Chapter 13

“Waldo” Patterns^*

In recent years, a fictional cartoon character named Waldo^© has been popularized and promoted in books, posters, puzzles, and a game entitled “Where's Waldo?”^©. His creator, Martin Handford, has made it a challenge to find Waldo in the midst of hundreds of other cartoon figures. Camouflaged and hidden in the extreme recesses of these pictures is Waldo. His location is difficult to identify, but once shown or discovered it becomes obvious. This exercise reminded me of a similar process I have been involved in for years—identifying, on a chart, price patterns that are obscured and overwhelmed by the price activity surrounding them. Once I became aware of what to look for, however, this process was simple. Consequently, I have labeled these chart relationships and patterns as Waldo patterns. Rather than get into a lengthy discussion regarding their genesis, I will merely highlight their existence and underscore some of the observations I have made regarding their implications. Suffice it to say that I suggest you research these Waldo patterns to determine whether they might play a role in your trading program. Whether you deal in equities, futures, or cash markets, these patterns should convey similar messages.

When I started in the investment business, I was introduced to all the generally accepted market models, indicators, and techniques. It took approximately one year of hard work and heavy indoctrination by market technicians before I fully grasped the commonly used systems and approaches to market timing. What I learned always appeared good on paper, but to reproduce it and apply it was difficult. My solution was to create original research regardless of the time and expense involved to accomplish it. What surfaced from this research project was the revelation that many of the interpretations assigned to widely followed and often quoted market patterns were just the opposite of what they should have been. This discovery shattered the faith I had in conventional wisdom and forced me to conduct my own research and market timing investigation. I emerged from my self-education with the following principles, which I have adhered to ever since:

1. Most traders believe that increasing volume is an important companion of a genuine price advance. I concur in some instances on a price continuum but my research suggests that such a development is definitely not always the case. For instance, once price has formed a low, I prefer to see light volume because, typically, it suggests a shortage of supply. I defy traders to prove that they correctly purchased the absolute price low. I associate such claims with the many celebrated fish tales. My experience shows that lows are made once the last seller has sold and, by default, price moves sideways to higher. Generally, when heavy upside volume occurs coincident with a new price low, it is of a short covering variety and consequently short-lived. In fact, such a situation generally establishes a price vacuum in which price declines even faster once the decline resumes; this occurs because premature buying has depleted the buying reserve and at the same time has increased the selling pool. These short covering rallies are typically characterized by their steepness.

   Many traders like to relate current upside price action to a reference high recorded some time before. Richard Russell, of Dow Theory Forecasts, made a notable observation many years ago, which I follow to this day. At that time, many traders were focused on a Dow Jones Industrial Average peak recorded many months earlier. The market was advancing on exceptionally heavy volume. Contrary to popular belief, Russell observed that (1) the price movement was running into heavy resistance because of the large volume, and (2) more than likely, price would stall and reverse prior to any penetration of the previous highs. He was correct. I conducted my own research and concluded that an ideal situation arises when price advances and volume is light, suggesting a shortage prior to the price peak. Once the high is exceeded, I look for volume to increase significantly, for two reasons. First, I expect to see short covering and stop loss buying to occur at and above the old price high. Second, trend followers are likely to initiate positions precisely at that price high and above. Consequently, I prefer to see volume explode subsequent to a breakout above a previous high but not before. These same observations apply to price and volume when price declines and the prospects for a previous low's being penetrated are being evaluated.

