I have been in the trading business for nearly 20 years as a trader, fund manager, and educator, beginning on the floor of the Chicago Mercantile Exchange. If I had to list the top three mistakes I see most traders make, one that would definitely make the list occurs when people decide to enter the market. Most traders today still buy and sell "breakouts," and trading breakouts can be high risk, high stress, low reward, and low probability... or this strategy can be low risk, low stress, high reward, and high probability. The difference lies in when you enter into this type of position. I will use a trade I took last week in the copper futures market to illustrate the proper way to enter the position and explain the wrong way to do it.
Before getting into the details of the mistake and correcting it, it's important to understand two key components of markets.
1. Why do prices move in any market? Price in any market turns at price levels where demand and supply are out of balance. The consistently profitable trader is able to identify a demand and supply imbalance, which means knowing where banks and institutions are buying and selling in a market. By quantifying institutional demand and supply areas on a price chart, you can identify market turns and market moves in advance with a very high degree of accuracy.
2. Who is on the other side of your trade? Trading is simply a transfer of accounts from those who don't know what they are doing to those who do. The consistently profitable traders know that a novice trader is on the other side of their trades.
Notice area "A." Area "A" is the origin of a strong decline in price. Most breakout traders will look to sell short as price breaks out to the downside (A) from the supply level. This type of breakout entry is typically the "sucker bet." Traders see price moving lower from supply and they give in to emotion and short into that initial decline while price is falling. The problem is that by the time you short the breakout from supply, price has moved so far that it becomes a high-risk and low-reward trade. Instead, I chose to sit back and let the breakout happen because that breakout tells me that there is a demand and supply imbalance at the origin of that breakout. This is exactly where the significant sellers are. Next, I wait for price to return to the supply area. When it does at "B", I am a very interested seller as I am confident I am selling to a novice buyer. I know this because the buyer at "B" is making the two mistakes that every consistent losing (novice) trader makes. First, they are buying after a period of buying, and second, they are buying at a price level where supply exceeds demand.
Copper Futures Trade: July 3, 2013
For shorts, many identify a market in a downtrend by using a 20-period moving average (I don't). Instead, identify the origin of a strong move and draw two lines around the price action to create a supply zone (yellow shaded area). Make sure the supply level has the pattern that represents where banks and institutions are selling as that is key. Then, make sure there is a significant profit margin (profit target).
Sell short at "B" when price touches the bottom black line of the level and place your protective buy stop just above the upper black line. Adjust your position size so that you are not risking more than you are willing to lose. This is the proper way to enter the position, not on the initial breakout.
People who enter the market on a breakout end up placing their protective stop right where they should be entering. This can be very frustrating because they stop out for losses often, yet they are typically correct on ultimate direction. The proper breakout entry works in any market and any time frame. A key component to making these work, which is beyond the scope of this article, is this: When taking any buy or sell entries in markets, make sure you know exactly price's location is with regard to the larger time frame supply / demand curve. Whether you trade stocks, futures, forex, or options, understand that behind all the candles on your screen, in all these markets are people and their emotions. Most will fall for the emotional breakout trading traps while others will get paid from them. In short, instead of entering the market on the initial move higher or lower from a level, enter on the first pullback into the fresh supply or demand level. This is one of the most common mistakes I see traders make.
Editor's note: This story by Sam Sieden originally appeared on Online Trading Academy
To read more from Online Trading Academy, see:
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Breaking Even and Crossing Over