PeoPle

PeoPle

J. C. Parets

www.tradersonline-mag.com 11.2014

how i trade False signals

J. C. Parets is the founder of the asset-management company Eagle Bay Capital based in New York City (contact: info@
eaglebaycapital.com). He is a 10-year veteran and well-known Market Technician. JCs work has been featured on CNBC,
Bloomberg, Fox Business and Business News Network. He is often quoted in the Wall Street Journal and online media, as
well as on his website www.allstarcharts.com and on Twitter @allstarcharts where he was recently named by Business
Insider as one of the top 100 Finance People to follow on Twitter. Currently, he is in the process of founding a hedge fund of
his own, which is managed on the basis of traditional price analysis and sentiment. Marko Graenitz interviewed him on the
phone stay tuned for some exciting insights into the mindset and trading of one of the leading technical traders as of today.

TRADERS: How did you get into trading?

in companies, some people didnt really know what they

Parets: I grew up in Miami, Florida. Now and then, my

were actually doing. While stocks and their companies

father would trade traditional investment funds (mutual

were being analysed from a fundamental perspective, at

funds). In the late 1970s and early 1980s I first found out

the end of the day it was mainly all about selling certain

about it. At that time, though, things were completely

products to the companys clients. My sense was that the

different on the markets. Interest rates were very high,

analyses did not generate any specific added value.

well above ten per cent, and investing in bonds was really
good relative to the stock market. I then went to college
in Connecticut.

TRADERS: Is that why you moved away

from fundamental analysis?
Parets: Yes, I decided to focus on technical analysis which

TRADERS: What did you learn during those years?

seemed advantageous to me simply because you can use

Parets: While at college, I did an internship in the wealth-

technical instruments to directly manage risks. And thats

management department of Merrill Lynch. I had an

what matters in the stock market in general and in trading

interesting time and learned a lot. But I also realised that

in particular.

it was simply too big a company for me. I was still young
at the time and had little experience, but even then I was
surprised to find that, in spite of holding certain positions

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TRADERS: Where did you pick up your knowledge

of technical analysis?

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Parets: I read a lot of books, including the two classics by

F1) False Breakout from rising triangle

Robert Edwards and John Magee (Technical Analysis of

Stock Trends) and by John Murphy (Technical Analysis
of the Financial Markets). Ralph Acampora, too, was one
of the guides who had a profound influence on me during
that time.

TRADERS: How did you know

that you would be able to make it in trading?
Parets: I just put all my energy into it and traded both
my own money and that of my clients. However, I wasnt
really successful all the time. I can well remember, for
example, making several losses when trading options.
But then thats the way the learning curve works. Youve
got to enter the fray, make mistakes and then really learn
from them.

Time and again, price hits the resistance area from below, forming increasingly
smaller downside pullbacks. As soon as prices rise above the resistance, this
will traditionally be interpreted as a long signal. However, if there are no followup orders and the upside breakout movement falters, there is a high degree of
probability of a false signal being generated and prices plummeting.
Source: www.allstarcharts.com

TRADERS: What is your basic trading philosophy today?

Parets: Supply and demand are the cornerstones of any
understanding of the markets. These two quantities are

real world things dont always pan out the way they do

ultimately based on human nature that can be applied to

in the textbook. If the price rises above the resistance

almost everything.

and the bulls seemingly have the upper hand but do not
place any follow-up orders, and the upward breakout

TRADERS: What are your favourite patterns?

movement falters, a false signal is highly likely to be

Parets: Quite clearly, failed patterns.

generated.

TRADERS: Failed patterns?

Could you please explain that to us in more detail?

TRADERS: When exactly would you enter the trade?

Parets: Sure. The idea is simple and plausible: Invariably,

case of Figure 1, Ill achieve that by making the entry as

the market tries to make things as difficult as possible

soon as price crosses the former resistance line from top

for the majority of traders. So when a certain pattern

to bottom. Thats pretty early, but at the same time my

emerges whether its a support, resistance, triangle, flag,

risk is very small and, if successful, I can make a much

head and shoulders, or whatever, it wont work according

higher profit. Great trades have an RRR of 6:1 and higher.

Parets: I try to maximise my return/risk ratio (RRR). In the

to the textbook except in the rarest of cases. After all,

price range rather than at a very precise point. That is the

TRADERS: Why dont you wait for additional confirmation

for example, for the price to cross below the rising triangle
line?

first insight you should have gained as a trader: Do not

Parets: If I were to wait that long, the RRR would be a

use the setups too rigidly but look out for certain areas

lot worse. Of course, the hit rate will then be higher, but

where the signal can be expected.

overall I would probably not do so well with this safer

its not as simple as that in the markets. More often than

not, the setups are more likely to function in a certain

why

version. However, if I already enter at the old resistance

false signals make for such good setups. Lets use the

line above and the false signal does not work (i.e. the

classic breakout from a triangle as an example (Figure 1).

price continues to rise according to the actual breakout),

Time and again, the price will hit the resistance area

Ill only have minimal losses that I dont have to worry

from below, forming increasingly smaller downward

about. But if it does work and the price plummets, I can

pullbacks. This is bullish since the bulls are increasingly

make a really big profit.

