Some Trading Thoughts

Sunday, May 03, 2009

Great quote borrowed from Bear Mountain Bull:

"'I think X will happen, so I’m going to do Y'
is totally different than saying
'When I see X happen, then I’m going to do Y.'”

Technical analysis seeks to create profitable if-then chart setups. For example, a bull flag pattern is a pattern of strength indicating increased buying interest. The chart is setup by a large move higher and an upper level consolidation.
This chart is a favorite of many technicians and offers excellent risk-to-reward to traders. Yet, this pattern is not infallible nor does it forecast anything before it triggers. The pattern triggers a long by breaking the upper level of the flag signaling the continuation of trend and traders will enter long positions. Yet, many traders attempt to anticipate the development of this pattern entering positions far too early. Clearly, anticipation and foresight are useful but they must be used wisely and understood as such.

Entering a long prior to a breakout creates many risks. First, the flag may fail, or breakdown. In this case, the buying interest dissipates and the selling overwhelms breaking the pattern to the downside. The trader has now lost by entering a position based on a pattern that never developed. Second, the pattern may draw out over a much longer period of time than desired. Perhaps the stock has a large one-day move higher and then bases for three months at the upper level. Meanwhile, the trader sits in a position entered just a few days after the large move and incurs a large opportunity cost of his capital. During these excessive holding times, the stock may continue making lower lows within the descending channel stopping the trader out or forcing him to hold losses with no defined stop loss.

Anticipation is crucial for the successful technical trader. Yet, too often traders attempt to anticipate the development of a pattern far too early causing entirely unnecessary losses. Remember, technicals create good risk-to-reward if-then setups. Anticipating the formation of a pattern defeats the purpose of the style. Allow the pattern to form before entering. If the move is real, you will not need to be early and will likely lose far more capital being too early rather than initiating when the pattern triggers.


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