Views Article – Sharenet Wealth

Turning Patterns Into Profits

It was legendary trader Linda Raschke that famously said: “All you need is one pattern to make a living”, a comment that has inspired many a trader and investor to focus on the price action and chart structure as opposed to a narrative which may contain a certain bias. As elementary and simple as the concept of a pattern may seem, to some traders (both individual and institutional) it could mean the difference between a profit and a loss, hence paying attention to what the chart say ‘says’ is a powerful tool when attempting to generate alpha and more importantly, manage risk. On numerous occasions you many have seen phrases such as head and shoulder, pennant or bull and bear flag, which may seem foreign to some readers while some of you may have successfully used these patterns yourself. Whilst nothing in the financial markets are one-hundred percent guaranteed, we prefer setups and trades that give us a fair chance of succeeding and where the odds are skewed in our favour.  

The Rise of the Machines

Over the last two decades, the use of technology has become an important driver of decision-making in the trading among both individual and professional investors. While data for individual investors is hard to come by, we have a bit more to go on for the institutional funds. For example, some of the world’s largest hedge funds such as Renaissance Technologies make use of large data sets to direct investment decisions some of which include repeatable patterns in price and chart formation. Another example is London-based MAN Group which employs similar techniques to produce profits and manage risk for it’s clients. According to a February 2019 article by Bloomberg, the global algorithmic trading market is expected to surpass US$ 21,685.53 million by 2026. What a fascinating statistic, showing us that there is a clear move toward systematic-driven investing and trading.   

(source: istock)

Part of the algorithmic and machine-driven strategies is a technical analysis approach, where computers (and humans) are used to scan for certain patterns which also include key moving averages among others. Using an example of a moving average, it was another famous trader, Paul Tudor Jones that made the statement that “Bad things happen below the 200-day moving average“. While the approach is simple, it effectiveness cannot be overemphasized in today’s environment. Take for example Shoprite Holdings (SHP), which lost the support of it’s 200-day simple moving average in June 2018 and which led to a sustained downward trend until recently when it reclaimed it’s 200-day moving average on the back of a better-than-expected market update.

Another example of using the 200-day moving average as a long term guide was Anglogold Ashanti (ANG), where we note three signals to go long and short over a 5 year period. In addition to this, multiple patterns can be identified. These include an inverse head and shoulder breakout in January 2016, a head and shoulder breakdown in October 2016, a bull flag breakout in June 2019 followed by another bull flag breakout in April 2020.       

Using Technical Analysis As A Risk Management Tool: 3 Case Studies

While traders often focus on using the chart as a tool to predict prices, we also see the technical analysis as a risk management tool to protect capital. To use a motoring analogy, while the fuel gauge is most watched, and the gear box is most mostly used, the brakes still serve as an important feature of the journey and may prevent you from seeing a major accident occur. Think about it this way: whilst a share may at times offer fundamental value and the business strategy may be convincing, a look at the chart may reveal underlying price action that is not in line with the prevailing positive sentiment at the time.  

A great example of this is local stock, Discovery Holdings (DSY). Whilst the fundamental thesis attracted the attention of both the institutional and retail community with it’s then-to-be-launched bank, our long term technical review uncovered some ‘technical red flags’. At the time (18-October-2018), with the price trading at R154.40 we noted a break of the 16-year incline support where our comment was as follows: “Discovery: ultra long term trend has been up. In 16 years we’ve seen the share go from R6 to R190. Technically, this trend is being breached, with the MACD & RSI diverging. China (Ping An) story + new bank. Good STORY but watch the chart too. Also premium to embedded value.” While the price hovered around these levels for a short while, we maintained our long term technical view that the technical risk-to-reward on the long side remained unattractive. Over time we saw the price slowly drift lower as the market factored in the poor SA economic environment as well as the share’s high valuation. During January 2020, a major catalyst was the breakout of the Covid-19 pandemic which saw the price plunge to a low of R54.50.  

DSY Monthly Chart

DSY Monthly Chart Follow-Up

Take Sasol, another popular share and large holding in the local market which came under our review in November 2018 and where the technical setup flagged the potential downside. Here, we noticed the formation of a multi-year head and shoulder pattern and the risk of a downside break of the 14-year channel. Fast-forward and we saw the price take a massive knock from over R430 to a multi-year low of R21, driven by a plunge in oil prices and concern around the company’s prospects, including it’s balance sheet. The identification of this risk may have helped protect capital by alerting the trader to either sell the share or avoid entering prematurely.

SOL Monthly Chart

SOL Monthly Chart Follow-Up

Our final example is on the long side, where the monthly chart served as a guide to identifying potential upside in Impala Platinum on a long term basis. Despite the fact the negative news continued to plague the platinum sector into late 2018, our review and perspective of the monthly chart helped uncover a potentially favorable risk-to-reward scenario. Sitting on a 25-year support at the time, the share price appeared ripe for an entry at around R19.26, a level which coincided with the share’s multi-year downward channel. While we expected the price to move higher, it surely surpassed our expectations on the long side by appreciating 800% off these lows. The risk here was that without the chart, we may not have been able to identify the potential for a significant gain.

IMP Monthly Chart

IMP Monthly Chart Follow-Up

Each day, the Sharenet team scours the market for opportunities from both a fundamental and technical standpoint, using world-class technology (including technical charts) as tools to determine the risk and potential profit opportunity for both short term and long term traders and investors, with frequent communication to existing clients about potential profit-making opportunities. If you’d like help “Turning Patterns Into Profits”,pleaseget in touch with the Sharenet Securities Dealing Desk today on (021) 700 4800 or send us an email at Alternatively, you may fill in the form below and we will get in touch with you.

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Lester Davids

Investment Strategist

Lester Davids graduated from the Cape Peninsula University of Technology with a National Diploma (Internal Auditing) in 2006. He has worked as a Risk Management Consultant for Old Mutual's Group Schemes Division and as Internal Auditor for multinational professional services firm Deloitte. At Unum Capital he was responsible for in-house tactical and strategic technical analysis research which largely included idea generation for the trading desk as well as the group's client base. In 2020 Lester joined Sharenet Securities fulfilling the role of Investment Strategist responsible for multi-asset class research in both local and offshore markets.