Tuesday, March 30, 2010

Preparing for False Breakout Moves in the Stock Market

Note how often in recent market action we've seen prices move above or below a recent high or low, only to snap back into the prior trading range. These false breakouts can be challenging for traders, as they assume that we'll see range extension and the beginning of a trending market. Instead, the market simply sustains a longer-term trading range.

By the time the market does experience a catalyst to move it outside the extended range, many traders are so beaten up by getting chopped up on false breakouts that they can't participate in the directional move.

What I find among short-term traders is that they often will presume that breakouts will continue in their direction without actively planning for the possibility of retracement. When we see that stocks have broken to new highs (as we did this morning), but that other asset classes aren't participating significantly and that the number of stocks making new highs has been waning, we want to actively build a scenario for a possible reversion trade. Once the correlated asset classes begin to retreat, stock prices stall out, and we see NYSE TICK pulling back, we're then prepared to act on the scenario we've built.

It is much easier to act on market action if you've visualized and planned for it in advance.