How to Trade the Trader
Quint Tatro
It had already been over an hour, and I could tell the entire plane was getting anxious. We hadn’t moved more than 5 feet as the rain came down and the thunder continued to pound. Barely any air squeaked out of the overhead nozzle, and a toddler two rows in front of me was starting a fit of rage. Over the loudspeaker, the pilot updated us that our status had not changed, that we were still awaiting word on when we would be able to take off. I had experienced an exhausting 24 hours up before this, and I was getting a little frustrated. I had been in this situation many times before and doubted I would make it home to see my family any time soon.
Charlotte was a nice city, but not one where I wanted to spend the night. With my trusty smart phone, I pulled up the local weather map and saw that there was no chance of our storm letting up any time soon. I peered out my window to see at least 20 other planes in a similar situation, with another 10 or 15 waiting in an orderly line behind them on the runway. I made an educated guess that in a matter of minutes we would be pulling back into the airport and be grounded for the evening. My travel experience told me that to secure a hotel room I could not wait and had to act immediately. If I was wrong, a canceled room reservation would be a small price to pay to hedge my gut feel.
Instead of feverishly dialing the phone to call various hotels, bringing attention to what I was doing while sitting in my comfy aisle seat, I loaded up my phone’s web browser, navigated to my favorite travel site, and booked a room at the closest available hotel. No more than five minutes after I had submitted my information, the pilot returned to the loudspeaker notifying us of our new evening plans, grounded in Charlotte. Within seconds, cell phones everywhere were out and being dialed. I listened as frantic travelers attempted to book reservations for only a limited number of rooms available to only the quickest fingers. Other unsuspecting and notably novice travelers looked around to those on the phone as if they too should be doing something. However, most had no clue what was to come next. The follow-up announcement from the flight attendant informed everyone that it was best to proceed to customer service where they could be rebooked for a morning flight and discuss evening accommodations. Yeah, right.
As I suspected, the gate was chaos when I exited the plane. Passengers had questions about baggage, compensation, travel arrangements, and hotel accommodations for the overworked agents. I dodged the madness and went as quickly as possible to ground transportation to find the next available cab. On my way, I passed the customer service counter and saw a line no less than 300 yards long. As I exited the baggage claim area and caught the next cab, I couldn’t help but notice the mad group of travelers congregating around the hotel phone bank clamoring for what was sure to be a steady stream of sold-out hotel rooms. As I told the cab driver my destination, I placed a call to central reservations to start rebooking my own return flight the next morning. Thirty minutes later, after being checked in and now comfortable in my room, I thought about all that had just happened and couldn’t help but recognize the similarities with this experience and trading.
For many years, the vast majority of traders had absolutely no clue about how best to approach the market. Considering that the market went on a 20-year bull run from 1980 to 2000, why should they? Numerous books were written and studies conducted concluding that all an investor needed to do was adhere to a balanced portfolio with a diversified mix of stocks and bonds. When the tech bubble of 2000 popped, the game changed. Slowly, a large group of investors began educating themselves about market movement, many of whom found a home within the world of technical analysis. Although the technology bubble was fierce, it didn’t truly have a lasting effect because only a few short years after the market hit bottom it advanced to new all-time highs. Passive investors were rewarded for their patience, and once again most investors were lulled into a false sense of security. As time progressed, the arguments surrounding passive investing and diversification again took center stage.
But then there was 2008, the real game changer. The precipitous decline caught almost all passive investors and novice traders off guard, resulting in significant damage to their portfolios. A real bear market not seen since the early 1970s sparked a new wave of trading education when a vast majority of investors became fed up with traditional methods that clearly neither worked nor protected them from losses.
Most technical analysis traders did just fine in 2008, and I believe it is why this style immediately became popular among the investor crowd seeking a new way to manage their money. When significant multiyear uptrends were broken in the indices, those adhering to basic technical analysis principals didn’t ask questions, they sold. Rather than hold onto hope that things would turn out okay, technical analysis traders acted on what they knew, protecting themselves from one of the most vicious declines in history. This did not go unnoticed and almost overnight, a flood of new traders studying everything from moving averages to stochastics emerged on the scene.
