Retail traders abandoned the markets in the last three years, and there are few signs they'll return anytime soon. The latest numbers from the discount brokerage houses confirm that the exodus continues unabated, and this marks a sea change in the way market survivors will do business.
You know these former traders very well. They're the relatives who whispered hot tips in your ear during weddings, and next-door neighbors who rode Cisco (CSCO:Nasdaq - news - commentary - research - analysis) to the sky and back down again. They're also the daytraders and board slugs who thought the market was printing money with their names on it.
Recently, RealMoney's James De Porre pointed out how trading now pits professional against professional. He rightly wondered how the new playing field might reduce or eliminate the edge that's kept us in the game through these hard times. I thought I'd add my two cents and outline my take on this market.
Some believe technical analysis has failed in this brave new world, but that's not quite true. In fact there's a real disconnect when it comes to understanding the power of the price chart and its many limitations. Technical analysis gives traders a map of the market, but it can be a poor buying or selling tool. In other words, it shows the price levels where trading decisions need to be made, but it doesn't always tell you what those decisions should be.
Classic books tell us to buy breakouts and sell breakdowns. This strategy still works during big trends, such as active phases of rallies or selloffs. But traders don't have the luxury of waiting for these relatively brief intervals. The vast majority of the time, modern markets are caught on the chopping block, rather than going directly from one price level to another.
Let's look at the chopping block, because it will be the main venue for pro-vs.-pro battles in 2003. Conflict or indifference characterizes these extended periods, forcing traders to outwit each other with contrary strategies and time frames. These tactics include fading breakouts, reversing overnight momentum and defying common wisdom on things like gaps and trendlines.
The chopping block will drive you crazy if you think technical analysis is a simple recipe book. The whole point is to shake out traders who bury their noses too deeply in patterns and indicators. The funny thing is these whipsaws actually prove the value of technical analysis rather than undermine it.
Many professional traders will buy breakdowns just to catch you in a short squeeze. Over the months, I've documented other fading games such as rinse jobs and pattern failures. This odd way of doing business becomes the rule rather than the exception during the chopping block. To survive in this hostile environment, you need to recognize when price is caught in this stage and when it's ready to change gears and head for higher or lower ground.
Memorize the chart above, because it's important for your survival. Almost every "real" trend begins after an opposite breakout or breakdown in the futures markets. When a chopping block develops, step back and outline its dimensions. Then wait for support or resistance to break, and watch what happens next.
The rally or selloff out of a chopping block draws in momentum traders who see the same thing you do. But the real signal comes on a clean break in the opposite direction. You may not realize it at the time, but you're witnessing the first primary wave in a new trend.
Why does the market move in this diabolical manner? It goes back to our common view of technical analysis. Support and resistance levels are nothing more than pivot points in the chopping block. Smart traders line up against those unfortunate souls who follow the book when they buy breakouts or sell breakdowns.
I know what you're thinking: All I have to do to make money is trade the opposite direction and join the fade. But just reversing gears won't work, because time traps are set against you as well. In other words, the breakout may go up for a day and squeeze out your short position and then drop back into the block the next morning or the next week.
How do you profit in this environment? You only have two choices. First, trade at the edges of the block after the endless games shake out everyone else. Second, play the fading game well. Take a step back and learn how to read price and time traps.
The first thing you'll notice is how the market draws pretty pictures through sentiment and price action. Then look for an ambush once the majority believes the illusion and takes new positions.
At the start of each day, ask yourself what price action would undermine the most traders. Often that's exactly what will happen in that session. For example, how many times have you been caught buying an opening gap after a rally, only to watch it fade and reverse into a selloff? It's called a bull trap for a reason.
Does this contrary thinking sound like a lot of work, just to make a buck? Well, yes and no. It does require a different skill set from the one you were taught during the long bull market. But it's the only way to survive if you want to trade in the big leagues.
