Traders’ Mistakes Provide Opportunity

By ,

Editor’s note: Murray Dawes is the editor of Alpha Wave Trader, a short-term trading service that trades stocks and indices from the long and short side. He is filling in for Harje while he is away overseas.

Notre Dame destroyed? Surely not.

I think the whole world will mourn the demise of that magical building. My mind is immediately flooded with mental images of walking hand in hand at night, lost in young love, traipsing across the Seine towards Notre Dame.

So clichéd, but for me a cherished memory.

I just watched a short video of Parisians singing Ave Maria as they watched it burn. It was incredibly touching. It would be like watching the Opera House burn to the ground for Australians, except the Notre Dame cathedral was built from 1160 and took nearly a hundred years to complete. That sort of history is not something Aussies can contemplate. Very sad.

Now on to less important things.

I will be writing about my technical analysis approach to markets for people who are interested in such things and want some help with their own approach.

Last week I began explaining some of the technical analysis patterns that I look for before entering trades and gave you a few characteristics that they display. This week we will really get stuck into some of the theory so that any of my future articles about potential opportunities make complete sense to you.

Let’s revisit the widening distribution that I began explaining to you last week and delve a bit deeper into it.

Free report: Aussie stock picker, Sam Volkering (with gains as high as 1,431% in the last 18 months) reveals what he believes are his next four big potential winners.

The widening distribution

Money Morning

Source: Port Phillip Publishing
[Click to open new window]

This is the basic pattern that develops across all markets and in all time frames. When you don’t understand it, you are at the mercy of it because it wrongfoots the bulls and the bears. It can come in a million different forms, but the overriding characteristics remain the same. A series of false breaks around a central point of control that eventually resolves itself after traders are fatigued. The size of the false break has a relationship to the initial size of the range with the level 25% outside and 61.8% (Fibonacci level) outside being major support and resistance.

There is an added characteristic that I haven’t mentioned yet. There are levels within the range that also provide support and resistance. Those levels are incredibly important because they also describe the areas where prices often find support and resistance within trends.

The key levels within a range that often see a reversal in prices back to the point of control are 12.5% to 25% and 75% to 87.5%. I will show you a great example that has been forming for the past year in the E-mini S&P 500 futures.

E-mini S&P 500 futures weekly chart

Money Morning

Source: CQG Integrated Client
[Click to open new window]

In the above chart I have numbered each time prices reversed in the buy and sell zones within the range and returned to the point of control. As you can see, there were 10 times that it occurred. If you were expecting such things to occur, do you think that knowledge might have come in handy?

Also, as an aside, notice that prices were rejected from the level 25% above the range before plunging all the way to the level 61.8% below the range. That level is an incredibly important level. Notice how sharply prices reversed from the level 61.8% below the range. The S&P 500 has been in a strong rally for years, so it does make sense that the final support zone of a distribution within a larger uptrend has a lot of people lined up ready to buy.

Think of it in terms of mean reversion. If the trend is up, but the market is consolidating and seeing weakness, you would want to buy when the market is at its weakest point within the short-term structure. That point is 61.8% below the range. If the market is going to continue trending to the upside, it will usually start with a big false break to the downside that shakes traders out of their long positions and entices bears to get short.

I will show you over the next few weeks that the key levels I gave you above of 12.5% to 25% and 75% to 87.5% are incredibly important. They are the only retracement levels that I focus on. They can be used when looking at waves within a trend to work out where the market often changes direction. They happen so often that it is quite difficult to see just how prevalent they are. Almost like not seeing the forest for the trees.

The reason why the 75% to 87.5% retracement level is so powerful is that you can get great risk/reward characteristics when placing trades in this zone.

As I said last week when describing some of the key insights I have made in my years of observing markets, prices constantly revisit old ground to shake traders out of their positions. That applies whether the market is trending or range bound.

If a large up-wave occurs and traders get bullish and start buying, expecting the trend to continue, how do you think most of those traders would feel if prices retraced 87.5% of that wave? Most of them would have run away or would be feeling under a lot of pressure with out of the money positions unless they had taken part profit while they were in the money.

Expectations would be that the whole wave would be retraced and that potentially prices would continue going down. There wouldn’t be many traders who had bought the previous up-wave who would be in the money. Only the traders who had bought the very beginning of the up-wave and there wouldn’t be many of them.

If prices then rallied from that zone back to the high of the previous wave and broke out to new highs, I assure you there would be plenty of traders who had been shaken out of their positions who would be spitting chips. They would possibly even try to buy the breakout in the hope of catching the move higher, only to end up being caught in the false breakout of the high and shaken out once again.

When you don’t understand the underlying characteristics of how prices move you end up as a ragdoll tossed around by the market and your own emotions.

The best time to enter a trade is when other short-term traders are being shaken out of their positions. All the characteristics of price action that I will show you over the next few weeks, will ultimately be based on describing when other traders are being shaken out of their positions and I will be showing you how you can enter trades that have a stop-loss at a point where you should be proven wrong.

If you want to check out my regular videos that I release each Monday for Money Morning subscribers, you can find them here. On Monday I had a look at a few rare earth stocks that have all seen strong buying interest over the last few weeks.


Murray Dawes,
Editor, Alpha Wave Trader

PS: Revealed in our brand-new Money Morning report: ‘Three Small-Cap Stocks to Own Right Now’. Click here to claim your copy of the free report.

About Murray Dawes

Murray Dawes is the Editor of Pivot Trader and contributing Editor at Money Morning. He was one of five, from 5,000 applicants, chosen for a graduate position with the Swiss Banking Corporation — now part of banking giant UBS. The bosses quickly cottoned on to his potential and pushed him…

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