 top at $125.03. On week later, this ETF pulled back and spent nearly a month trading either side of the 2011 high. Had a trader gone short on this pullback and Wash & Rinse sell signal, he would have likely been stopped out when TLT raced back up to a new high in the second half of June.
However…
A new Wash & Rinse pattern setup materialized. You see, TLT posted a high of $130.38 on June 1st and then pulled back. On July 23rd, the ETF closed above the June 1st high and stayed above for four days. But on July 27th, TLT dropped back under the June top and stated to decline in earnest.
By mid-September, TLT had dropped over fourteen full points from the July top. As a matter of fact, the bear market decline carried on for nearly a year and a half and dropped thirty-one points from high.
2013/2014 – In August of 2013, TLT posted a two-year low of $102.11 and bounced. The bounce eventually faded and this ETF traded to a new low of $101.17 on New Year’s Eve.
TLT blasted higher the very next week and started a thirteen-month run that boosted the price of the ETF by over thirty-seven points.
2015 – Soon after the New Year started, TLT surpassed the 2012 record high of $132.22. One week after the initial breakout, TLT pulled back to the 2012 high and immediately bounced. This solidified the breakout.
After posting a new record high of $138.50 on January 30th, the ETF started to weaken. One week later, TLT closed back under the 2012 top. Ultimately, TLT declined roughly twenty-three and a half points in about five months.
2016 – In late June, TLT gapped higher and surpassed the 2015 high. It peaked out at a new record price of $143.62 on July 8th and then sunk for a week. The market then went into a tight trading range until just after Labor Day. Interestingly, the bottom of the trading range was either side of the 2015 high.
TLT finally left the trading range on September 9th, but a bounce into late September soon followed. Coincidentally, the bounced ended right around the same level as the 2015 high point!
TLT rolled over at the end of September and started another descent that finally bottomed out in mid-December at 116.80. At this price, TLT had dropped nearly twenty-seven points in a five month period.
Worth a Look
At first glance, the new trader may be discouraged by the fact that double tops and double bottoms don’t appear as frequently or as perfectly as they were led to believe. Worse yet, the breakout trades often fail as well. But don’t throw the baby out with the bathwater.
As you saw in this post, the classic pattern “failures” can actually be one of your best opportunities for profit. I know professional traders who rely on this pattern and use it as one of their main trading tools.
In the next post, we will further discuss the Wash & Rinse pattern and how you can make it yours. In addition, we will also take a look at some markets that are currently setting up for potential reversal trades. You don’t want to miss this!
More Articles by Jason Pearce:
How to Trade with Moving Averages, Part II
How to Trade with Moving Averages, Part I
Market Returns Do Not Equal Investment Returns with Leveraged ETFs
Is The Canadian Housing Market Bad for Canadian Banks?
2017: The Death Year for Stocks
Potential Bond Market Reversal Ahead