2. Many traders believe that reversal bottoms and tops are important trading signals. I disagree. I invite you to examine the price charts of most of the actively traded stocks and futures. Generally, price reversals—days in which a low exceeds the previous day's low to the downside and price closes higher, or days in which price exceeds the previous day's high to the upside and price closes lower—are caused by short-term traders, and prices typically resume their trend once they are completed. Trading days in which price declines and a down close versus the previous day is recorded, or trading days in which price advances and an up close versus the previous day is recorded, are more significant and durable and are likely to occur at price bottoms and tops. There is one pattern that assumes the same significance as the one previously described. In that pattern, a reversal occurs and price closes greater than all previous four closes in the case of an upside reversal or closes less than all previous four closes in the case of a downside reversal.
3. Typically, markets experience a consolidation phase whenever a particular day's price range is more than two times the previous day's price range. This is more apparent if price has been trending for a period of time.
4. Assume the lowest price recorded is 10 or more days ago and, prior to that low, all previous 10 days' lows were higher. Label this low day as the reference day. If the next 2 days are down closes and both record range lows beneath the reference day's close, a price low is likely being formed. To establish a price high, reverse the conditions.
5. Generally, when price closes unchanged versus the previous day's close, price continues to move higher if the previous day's close is up and to move lower if the previous day's close is down.
6. Once a short-term low is formed, by subtracting the difference between that day's close and low and comparing it with the difference between the previous day's close and low, conclusions regarding the following day's upside potential can be determined. Specifically, if the difference is greater one day ago than two days ago, the prospects are good for a rally, provided that the following day's low does not violate the previous low. Conversely, once a short-term high is formed, by subtracting the difference between the previous day's high and close, conclusions regarding the ensuing day's downside potential can be established. If the difference is greater one day ago than two days ago, the prospects for a decline are good, provided that the following day's high does not violate the previous day's high.
7. A downtrend can be reversed once a price open or close is recorded that exceeds upside the price close four days before the most recent TD Point Low. This must occur within four days of the TD Point Low. If two price gaps are recorded on two days up to and including the first reversal close, the reversal is suspect. Conversely, an uptrend can be reversed once a price open or close is recorded that exceeds downside the price close four days before the most recent TD Point High. This must occur within four days of the TD Point High. If two price gaps are recorded on two days up to and including the first reversal close, the reversal is suspect.
8. If the close 1 day ago is less than the close 5 days ago, and the close today is greater than all previous 7 days' highs but not all previous 11 days' highs, a short-term top is formed. Conversely, if the close 1 day ago is more than the close 5 days ago, and the close today is less than all previous 7 days' lows but not all previous 11 days' lows, a short-term low is formed.
9. Prepare for a potential change in market personality when volume levels on a particular day exceed—or surpass significantly on a percentage basis—historical relationships between volume–open interest levels. This could suggest the potential of an ensuing directional price change.
10. Most trend followers buy when price exceeds upside all previous highs for a prescribed number of days, or sell when price exceeds downside all previous lows for a prescribed number of days. A common practice is to buy once a high exceeds all previous 40 days' highs and to sell once a low exceeds all previous 40 days' lows. Many trend followers remain invested at all times. However, some prefer to take profits and position themselves neutral once price records a 20-day low or a 20-day high. Typically, trend following produces less than 35 percent winners; if portfolio diversification is applied, the likelihood of participating in the trending markets is enhanced considerably.
11. A number of market analysts have observed seasonal price tendencies in the commodities markets. Numerous books have described a number of these observations. What has been often overlooked, however, is the fact that there exists a propensity for stocks to exhibit a similar seasonal behavior. I predict more research will be conducted in this area.
12. Most traders apply the identical overbought/oversold decision rules to bull and bear markets. In an uptrending market, oversold readings occur only for a short time and overbought readings are more dominant. Conversely, in a downtrending market, overbought readings appear for only a short time and oversold readings occur more often. The overall trend of the market, or the market environment, is a critical factor to consider when interpreting overbought/oversold oscillators. (See Chapter 3.)
13. Prior to the completion of my work regarding trendlines (TD Points and Lines, see Chapter 1), I used a technique to perfect trendline breakout entries. Specifically, I would draw a trendline. If it was an up trendline, I would wait until downside penetration was exhausted. Then I would use the low defined by the sell-off as my sell entry once a subsequent rally was completed. Conversely, I would trace a down trendline and await the completion of the upside penetration. Then I would identify the high defined by the advance as my buy entry once a subsequent decline was completed.
14. Traders like to identify support and resistance levels and often anticipate specific price activity to occur at these price levels. My experience suggests that the concept of support and resistance does have application to stocks, but due to the high turnover in the futures markets, the principle has no application except in intraday trading.
15. One factor overlooked by many traders when operating a market timing system is the significance of specific days of the week, of the month, or of the year. I have conducted some research regarding this area of systems analysis and my findings suggest a more than casual influence.

^*Copyright 1987 by Martin Handford, Little, Brown and Company.