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Lessons from the Pros

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Market Traps, Novice Traders Beware

Tue, Oct 27 2009, 10:14 GMT
by Sam Seiden

Online Trading Academy

There is a hand signal we use on the trading floor. The signal is to put your hand to your throat like your choking yourself. The name for this signal is "hung." Not a pretty visual I know but its meaning is just as uncomfortable. A trader will do this when they are stuck in a very bad losing position. Most often, it was someone buying right into supply (resistance) right before price collapsed, or selling short right into demand (support), right before a strong rally. Whether the action was a mistake or simply foolish trading like they do in Foolsville, the result can be catastrophic which is where the floor trading hand signal, hung, derived its name.

A more common name for this in the world of technical analysis is the Bull Trap and Bear Trap, two of my favorite market opportunities. Before diving in and learning what this looks like on a chart and how we trade this, it is important that you understand how to properly think this setup.

The Logic

When there is a news or economic event that invites the masses into the market to buy and price happens to be into an objective supply level with a significant profit margin below, we have a Bull Trap scenario. What happens is that an above average number of buyers buy after a rally in price and right into supply with plenty of room for price to fall below. So, once the last buyer buys, the masses are stuck buying the high price, no more buyers, price collapses. Most of those buyers now have to sell for a loss which only helps price slide lower. It was, however, the combination of the positive event and price being at a level where supply exceeds demand that was key. An "event" can be in the form of news or a popular chart pattern such as a breakout, for example. 

The Setup

The charts above are the S&P; small time on the left and a weekly chart on the right. This picture was taken during one of our XLT - Stock Mastery sessions. The topic of that session was "Advanced Bull and Bear Trap Strategies." On this day, a Bull Trap trading opportunity was at hand; here is how it worked. Notice the chart on the right, the S&P, was trading right into the origin of that gap down from last year. Keep in mind that gaps represent the picture of a strong supply and demand imbalance. In this case, it was a gap down which meant that supply exceeded demand. Knowing where price is at in the larger time frames will always be a big help when short term trading or swing trading. It lets us know which side of the market is carrying the best odds. Knowing that the S&P was reaching some larger time frame supply, let's now focus on the smaller time frame chart on the left. The supply level shaded in white is the area that represents the origin of that gap. The circled area on the chart is a high that is higher than the prior day's high, here is where the Bull Trap begins. When price breaks out past that prior day's high, the majority of market speculators are going to become very bullish because of the breakout. This is a trap because what these masses don't realize is that price is breaking out into a price level where supply is likely much greater than demand. Instead of jumping on that novice bandwagon, it is typically a better choice to be the seller to these buyers as they are falling for a trap. The demand level below was the first target; the trade worked as planned. As always, had it not worked, the risk was small and as I always say, proper risk management is the key to long-term success. 

The Rules

• When a significant event invites buyers into the market and price is at supply and you have an appropriate profit margin below, sell short.

• When a significant event invites sellers into the market and price is at demand and you have an appropriate profit margin above, buy.

Mastering the Mental Side

If you own a car dealership and are in the business of selling cars for profit, who do you want walking through your doors? Choice A: people who work at other car dealerships and sell cars. Choice B: people who are buying a car for the first time. Of course, we are going to choose choice "B." People who work in the car industry know the real value of cars which means it will be harder to sell to them at desirable prices if you're the dealer. The new car owner knows much less about the true value and will also give in to emotions such as greed. This individual will bring your dealership a much higher profit. Make sure you are trading with market speculators that have no idea what they are doing. Sell to them when price is at a level that you know is too high. Buy from them when price is at a level that you know is too low.

Published on  Tue, Oct 27 2009, 11:35 GMT