Importance of Dark Cloud Cover Pattern with Trade Examples

DARK-CLOUD COVER

Our next reversal pattern is the dark-cloud cover (see Exhibit 2.22). It is a dual-candle pattern that is a top reversal after an uptrend or, at times, at the top of a congestion band. The first day of this two-candle pattern is a strong white real body. The second day's price opens above the prior session's high (that is, above the top of the upper shadow). However, by the end of the second day's session, the market closes deeply within the prior day's white body. The greater the degree of penetration into the

Exhibit 2.22. Dark-Cloud Cover

THE IMPORTANCE OF PROTECTIVE STOPS

One of the more powerful aspects of technical analysis is that it can be used as a mechanism for a risk and money management approach to trading. Defining risk means using protective stops to help protect against unanticipated adverse price movements.

A stop should be placed at the time of the original trade, since this is when one is most objective. Stay in the position only if the market performs according to expectations. If subsequent price action either contradicts or fails to confirm these expectations, it is time to exit. If the market moves opposite to the chosen position, you may think, "Why bother with a stop? It is just a short-term move against me." Thus, you stubbornly stay with the position in the hope the market will turn in your direction. Remember two facts:

1.  All long-term trends begin as short-term moves.

2.  There is no room for hope in the market. The market goes its own way without regard to you or your position.

The market does not care whether you own it or not. The one thing worse than being wrong is staying wrong. Lose your opinion, not your money. Be proud of the ability to catch mistakes early. Getting stopped out concedes a mistake. People hate to admit mistakes since pride and prestige get involved. Good traders will not hold views too firmly. It has been said that famous private investor Warren Buffet has two rules:

1.  Capital preservation.

2.  Don't forget rule 1.

Stops are synonymous with rule 1. You have limited resources. These resources should be maximized, or at a minimum, preserved. If you are in a market that has moved against your position, it is time to exit and find a better opportunity. Think of a stop as a cost of doing business.

Since so much of the Japanese candle terminology is grounded on military terminology, we will look at stops in this context as well. Each trade you make is a battle—and you will have to do what even the greatest generals have to do: Make temporary, tactical retreats. A general's goal is to preserve troops and munitions. Yours is to save capital and equanimity. Sometimes you must lose a few battles to win the war. The Japanese have a saying, "A hook's well lost to catch a salmon." If you are stopped out, think of it as you would a lost hook. Maybe you will catch your prize with the next hook.

white real body, the more likely this is a top. Some Japanese technicians require more than a 50-percent penetration of the black session's close into the white real body. If the black candle does not close below the halfway point of the white candlestick, it may be best to wait for more bearish confirmation following the dark-cloud cover. In some circumstances I will also view it as a dark-cloud cover even if the open is over the prior session's close instead of the prior session's high.

The rationale behind this bearish pattern is readily explained. On the first session of the dark-cloud cover, the market is ascending with a strong white candle. This is followed by a gap higher on the next session's opening. Thus far, the bulls are in complete control. But then the whole technical picture changes as, on the second day of this pattern, the market closes not only beneath the prior close, but well within the prior day's real body, offsetting much of the gain of the first session. In such a scenario, the longs will have second thoughts about their position. Those who were waiting for selling short now have a benchmark to place a stop—at the new high of the second day of the dark-cloud cover pattern.

Importance of Dark-Cloud Covers Include:

1.  The greater the penetration of the black real body's close into the prior white real body, the greater the chance for a top. (If the black real body covers the prior day's entire white body, it would be a bearish engulfing pattern rather than a dark- cloud cover.) Think of the dark-cloud cover as a partial solar eclipse blocking out part of the sun (that is, covers only part of the prior white body). The bearish engulfing pattern can be viewed as a total solar eclipse blocking out the entire sun (that is, covers the entire white body). A bearish engulfing pattern, consequently, can be a more meaningful top reversal. If a long white real body closes above the highs of the dark-cloud cover, or the bearish engulfing pattern it could presage another rally.

2.  During a prolonged ascent, if there is a strong white day that opens on its low (that is, a shaven bottom) and closes on its high (that is, a shaven head) and the next day reveals a long black real body day, opening on its high and closing on its low, then a shaven head and shaven bottom black day has occurred.

3.  If the second body (that is, the black body) of the dark-cloud cover opens above a major resistance level and then fails, it would prove the bulls were unable to take control of the market.

4.  If, on the opening of the second day, there is very heavy volume, then a buying blow off could have occurred. For example, heavy volume at a new opening high could mean that many new buyers have decided to jump aboard ship. Then the market sells off. It probably won't be too long before this multitude of new longs (and old longs who have ridden the uptrend) realize that the ship they jumped onto is the Titanic. For futures traders, very high opening interest can be another warning.

Just as a bearish engulfing pattern can be resistance, so too the highest high of the two sessions that formed the dark-cloud cover should be resistance. This is shown in Exhibit 2.22.

A dark-cloud cover in Exhibit 2.23 stopped a rally. The day after this pattern, Intel pushed up and failed near the high of this pattern near $71. The stock stalled again near $71 a week and then two weeks later. Observe how Intel poked its head above the resistance line on January 20, but the failure to close over the resistance keeps resistance intact.

Exhibit 2.23. Intel-Daily (Dark-Cloud Cover)

Exhibit 2.24. Wolverine Tube-Daily (Dark-Cloud Cover)

In Exhibit 2.24 we see a rally that began mid August. On August 22 the stock gapped higher and formed a hanging man session, but its potential bearish implications were not confirmed the next session since the next day's close was over the hanging man's real body. The stock had a final push with a gap higher opening on August 28 at $43.25. On that opening it looked fine from the bulls' perspective. It closed down at $40.62 by the end of that session. This completed a dark-cloud cover since the black candle pulled well into the prior session's white real body.

While this was a well-defined dark-cloud cover, from a risk-reward perspective it may not have been a good place to sell. This is because the dark-cloud cover was finalized on the close of the second day of the pattern, and by then it was well off its highs. Using the concept of the dark-cloud cover as potential resistance, one could wait for a bounce to near the dark-cloud cover to sell (assuming this occurs). In early October a rally to the high of the dark-cloud cover showed signs of running out of steam with a small black real body and

Exhibit 2.25 NASSDAQ Composite-60 Minutes (Dark-Cloud Cover)

the same highs for four consecutive sessions at $43.25. The decline from early October ended with a hammer that confirmed a late September support area.

Dual bullish engulfing patterns at 1 and 2 in Exhibit 2.25 underscored the solidity of support in the 3275/3250 area. The rally from the second bullish engulfing pattern hesitated at the dark-cloud cover. Immediately after this pattern, a white real body marginally penetrated the dark-cloud cover's resistance (shown at the horizontal line). While not a decisive breakout, it was a close above resistance and as such a positive signal.

Exhibit 2.25 reflects the importance of adapting to changing market conditions. To wit, the breakout above resistance at the first dark-cloud cover puts the trend higher, but the next session our market view changes from positive to a more cautionary one. Why? Because the day after the breakout a black candle completed another dark-cloud cover. This second black candle reflected an inability by the bulls to hold the new highs.