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Decoding Failure Swing Patterns in Trading

12 Dec 2023

Introduction

A failure swing pattern is a phenomenon that occurs when the price and the relative strength index (RSI) diverge from each other, showing a loss of momentum and a possible reversal of the prevailing trend. The RSI is a widely used momentum indicator. It measures the price movement's speed and strength of the price movements on a scale of 0 to 100. The RSI can also show the overbought and oversold conditions of the market, which are usually above 70 and below 30, respectively.

The failure swing pattern can be observed in different markets and time frames, such as stocks, commodities, currencies, indices, etc. For example, the chart below shows a bearish failure swing pattern in the Nifty 50 index on a daily time frame:

How to Identify Failure Swing Patterns?

You can identify this pattern only if you understand the concept of divergence and the criteria for the bearish and bullish failure swing patterns.

Divergence is when the price and the RSI move in opposite directions. It indicates a disagreement between the price action and the momentum. It can be positive or negative, depending on the direction of the price and the RSI. 

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Positive divergence occurs when the price makes lower lows, but the RSI makes higher lows, suggesting a possible bullish reversal. Negative divergence happens when the price makes higher highs, but the RSI makes lower highs, suggesting a potential bearish reversal.

However, divergence alone is not enough to confirm a reversal, as the price may continue to move in the same direction for a while despite the weakening momentum. That is why we need the failure swing pattern, which adds another layer of confirmation to the divergence signal.

The criteria for a bearish failure swing pattern in an uptrend are as follows:

  • The price makes a higher high, but the RSI fails to make a higher high, creating a negative divergence.
  • The price dips below the previous swing low, but the RSI stays above the last swing low, creating a lower low in the price but a higher low in the RSI.
  • The point where the RSI falls below the previous swing low is called the fail point and triggers a sell signal.

The criteria for a bullish failure swing pattern in a downtrend are as follows :

  • The price makes a lower low, but the RSI fails to make a lower low. This creates a positive divergence.
  • The price rises above the previous swing high, but the RSI stays below the last swing high, resulting in a higher high in the price but a lower high in the RSI.
  • The point where the RSI rises above the previous swing high is called the fail point and triggers a buy signal.

Factors Affecting Failure Swing Pattern

The factors that influence the validity of the failure swing pattern are :

  • RSI settings: The default setting for the RSI is 14 periods. However, you can adjust it according to your preference and trading style. A shorter period will make the RSI more sensitive and responsive but more prone to noise and false signals. A longer period will make the RSI smoother, more stable, and more lagging and delayed.
  • Market conditions: The failure swing pattern works best in trending markets, where the price and the RSI show clear and consistent swings. In sideways or choppy markets, the price and the RSI may not diverge significantly or form clear fail points, making the pattern less reliable and valid.
  • Volume: It is an important indicator that can confirm or deny the failure swing pattern. A high volume at the fail point can indicate a strong and genuine reversal, while a low volume at the fail point can indicate a weak and false reversal.
  • Confirmation signals: They are additional indicators or tools that can support or reject the failure swing pattern. For example, a break of a trend line or a support or resistance level at the fail point can reinforce the reversal signal, while a bounce or a rejection at the fail point can negate the reversal signal.

Conclusion

The failure swing pattern can occur in both uptrends and downtrends, and it can signal a bearish or bullish reversal, depending on the direction of the divergence and the fail point. The fail point is the point where the RSI breaks the previous swing high or low, confirming the reversal and triggering a trade signal.

 

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