Technical Tuesday - How To Play A Fakeout

She's gotten rid of her newbie trader jitters.  She has "let the game come to her".  And then, she sees it.

It's a triple top breakout.  But it's not just any triple top breakout... it's one that followed 7 major precursors to a buy signal, and everything she'd been taught to watch for in the financial market says "all systems are go!"


The background noise of her two children arguing fades as her focus moves to the volume coming into the trade, confirming that there are institutions pulling the trigger on the same exact trade she's making. 

She hits "submit" and off she goes!

She experiences the feeling that can only be understood by other meticulous traders.  Rewarded for her studies and courage, she watches her account value grow rapidly after the market rips through that pesky resistance level to new highs. 

She isn't done!

She sets her stop loss, proving to herself that she's not here to gamble the kids' college funds away, but to run a trading business.  She's using responsible risk management.

Days pass and she has repressed her giddiness at the new market highs, and she's ignored the pain we all pretend not to feel when our trade is off its highs but still profitable.  Everyone knows you can't sell at the top.  Besides, a new resistance level must form if we're going to see the next breakout.  When this happens, the old resistance should become the new support level. 

It's 8:29 a.m. eastern time.  She's just dropped both children off at school and is waiting on line in the Dunkin' Donuts drive thru.  Talking with her friend, she jokes on the phone how Dunkin' Donuts must lace their coffee with speed, when suddenly her friend's voice fades and she hears the jobs report announced over the radio. 

What she heard was "blah blah blah numbers numbers blah blah blah and S&P Futures are tanking, in fact European markets are too."

She's felt this before in the pit of her stomach, but it was before taking the trading course she bought online.

The clock strikes 3:00 p.m. and, after recovering some of the initial losses, the market has been on a slow bleed all day long.  She watches as the market rips through that new key support level like shrapnel.  It's clear the market has a new agenda. 


Not a single tear is shed.  Not even close.  She went from a proud hero to a humble person deciding to take her loss before the stop loss price is even hit.  She knows the fate of the stock market.  But she remains strong.  The only question she has now is: "Where did I go wrong?"


Taking Your Licks

I've been a trader since I was 17 in 1995.  I've worked with quite a few traders who I'd say were among the best on Wall Street, where I managed money for myself, institutions and retail accounts.  Surrounded by traders, many of whom were only trading their own fortunes, I would seek out the answer to this mom's question.  I did it every time I felt the frustration that she was left feeling.  

The question is like a credit card company asking where they went wrong because some of their customers defaulted on their debts.  It's like a retail store asking where they went wrong because some of their merchandise was stolen off the shelves. 

Sure, there are measures that can be taken to reduce the loss, but losses simply can not be avoided.  And the "fake out", as traders like to call it, is the number one problem that I'd say is unavoidable.  

I ended the story, above, before we found out if she actually even did "go wrong".  But I'll tell you what most traders fail to do in this scenario, and that is to get on the other side of the trade immediately.

There are caveats, of course.  Those caveats have to do with all of the different possible variables of this hypothetical scenario.  So instead of distracting from the point by flooding you with those caveats, let's use today's stock market situation (which is actually where I pulled the intraday charts from, above). 


Today's Market

Before the stock market made a healthy move higher, the SHORT-TERM traders saw their SHORT-TERM buy signals.  Of course, the short-term trend can be up while the intermediate-term trend is down while the long-term trend is up.  (Mix the combination any way you chose, and the point remains that there are trends within trends.)

While short-term (days to weeks) traders saw confirmed buy signals, intermediate-term (weeks to months) traders saw precursors to the buy signal of their most important indicators (which is a discussion for another time).  We saw buy signals in indicators that typically precede the true intermediate-term buy signal.  While we didn't get a confirmed buy signal from the main intermediate-term indicator, we saw buy signals in indicators that typically precede the true intermediate-term buy signal.

STOP HERE.

This is the key to this entire article:  The more evidence people see that the market is likely to move in one direction (in this case, up), the more money is going to go into that trade.  In other words, there are more bets taken that the prevailing trend will continue.  But never forget the flip side of that: If the trend does not continue, but it instead reverses, there is that much more stock that will be exited, thus putting that much more price pressure on the opposite direction!

If you see seven precursors to a breakout, then the rest of the world is seeing many signs of strength too.  Those people (or institutional computers) are also setting stop losses to exit their positions in the event they are wrong.  That causes a sharp counter-move.

The Question:  Will this mean a loss or a gain?

Let's look at this from another angle.  There are bearish traders out there who saw the market break above a resistance level.  Those traders sat on the sidelines hoping and praying that the penetrated resistance level would not hold as a new support level.  Once they see prices come back below that level, they will "jump ugly" on the short side because they know all those bulls who bought stock will have to limit their losses and sell, thus pushing the short-sellers into profitability. 

Look below:

The chart of the S&P 500 shows the entire sequence of events I've just described...


The first thing we have to do is identify the resistance level that needs to be penetrated.  Below, that resistance level is highlighted in yellow.


It's important to find confirmation that the resistance level is an important one.  You can see a second yellow circle showing where the market tried to move above the first attempt, but couldn't do it.  In fact, the market closed that day all the way at the low of the day -- the bottom of that red candle.

This tells us that the market said "NO WAY - Back on up!"  If bulls can push past this level, it will be an important sign.


We draw a line, but we want to see if there is any historic significance of this price level.  It even makes sense to go back several years. 


We won't go that far, but let's zoom out a bit and extend the horizontal line.



There it is.  In the beginning of this year (and later, slightly higher) the market saw this as an important level.  Let's zoom back in to today's market...


We have a triple top breakout here, which is highlighted with the pink circle.  This is the breakout you saw in the intraday charts at the top of this article.


But, as you can see, the Fed and several manufacturing numbers, along with negative words from Goldman Sachs, pushed the market way down with a very bearish candle (day's trading range).  When you see such a big down day, especially when it closes at or close to the low, you should expect more stock market weakness to come.


But add to that fact that there was lots of anticipation built up before the upside breakout.  There were several intermediate-term indicators doing what they often do before it occurred.  There were obviously lots of bulls with lots of money pushing the market higher -- but those institutions were also ready to exit their positions as soon as they started losing money!

And that's what makes support and resistance levels so important!  The above chart is a bear's dream.  And not just any kind of dream!

Bears want the market to go down.  If there's a line drawn in the sand and bulls are going to sell if that line is crossed, that means lower prices... and bears know it.  For the bears to enter their short positions, they must enter that position by first SELLING stock.  So you have two forces at work pushing prices lower.

The pattern was an intermediate-term pattern -- it took over a month to build.  The most important intermediate-term indicator never confirmed that it was time to get bullish and buy stocks in this case.  If it had, I'd say it was not a good time to get bearish. 

But when you see a level established as being an incredibly important level to break through, as you see in the light blue line above, and that breakout turns out to be a fakeout, you can sit there and lick your bull's wounds, or you can switch teams and get that money BACK!!

It's much less likely that the market will now turn around, fighting off all the new bears coming in as well as those bulls selling to limit losses and advance. 

But if it does somehow advance back through that key level again, soon, that makes the level even more important.  It can be played, once again, as a bullish position. 

This may seem very stressful.  And there's a good reason for that -- it is.   Every business has its stressful moments.   But when you see these occurrences that don't happen very often, you can stay and fight.  And, if you hang in there, you'll most likely be rewarded big time.