The second aspect leads us to the reason

busy breaking the resistance. As soon as prices rise

above resistance, that is traditionally interpreted as a
long signal since this barrier has now been removed. In
principle, this is certainly not wrong. Its just that in the

TRADERS: In Figure 1 you mention that there may be a

rapid movement when a false signal is formed. Whats the
reason for that?

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www.tradersonline-mag.com 11.2014

also works vice versa for falling triangles (Figure 2) as

F2) False Breakout from Falling triangle

well as for many other price patterns.

TRADERS: Does that mean

that false signals can function universally?
Parets: Yes, exactly. Thats what makes this so interesting
and helps to find many good setups. Lets take another
example, the classic head and shoulders pattern. Here,
the key area is the neckline. If price falls below the neck
line, there will be a classic short signal (Figure 3). Things
will be getting interesting if this pattern fails (Figure 4).
Again, it is not unusual here for a quick countermovement
Similarly to Figure 1, Figure 2 shows the emergence of a false signal in the case
of a falling triangle.

to occur in the opposite direction, a movement which will

provide excellent RRRs. A wonderful large-scale example

Source: www.allstarcharts.com

of this was found in 2010 in the S&P 500 (Figure 5). After
the formation of a classic head and shoulders pattern that
was seen by more or less everybody at the time, there
Parets: This is the key benefit to be derived from trading

was a downward break of the neckline at the end of June

false signals. If the trade works, very fast movements

2010. I well remember how this signal caused reputable

may occur generating excellent results for the trader. The

analysts to announce the beginning of a bear market.

cause of this rapid movement is obvious: Overcoming

the resistance has caused most short traders to leave

TRADERS: But things turned out differently...

the market and they are now coming back as prices are

Parets: Yes, indeed. Prices were only able to maintain that

falling. In addition, those traders who have speculated on

new-low level for a few days. Thereafter, the market kept

continued rising prices during the breakout movement,

going up. In ten months, the market rose by about 300

suddenly find themselves left behind and need to exit

points, based on the neckline of the head and shoulders

i.e. sell to limit their risk. Its like a trap that has snapped

pattern, i.e. by almost 30 per cent. The risk that traders

shut, and the trader needs to get out quickly, all of which

had to incur for that when crossing the neckline in July,

exacerbates the price decline. Obviously, the whole thing

however, was only about 40 points if the position was

secured below the breakout low. But in my trades I usually
go even further to achieve the highest possible RRR and
set my stop even more aggressively.

F3) classic head and shoulders Pattern

TRADERS: Now thats intriguing and will really be of interest

to many of our readers. How exactly do you go about it?
Parets: Lets take the example in Figure 4. Suppose
the price goes back up to the neckline again after the
downward break. Once the price is slightly above that
level, I can see the false signal as a given and go long.
But I dont place the stop at the low of the previous
breakthrough movement that would be too far away.
Instead, I put the stop almost directly below the area of
the neckline. That way, I have a tiny absolute risk with
relatively enormous opportunity for profit.

The classic head and shoulders formation appears as a top-forming pattern,

indicating falling prices once the price level violates the neckline.
Source: www.allstarcharts.com

TRADERS: Thats right, the RRR is sensationally high in this

case. But isnt it true here that you will constantly be stopped
out as soon as there is the smallest counter movement?
Parets: Well, that will happen now and then. But my
experience has been that the rebound above the

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neckline, i.e. my entry point, is the crucial trigger. After

F4) head and shoulders False signal

all, it will become clear at this point that the previous

signal in this case a head and shoulders short signal
is very likely to have failed. And if that is really the
case, then the upward counter movement should now
occur quickly. If that does not happen and prices fall
below the neckline once more, there will again be a
high risk of the false signal being a false signal

and

prices possibly falling after all, as originally indicated

by the pattern. So once prices are below the neckline
again, they usually fall to the low of the first downward
breakout movement anyway and then even further,
which is why I dont include this area in my stop in the
first place.

TRADERS: That sounds plausible, thank you so much for

the explanation. When do you exit such a trade?

