In part one we covered some of the history of Technical Analysis: The difference between Technical and Fundamental Analysis; How Views of Technical Analysis Shifted; Why views of Technical Analysis Shifted; What the catalyst was that made Technical Analysis the premier form of analysis for everyday traders almost overnight; How the shift effected the market; How Technical Analysis set itself up for becoming one of the most effective tools Wall Street could ever hope for in taking your money; How Wall Street adapted to the changing environment and Why to this day, with Technical Analysis being clearly used against traders, traders REFUSE to adapt and keep falling for the same traps every day, in every asset and in every timeframe for every kind of market participant.
Now we'll look more closely at how Technical Analysis has become an asset for Wall Street; Why they use it; What advantages they have; How to Spot it; How to use it to your advantage.
As Wall Street quickly adapted to the near overnight mass migration to Technical Analysis when the Internet changed everything, they found there were plenty of ways they could use this to their advantage. Up until the Internet Wall Street was characterized by brokers, you probably remember the cocktail parties and the hot shots talking about their “Stock Broker”, their portfolio, etc. A profitable business model characterized by the Stock Broker, along with 401k's, IRAs and the rise of Mutual Funds had been a multi-decade long propaganda war waged by Wall Street to keep this model profitable.
The brainwashing used to protect and perpetuate the business model was so pervasive that even the most critical thinkers in the market were brainwashed in to accepting certain ideas as infallible truth.
Lets take a look at a few you might have heard of:
“Dollar Cost Averaging” - With most stock brokers charging something around $80 a trade ($160 for a round trip), this was an indispensable piece of propaganda. Realize that taking a series 7 test and becoming a Stock Broker does not mean that the broker had any talent whatsoever with regard to the market. In many cases the firms they worked for told them what to push and they were not much more than phone salespeople, calling their clients and trying to talk them in to buying or selling a specific stock. The broker/brokerage received the commission (and lord knows what else) and the client believed their broker was skilled in the market.
When those trades went wrong (and remember we were still in a world dominated by fundamental analysis and buying value) a client called their broker and just like traders today moved by the emotion of a loss, wanted out; that's not good for the brokerage, they lose Assets Under Management, they potentially lose a client, so the idea of “Dollar Cost Averaging” was a common theme perpetuated over decades. The logic went like this, the client called complaining about a loss in a stock and the broker simply touched on a concept that had already been pounded in to the client's brain, the broker only needed to say, “If XYZ was a good deal when we bought it at $10, it's twice the deal at $5.00 and since we have a $20 target, you can buy more and reduce your average cost to $7.50!” in doing so not only did the brokerage keep the account, the sold more shares, gathered more commissions and turned an upset client in to a happy one. The truth is dollar cost averaging is simply throwing good money after bad as people don't want to take a loss, they don't want to be wrong and they want to make the money back in the same stock they lost it in- but does that make sense? Revenge trading? Or are you better off making the loss back in the best looking trade at the time?
Next, “A Well Diversified Portfolio”...
This is a great one, this not only helped the broker sell more stocks, it helped them sell another product to a booming industry, selling Mutual Funds to millions of employees who had 401ks- remember those? Remember when everyone had a 401k? Remember how common Mutual Funds were back then?
The truth is by law, unless you are a qualified investor which most of the population is not, a Mutual Fund (long only) was your first and sometimes only choice. However by law a Mutual Fund couldn't buy more than 5% of the funds portfolio in any one stock, this meant Mutual funds had to hold a minimum of 20 stocks to comply with the law. This gave rise to the “Diversified Portfolio” which in my view is simply a path to underperformance. However to sell all of these new Mutual Funds to all of these millions of 401k holders, the concept had to be sold and it was, it still is to this day because Wall Street does such a good job at spreading their propaganda. This was also a blessing for Brokers as they could collect huge commissions on a well diversified portfolio.
How about diversification and the different strategies like growth, aggressive, wealth preservation and the concept of “Less Risky Assets”? If there's one lesson we learned from the Housing Bust, it's no asset is safe, no asset is safer than another and when your money is in the market, it is ALWAYS at risk so why would you chose to take a path that has less potential for returns and still all the risk? What could be less risky than a Mortgage Backed Security, an asset that is backed by real, tangible property and in a market in which property prices were blowing through the roof? It would seem this was a safe bet, however MBS became a symbol of a market and economic system that was days away from total collapse. Were the big companies like Enron, Global Crossing, WorldCom safe bets?
