Bear Traps, Patience and the Wisdom in Following the Market

I have received numerous questions and comments from traders asking how they could have proactively positioned themselves to take advantage of the huge selloff in the NASDAQ and other indexes that occurred over the past two weeks or so.

So I thought it appropriate to spend some time looking back at a practical example posted on our Telegram Channel to highlight the importance of:

  • identifying commonly recognizable patterns,
  • knowing what the general population of traders expect to happen should that pattern unfold,
  • pre-empt what one expects to happen in conjunction with the event (i.e. add some sound risk management), and then
  • patience – spending time watching the market unfold (or not..)

The aim is not to prove that markets are predictable or that anyone can outsmart the market, in fact, quite the contrary. The aim here is to remind us that often the easiest trade is not to try and be the smartest person in the room, or to try and pick the next top or bottom, but instead to follow the path of least resistance all while never letting go of solid risk management principals because as we all know, markets do not move in a straight line and one can call a move 100% correctly and yet still be left with a loss at the end of it, due to poor execution of the strategy or trade.

Herd Analysis – January 7,2022

So lets begin by understanding that an enormous population of traders just like you, watch the exact same markets, and most likely use the exact same technical signals and indicators you do to choose trades.

Why this is an important point to realize is that it brings us back to understanding human behavior. If everyone sees the same sign, and everyone is expected to do the same thing should the sign pop up – then clearly it provides us with insight as to what is MOST LIKELY going to happen, but equally important, how some market participants may trade on the expectation of what others might do at similar levels.

On January 7th, in our 360 Traders Academy channel in Telegram I posted the following notes:

In there I highlighted the following two main points:

  • Identifying key levels where some action may occur
  • What to expect when we get there

The first point was to recognize that thousands of traders would look to these lows, testing the support now for the 3rd time (after not clearing the highs of a prior double bottom I might add), and expect the market to continue lower should a break to the downside unfold.

Secondly, KNOWING that the market is looking for this break – also a reminder to tread carefully and not just throw your entire trading capital behind this position, as this is prime breeding grounds for Bear Traps.

A bear trap is a technical pattern that occurs when the price action of a stock, index, or another financial instrument incorrectly signals a reversal from a downward trend to an upward trend.

Investopedia

Observing The 1st Break – January 10,2022

On January 10th, I posted the below follow up message on our Telegram Channel.

We have now, for the first time, broken through the key technical level observed by so many traders across the globe. However, sticking to our initial observations leading up to this point, recall that a word of caution was raised about the possibility of a bear trap that may form.

Clearly visible from the below is the extent of that trap. What will be shown on a subsequent image is just how misleading those traps can be and the damage they can do!

Again, the important point to take away from this is not predictability of the market or price action – instead, the predictability of human behavior that remains constant more often than not, and THAT my friends is why we have risk management in place!

When trading, one does not compete with the market, there is no beating the market, one competes against your own willingness to accept the process and the willingness to allow for time and space for a trade to unfold or not, all while remaining fully prepared and ready to act when there. It does not help to have a plan, and then once you get to the point where the plan needs execution, to then deviate from it.

The benefit of trading with a risk framework in place, is it allows the comfort and ability to not have to call a move exactly right, or to be forced to hang onto a particular trade purely on conviction that the market is about to move in your favor – after all, all signs point to it … right!?!?! Instead, letting the trade naturally unfold allows for trading longevity as well as a good night’s sleep 🙂

The Importance of Risk Management

What is clear from our Telegram messages is that at no point did we anticipate throwing all our weight behind a move, regardless of direction.

We did not jump in with both feet on our shorts at the first sign of a break, nor did we spend all our money buying the bounce of the resistance line (a reminder that we use multiple signals / indicators at any one time to evaluate a possible trade).

Instead – scaling into positions (regardless of going long on the bounce or short on the break) was the preferred method, purely based on the fact that no one can predict markets, and we need to be forever ready to deal with what the market throws at you. However, knowing what is most likely to happen, based on human behavior and observable levels, allows us to skew our risk in favour of the most likely move.

I am always reminded of the saying “trade what the market shows you, not what you think will happen”. Here too this rings true, we trade the short on the break, however scaling in on smaller positions in case of bear traps (or perhaps taking profit sooner along the way).