Similarly to the triangle pattern, there may also be a false signal in the case of
the head and shoulders pattern.
Source: www.allstarcharts.com

Parets: I usually scale out of my trades; for example, at

previous resistances and other chart marks. This is where
I often set price targets. Since I only do a few trades at the
same time, I can really focus on the trade management of

TRADERS: Do you use market or limit orders?

the individual positions.

Parets: That all depends on how liquid the stock traded is.
When I trade extremely liquid stocks like Apple or Google,

TRADERS: Do you also use other setups

to find good opportunities for trades?
Parets:

Another

method

is

I usually simply use market orders, but for illiquid stocks

or options I use limit orders.

detecting

momentum

divergences. For this, I just use the 14-period Relative

TRADERS: What does your risk management look like?

Strength Index according to Welles

Wilder, the RSI(14), and look out for
divergences against price. If price

F5) head and shoulders False signal in the s&P 500

develops new highs, for example,

while the indicator does not form
any new highs, there is such a
divergence. Ideally, of course, there
are a divergence and a false signal at
the same time.

TRADERS: How do you find

good setups?
Parets: For one, I look through
hundreds

or

even

thousands

of charts. For another, we have

developed a screener to help us in
our search. Unfortunately, this search
can hardly be automated though.
But since the markets are fractal
and trades based on this can occur
on all time levels, there are basically
enough trading opportunities that

After the formation of a classic head and shoulders pattern, there was a downside break of the neckline at
the end of June 2010 (see arrow). This caused reputable analysts to announce the beginning of a bear market,
but what happened was the exact opposite: The short-term downside breakthrough turned out to be a false
signal and marked the start of a rally.
Source: www.tradesignalonline.com

can be found again and again.

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www.tradersonline-mag.com 11.2014

Parets:

Keep

your

ego

under

control. Or better still, have no ego

at all, when it comes to

playing

the markets. After all, its all about

making money, not about being
right. This is the most important
concept there is. If I need to exit a
trade with an RRR of six or higher
at a loss three times in a row, I just
couldnt care less because I know
that I will hit the jackpot at some
point even if I am right on my trades
in much less than 50 per cent of all
cases. Focus rather on what you can
control, i.e. your risk, and define this
precisely before every trade. Those
who dont do so run the risk of their
short-term trade turning into a longParets: I risk a maximum of one per cent of my trading

term unplanned investment if they miss the exit; that

capital per trade. That is the general consensus and well

is exactly what I have seen with traders plenty of times.

known to many traders. However, thats not the end of risk

Once your trading account is 50 per cent in the red, you

management, but only the beginning. Another important

need to achieve a 100 per cent return just to be break-

aspect is correlations as well as the overnight risk that

even again. Never forget that.

you run as a trader. In theory, anything can happen

I use for each position is twice the Average True Range

TRADERS: Have you ever regretted moving away

from fundamental analysis?

for a period of 14 days, the ATR(14). The aggregate of

Parets: No, absolutely not. Quite the contrary. Analysts

all open positions allows me to assess what risk I take

are usually inclined to follow the herd and very much rely

home. Almost always, the actual risk is, of course, much

on what is conventional wisdom. The reason for this is

lower, but in extreme scenarios double the ATR is quite a

that their career will soon be threatened if they go out

realistic level.

on a limb and turn out to be wrong. So they prefer to say

overnight. To allow that to be measured, the benchmark

what everyone is saying, and when in doubt, they err on

TRADERS: You mentioned that you take into account

correlations. How exactly does that work?

the side of the majority. Thats why it is often interesting

Parets: My goal is for the correlations of my strategies

for example, only four of 25 analysts recommend buying

or, specifically, my positions to be as close to zero as

a particular stock, this bearish sentiment is usually a good

possible. In practice, this will, of course, hardly be possible

indicator for you to take a look at the stock for possible

since somehow the trades are always at least slightly

long trades.

to do exactly the opposite of what most people do. So if,

positively or negatively correlated with each other. But

This will become even more clear when we look

on the whole, its a good goal to keep the correlations at

at how many economists in spring 2014 had expected

least low. When each strategy is profitable, but makes a

interest rates to rise for the following six months. In fact,

profit at a different time, I will have a nice overall capital

all 67 of the 67 experts interviewed did expect interest

development without any large drawdowns. In addition,

rates to rise! And what happened? So far, interest rates

my short trades serve to protect me like a hedge in case

have gone down significantly throughout that period (as

of unforeseen events by generating profits while long

of 17th September 2014). So if all the experts agree, then

positions are recording losses.

Id rather take the other side of the trade. As a trader, I

dont care what others think because I dont have to

TRADERS: Which is the most important concept in trading

you would suggest that beginners should understand?

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justify myself to anyone. This is another bit of freedom

that this profession gives you.