Short Selling is Risky, you face unlimited loss...
This is one of my favorite propaganda pieces and it's still alive and well today, albeit for different reasons. This is pretty easy to sum up, unless you were a qualified investor, most people only had access to long only Mutual Funds rather than Hedge Funds for qualified investors that could make money even in a declining market. This was a real threat to the Mutual Fund model so Short Selling was made out to be not only dangerous, but unpatriotic. Short selling does not have unlimited risk, you have to maintain margin on an account that is allowed to sell short, if that position starts going against you, the margin money that is like a loan from your brokerage is at risk and your broker will ask you to either come up with a margin call or close the position; if the market is fat moving, your broker will close the position without you even knowing as they will not allow their margin money to be put in danger so there really is no unlimited risk.
The fact is short sellers (like hedge funds) tend to be some of the best informed market participants out there, if a stock is in trouble or way overvalued, the shorts will make that adjustment. The shorts also provide an essential element in a market sell-off for those who wish to sell their stocks, short sellers provide liquidity during a market sell-off which normally would be hard to find or in other words, short sellers provide the market with buyers during a sell-off as the shorts have to “Buy to Cover” to close the short, that means for a long who wants out during a sharp downturn, there is a short there who is willing to buy, so shorts provide an essential service during the most difficult times in the market.
If a company lies, misrepresents, etc, is it unpatriotic to bet against that company? Would it have been unpatriotic to short Enron? The market is made of opinions, short sellers are just part of that. In reality short selling is no different than the typical long transaction, longs want to buy low and sell high, shorts are doing the exact same thing, but they just sell high first and buy long second. Did you ever think about it this way, if you went to your local car dealer and bought a new car that they had to order because they didn't have the interior you wanted, the dealer actually sold you a car short, yep, they sold something they didn't have only to later go out and get it to complete the transaction, in fact they may have had to “borrow” the car form another local dealer with the understanding they'd replace it.”
In any case, short selling was something Mutual Funds couldn't do and rather than have clients ask why or avoid Mutuals for this reason, short selling was just vilified. Stocks fall faster than they rise so often short selling is quite profitable.
Now-a-days we don't hear much in the financial media about short selling, but ask yourself, “What is CNBC's business model? Where do they get income from?” The answer is simple, from advertisers, many of which are listed companies, many of which appear on shows in a sort of informercial that you think is simply an interview with a CEO, you might not have known they CEO had to pay to be interviewed so for the financial media, reducing the number of potential income sources by irritating them with a short call against their company isn't good business.
The Mechanics... The Why?
This article is really about how Wall Street uses Technical Analysis against you and specifically one of the most common ways, “The Head-Fake Move” or what many traders see simply as an innocent “Failed move” with no thought beyond that.
So how does Wall Street benefit from head fake moves? What is a head fake move?
First of all a head fake move is simple, Technical Analysis has indoctrinated traders with specific concepts and re-enforced those by saying, “If the concept didn't work, it's because you didn't show enough discipline”, yes there's a lot of money to be made in Technical Analysis too and admitting it's not as effective as some think doesn't sell software, seminars, subscriptions, etc. A head fake move is simply a set up in which Technical Traders see a very familiar price pattern, support/resistance level or some other easy concept in which the trader has an expectation of what should happen because they have seen it in dozens of books, seminars, etc. The move comes as the trader expects, this is essential because while some traders will enter a trade early in anticipation of the expected move, most have been sold the concept of waiting for confirmation which is also often called by us, “Chasing the trade”.
When the move happens as Technical Analysis has taught, the trader makes their move, they are now committed to the position, then the trade simply fails rather than do what was expected and the trader is at a loss or has lost potential gains.
A simple example would be a stock that has been in an uptrend for several months, it pauses right below some long term resistance and forms a ascending triangle (a bullish consolidation/continuation price pattern), then the stock breaks out above both the continuation pattern as expected by the trader and breaks out above resistance, now the trader has confirmation that the bullish price pattern really worked and they buy (often just pennies above the resistance level), volume tends to swell as limit orders are triggered and the increased volume catches the eye of other traders that may be running volume surge scans (because they believe that increasing volume on a breakout is a sign of institutional money buying-which it isn't) and they chase the stock higher. At this point the stock may be making its rounds as a breakout on message boards, tweets, and even the financial media, this creates more demand which lifts price as more traders buy. Then something unexpected happens, price falls back below the breakout level, often pretty fast when looked at in relation to the entire event. At this point nearly every trader who went long the stock on the breakout is now at a loss as the breakout has failed and moved below support. This is a typical head fake move and most traders see it as nothing more than a failed move and never question why it happened or why it happens so often or who might have gained from it.