Rooted in its ability to take advantage of a crowd’s emotional behavior, this seismic shift of the crowd itself has challenged the basic principals from which technical analysis was developed in the first place. With its newfound popularity, you can no longer adhere to only the basic technical analysis principals with the utmost confidence they will work. Like sitting on the plane, you must think one step ahead of the other traders and consider their moves before they make them. The true edge must now be found in trading these traders who are trading these patterns.
Once you have a basic understanding of pattern recognition, along with a proper stop methodology, you need to know how to proceed with a trade-the-trader strategy. An effective phrase used often in trading says from failed moves come fast moves. The concept is simple. When so many are looking for the same move to occur, if this move does not transpire all those traders will be like the airline passengers heading for the exits simultaneously. This creates an incredible opportunity because so many traders must now reverse their positions, thus sparking a significant move that you can capitalize on.
The challenge with this strategy is knowing when to use it and when to refrain. Suppose, for example, that your previous two breakout trades resulted in a loss. It could be easy for you to conclude that these trades were anomalies and the next trade would be a success. However, quite possibly there may be a different issue in play. What if the strategy is no longer to buy breakouts but to short their failure? Meaning that, rather than buy a stock which has moved above a lateral trend line resistance point, the profitable play is to wait for this move to fail, at which point you would short the stock, seeking to capitalize on its decline.
Let’s assume for a moment that rather than take the next breakout trade you wait to see whether it follows the similar pattern of your previous two. When the trade punctures the level you were watching, it does in fact reverse, and rather than be thankful you did not enter this trade, you short the reversal with a stop over the high prior to the reversal. Odds are that what just happened is you capitalized on the misfortune of others who attempted to buy the breakout and were subsequently stopped out.
Let’s discuss a simple example assuming a stock had been trending higher and was approaching a key resistance level around $50. The stock looked and acted healthy, and it was obvious a break above the lateral trend line at $50 would lead to much higher prices. After some consolidating, the stock does in fact break above $50. Shortly after it does, however, it reverses quickly and closes the day below the $50 breakout level. In a traditional technical analysis strategy, you may have bought this break out, subsequently being stopped out once the reversal set in. Consider the fact that you were not the only one who saw this pattern, nor were you the only one who acted on this pattern. The number of traders following this strategy could be significant, thus creating an incredible amount of force once the traditional stop on the failure was taken. However, rather than entering the stock long on the breakout, let’s assume you would move in with a short position, seeking to capitalize on the downward thrust once the breakout failed. Odds favor a significant thrust lower, considering the vast amount of traders needing to reverse their positions once they realize traditional technical analysis did not work. The strategy you would have just used combined traditional technical analysis with the understanding of what the masses were doing and capitalizing on their movement. Once the traditional pattern failed, you made your move with a much higher probability of reward.
I have gained experience trading the trader in a variety of ways. I have gone long patterns that were traditional short setups, and shorted patterns that were traditional long setups. I have done this only after I have seen with my own eyes these basic technical-analysis patterns fail in other stocks I was observing. My trading is now evolving to become much more based on trading traditional pattern failures than it is on trading the traditional patterns themselves.
Figure 1 shows a daily chart of Halliburton from October 2009. I have drawn a key lateral trend line I identified and also noted on the chart what is traditionally a head and shoulders topping pattern. Basic technical analysis tells us that the best way to capitalize on this pattern is to look for the lateral trend line connecting the shoulders to act as resistance, thus moving in with a short on the stock in that area. While on the surface Halliburton looked as if it was rolling over, displaying all the attributes of a traditional technical analysis top, I had noticed peculiar strength in other oil and gas stocks in April 2010 and was curious if Halliburton would follow suit. If it failed, my profits would come from going long Halliburton once the traditional short area was surpassed and those who had been betting against Halliburton were forced to cover. Rather than anticipate pattern failure, I wanted to see this lateral trend line surpassed before I entered the trade. I waited patiently for the break up to occur. On April 20, the break did in fact take place, and I entered a long side trade above $32. Once the stock breached this level, as noted in Figure 2, it shot up quickly, confirming my suspicion that a large group of traders were forced to cover their shorts. The trade became quite profitable in just a few short days.
