Lesson two of my Purple Crayon series focuses on breakouts, fake-outs and how to discern between the two.
Let's talk about the S&P500's break over the "double top," which had been in place around the 1,345 level. As widely noted, earnings, a somewhat suspiciously sanguine Fed presser and general market animal spirits have taken the only stock index that matters about 1 percent over the peaks of February and early April. What does this mean? To this trader, it means a long-side trade set-up in the S&P with the following guidelines: Get long here and stop out if and when we close somewhere in the 1,330s, especially on large volume. This is barring a large gap to the downside that gives traders a decent-probability shot at a gain with a couple percent as a stop.
In traderdom, there's nothing that brings a smile to your face faster than a shot at "unknown but large upside with relatively low risk."
Since I'm incapable of being entirely cheery, I use some charts of recent market leaders to illustrate a more esoteric trading law: The Prayer of the Bad Trade. The Prayer of the Bad trade states that resistance at previous highs in a stock is created by those who got near the previous tops waiting to get back to even before selling. As in, "If I can just get back to even on that Agrium (AGU) I bought the last time I convinced myself the Chinese couldn't live without American fertilizer, I'll sell the stock and never do something so reckless again." After the collapse of 2007 and '08 and the rally since March '09, there is no shortage of charts where previous bag-holders are looking to get out whole and move on to other investment strategies.
I used Agrium and Exxon (XOM) as my examples here, but there are many. Can I be sure my hypothetical trader is on the other side of buyers anticipating a breakout creating the double tops? Nope. But I know double tops exist and I've gotten dozens, if not hundreds, of emails over the years from traders begging me to assure them they'll get back to even.
The lessons are simple: 1. Markets or stocks breaking above recent highs set up terrific risk/reward trading possibilities. 2. Anticipating a breakout by getting long ahead of a definitive move over those prior hides is a sucker's game. Always know who's on the other side of your purchase or sale of a stock; if it's a group of people desperate to get out of a position whole, it's best to wait until that selling supply has dried up before you jump in long.
Once again, trading isn't a game of perfect. It's a game of taking positions when the odds are on your side. A definitive breakout is exactly such a situation.
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