Similarly, we buy the bounce on the support in case the market wants to remain range bound, but yet again, in smaller risk sizes than normal due to the overall context we observe of where we find ourselves at this particular break/signal.

In other words, trade what the market shows you – but adjust your risk in accordance with context

We never try to change the game plan, just the size we trade during different parts of the game.

Patience & Wisdom

I have learnt this lesson early on in my career and anyone who has interacted with me knows that I always say – you cannot force a trade, let it happen and follow the market. Figure out who is winning and just jump on the band wagon. No need to be the first person to call the top or the bottom, no need to be the smartest. Take your time, whether you get in at the top, or closer to the middle of a move,… who cares! You will be trading tens of thousands of trades during your trading career so don’t place too much emphasis on any one single trade.

The above image shows all the daily candles leading up to the break, the massive bear squeeze and subsequent continuation of the move.

The market did end up “causing some pain below 15,500” as noted in our Traders Academy on the 7th of Jan. The market also ended up handsomely rewarding the shorts, but not after first scaring the living daylights out of them via a very solid and robust Bear Squeeze.

In summary then, the key takeaways on how one could have predicted this move and take advantage of it are:

  • FIRST – understand that you COULD NOT HAVE PREDICTED the move – at best, you could have been prepared for it
  • SECOND – understand that technical analysis is a graphical depiction of human behavior – and though the market is not predictable, one could argue that human behavior is a little bit more so at times.
  • THIRD – even considering the “relative” predictability of herd analysis – this too is not 100% predictable and for this very reason we NEVER TRADE WITHOUT PROPER RISK MANAGEMENT.

Looking back, this was a really nice and clear example of markets working and functioning exactly as it should. It should serve as a reminder to all that with context comes clarity, and perhaps stated better,… with context comes opportunity.

Now What?

Lastly, many have asked,… where to from here?

In sticking with my mantra that “no one knows nor can predict the market”, we shall continue to just Trade What The Market Shows Us.

The benefit of being a day or short term trader is that we do not need to be married to a trade or a view. We have the luxury of shifting in and out of positions, and directions, as the day or week dictates.

Having said that though, my personal take is that 2022 will be a difficult year for equities in general. This will make it particularly difficult to trade.

Interest rates rising is never a good thing for stocks and in particular, the economic environment we find ourselves in of lackluster economic growth, high government debt levels due to Covid stimulus, the virus itself and its impact on the global economy, combined with the constraint in global supply chains may see some corporates having a tough time realising the earnings needed to support current valuation.

In fact, they may end up shifting revenue from actual earning to “measured earnings” as a ratio.

Many companies sit on hoards and hoards of cash, and the quickest way to balance actual earnings with perceived earnings, at least in the eye of the investors, is to buy back their shares. This due to the fact that fewer shares in circulation, results in proportional higher earnings per share, even if the actual earnings are down. A bit of smoke and mirrors to add to the complexity of market analysis and perhaps a contributing cause of artificially propping up equity prices for a while.

I personally expect a bear market (if not already in one) yet won’t be surprised with a few bounces upwards along the way (especially if corporates indeed start buying back stock). Having said though, there are some major event risk out there not the least of which being the current Russia/Ukrainian tension along with inflated asset bubbles (especially housing) all over the place, so I will closely monitor the equity markets for the tell tale signs of a continuing bear market – i.e. the formation of lower lows and lower highs over the coming months.

See the below analysis of the NASDAQ as from mid-November 2021, showing multiple signs of possible continuation of the move lower.

  • Market is making Lower Highs and Lower Lows
  • The 50-day Moving average has turned lower – heading towards the 200 day for a possible “Death Cross”
  • Should a Death Cross occur – that typically signals potential for a major sell off, so will keep a close eye on that as well
  • The ADX indicator is firmly trending upwards, though not yet at “very strong” levels – so a lot more room to go, but already confirming the downward trend is relatively solid
  • Lastly, I would look for the NAS to have to close above 16,000 over the coming few months for us to avoid a full on Bear Market

A reminder that this is my own personal take, and like you, I cannot predict the market 🙂

It is not intended to be a trade recommendation.

Lastly, for those who have missed this initial move lower – stop beating yourself up – there will be plenty more to come. Stay in it, stay humble, stay nimble and keep learning!!!

Happy Trading