Figure 1 Halliburton forming a traditional head and shoulders top
Chart courtesy of Worden–www.Worden.com.
Figure 2 Halliburton moving higher after a failed head and shoulders top
Trading pattern failures can be a dangerous game. I do not recommend those who only trade in an anticipatory manner to embark on such a strategy, because you will only be guessing that a specific pattern will not work. It has been my experience that trading pattern failures is best done only after the traditional pattern has in fact failed, thereby giving you a clear level from which to place your stop.
Figure 3 shows a daily chart of IBM on which I have drawn a descending angular trend from the top in January. On April 14, the stock broke above this descending trend and proceeded to follow through with close to a $3 move. However, five trading days later, as noted in Figure 4, IBM abruptly fell back below the descending angular trend, resulting in a failed break. Had you taken this stock long, you would have been stopped out on a move back below the breakout level, resulting in a losing trade. Had you passed on the long rather waiting for a failure to occur, you could have had a significant profit once the stock begun its decline just a few days later. Although I didn’t short this pattern at that time, it was one of the many clues that gave me trepidation over the market as a whole in April 2010, allowing me not only to avoid the subsequent decline but profit in other areas.
Figure 3 IBM breaking a traditional descending angular trend
Chart courtesy of Worden–www.Worden.com.
Figure 4 IBM falling back below the descending angular trend
Chart courtesy of Worden–www.Worden.com.
Trading these patterns is no different from trading basic pattern recognition. You at first identify your target and wait patiently for the opportunity to develop. When it does, you simply move in, setting your desired stop at the point where the pattern would no longer be valid. Because pattern failure typically comes from a reversal trapping those traders playing a basic technical analysis strategy, it makes sense to use a stop at the level that would correspond to the reversal point. In the IBM example, the high on April 19 was 132.28, making this level a logical point at which to place a stop, had you shorted the stock once the failure took place.
I believe that 2009 was a year filled with pattern failure. Most of the time, it was bearish patterns turned bullish that caught unsuspecting shorts off guard and resulted in incredible snaps higher. It was through this that I first began exploring the impact of the number of traders looking to play basic pattern recognition. My findings have altered my strategy ever since.
I do not believe basic pattern recognition should be avoided altogether. There will still be many instances where patterns you see emerging will in fact play out in the manner they traditionally should. You do, however, need to adhere to a level of flexibility that gives you the courage to step in should these patterns reverse and move in the opposite direction. This cannot be based on what you think will transpire or what you feel should occur. This can only be rooted in your observations and pursued through the same trading strategy as you would with any other opportunity.
What separated me from the masses in the Charlotte airport was nothing more than experience. I knew how the crowd would react, and I knew the only way to ensure my overnight sanity was to move one step ahead of the crowd’s actions. I am sure others did the same, and they were the ones occupying the other rooms. I was not alone in my thinking, but I was in a much smaller group and therefore able to take advantage of the situation rather than be directed by it. Trading is no different, and the more that flock to basic technical analysis, the more important it will be to be moving one step ahead of the crowd seeking to profit from the failure of these patterns.
As you pursue your trading path, it is imperative you first become familiar with basic pattern recognition. Only through this solid understanding of the basics will you have the confidence and ability to explore other opportunities. Do not become overwhelmed by the thought of trading the trader, but do understand that you are not alone in your pursuit. To truly succeed, you must elevate your game above others and seek to capitalize on where their education ends.