A few things that make Technical Traders susceptible to head fake moves include their misguided assumption of support and resistance levels, these people are “technical” and as such they quote support and resistance to the penny, they don't understand it is an emotional process that creates both support and resistance and both are areas rather than exact points. However the Technical trader sees it differently, that means they often put their orders a penny or two above or below support and resistance. They also put their orders in with their brokers (limit orders and all of the different kinds available) which means Wall Street and most other traders with basic software know exactly where the orders are piled up. If you were playing poker would you show the person next to you your hand before you bet or at all? Yet it happens every second in the market.
These “Head Fake” moves happen in every timeframe from intraday to swing trades, to longer term moves over months and even years, they tend to be in proportion to the trend they are being used on. For instance, an intraday head fake move that come after a 2 hour uptrend may last 15 minutes or so. A break above resistance that has been in place at two different areas over the course of a year may make a head fake move that last a couple of weeks. A swing trade that has moved up for a week or so may make a head fake move of 1 or 2 days, it's difficult to say exactly how long (although we have tools to help us determine when they are coming to an end), but the point is they are somewhat proportional to the trend, price pattern, resistance/support level's length, etc. Secondly a Head Fake's length can also correlate to the size of the reversal coming as the move fails, sometimes we may only have a 2 week move up in to a month of resistance and expect a head fake move of only a few days and get a larger one than expected (so long as the signals we use still tell us it is a head fake) , then we can get some idea of the size of the reversal coming. Even though the trend up was rather short (2 weeks), if the head fake lasts longer than expected, the downside reversal is likely to be a lot larger and when you understand what is happening during the head fake move, yo will understand why a longer move means a longer or more severe reversal.
Why use head fake moves?
I think there are probably more answers to that question than I can imagine, but one reason is because Technical Traders are so stuck in the past and have not adjusted to Wall Street's tactics, Wall Street uses them because they are reliable, THEY WORK.
A few reasons may include the following, one of the oldest head fake moves is found in the boiler-room operations of penny stock manipulators, these guys have been around long before me in one form or another. I remember some of their tactics to sucker people in to a penny stock scam which is a type of head fake move: Posting on message boards like Yahoo Finance and I suppose Twitter and other Social Media sites. They use to send mass fax blasts. One of the most creative ones I encountered was the phone message, this went down like this. You got home and listened to your messages and some girl named Megan (insert any name) would say,
“Hey Jennifer, thanks for last night, I had a great time. Remember that doctor who was buying us drinks, well after you left he told me about a study he was involved in with this little biotech company and they found a cure for a type of cancer, any way, he told me to buy XYZ stock right away because this is going to turn in to the next Microsoft, I just thought I'd tell you. Hey, say hi to Rick for me, I'll see you tomorrow”
As far as you were concerned, it sounded like a message left for someone, but they dialed the wrong number and contacted you instead, but you now have this hot stock tip and go out and buy XYZ the next day”. A few days later XYZ takes off, more buyers come in and then the stock dumps to new lows faster than you can hit the sell button. HFT Flash-Crashes and Flash-Smashes seem to be the new form of this. However this isn't quite the abuse of Technical Traders, but does illustrate how the concept can be profitable.
A more typical scenario we see on every timeframe is to give a reversal some extra power. The stock moves up (or down) and crosses an obvious technical barrier which causes buying, when the stock fails and reverses below the obvious technical barrier, all of the new buyers (or short sellers in a head fake down) are at a loss, they start to sell which adds more supply than demand to the equation which pressures prices lower which causes more longs to sell, which adds more supply and cheaper prices and then even more longs who may have had a higher risk tolerance start selling and before you know it you have a snowball effect, this is why failed moves move so fast in the opposite direction.
In this case, the bid/ask spread can also be manipulated to lower prices, flashing quotes that never execute but scare traders can be employed, lots of different things, but all focussed on moving that stock lower fast and hard.
But Why?
The thing most traders don't understand is the way smart money (Big money) has to conduct the buying, selling, shorting or covering of a trade. Unlike most of us who trade in 100 lots, these are huge positions these institutions are in, we can sell our order all at once and maybe only move price a fraction of a percent, but if these institutional firms even put the size of their ask out in the market, prices would crash and their once profitable long would be at a loss before they sold the first share.
Institutions need two things to accumulate: Lower Prices and Supply.
To Distribute: Higher Prices and Demand.
It typically takes them weeks or even months to move a position, so they will sell in small pieces over a longer period of time in to higher prices and demand.
When accumulating they need the stock to be moving lower which automatically produces more supply which is what they need.
Lets say a large institution finished buying the SPY at after 2 weeks of down or sideways movement in the SPY, they then form a bearish price pattern, when that pattern breaks below its support and hits a new low like the June 4th market low this year (2012), shorts pile in. As the shorts pile in this gives one good last chance to pick up a lot of shares at an even cheaper price because the shorts acted on confirmation of the break below the bearish price pattern and as volume swelled, the shorts created a lot of supply as they are all selling short which is the same as selling and they are doing it at a new low in price-Perfect for an Institution to accumulate those shares long. Now all the institution has to do is wait for retail shorting pressure to subside and then start bidding price up until it crosses the breakdown (Head Fake ) point, at this point the shorts are now at a loss and start to cover, as they create that snow ball effect by continuing to cover at higher prices, the institutions accumulated position is moving in to a profit and they had to do VERY little to make prices move, they didn't need to make a huge purchase to push prices higher, they just needed to cross the head fake area.
In this scenario the Institution pulling the head fake move not only reduced their average cost and in a big way as volume was high, they also did it without anyone knowing what they were doing because as far as traders are concerned, the shares weren't accumulated, it's just the typical, “For every sale there must be a buyer”, they don't know the buyer is one entity. The institution also increased their holding in the position to whatever they may have originally wanted, they moved price up and in a snow ball way that will attract other buyers who will help move price even higher and as price continues to move higher, they have built in demand to start selling their shares at a profit to new buyers buying the stock that is making a sharp move higher.
On a smaller scale extra money is made by increasing volume as Wall Street makes money and a lot of it on the bid / ask spread, a lot of small transactions in which they will buy for $9.90 and sell for $9.95, do that several million times or a lot more and that adds up. They also make money for routing their order flow in what is called, “Volume rebates”, yes they make extra money by sending their transactions through a particular channel and the more volume, the more they can make. So there are a lot of reasons, a lot of different Wall Street types that are making money off this like the market maker who filled the order and knew what was coming so they bought at the lows for their own account to only sell higher.
All in all, we see these head fake moves at least 80% of the time before a reversal, it's usually one of the last events to occur before the reversal so we can use it to our advantage to get better timing on the reversal as well as better prices, less risk and higher probabilities.
In the final section I'm going to show you examples of head fake moves, how to spot them , how you can use them to your advantage instead of being a victim of them and why they make for some of the fastest moving and most profitable trades.
Before I do that I'm going to show you one head fake example (of many) in which we made a good chunk of change.
The trade was a quick one, a option (Put) trade in GLD. The original idea was posted here,
the idea was a simple, quick, head-fake trade.
This was the setup that we were watching and what we were watching for to enter the trade...
From that post... "Now we have another possible breakout of the range and again volume is low. To entice longs to buy this breakout, it will have to make a new high and surpass the former breakout to remove any lingering doubts."
We Already knew there was distribution before any break out (head fake move) had been made...
The 60 min 3C chart showed distribution right at the area in February that was the same resistance area from above.
Over the next 5 days we had our head fake move...
The next day after posting the set-up we had our move as updated HERE.
On the next day, we confirmed distribution again and then we made the initial trade.
On Feb 29th, GLD moved down and below the head fake level on a 1 day -5.3% move
If you wanted to stay in longer as this was a head fake move for a reversal, this is what GLD looked like...
This is the same way we entered just about everyone of our 10 longer term core shorts from Q1 2012, every one of them was in the green for a double digit gain within 3 months using ZERO leverage.
The next installment of this series will be the lest, I'll set up links so you can review them whenever you like.
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