February 27th, 2015
by Brandon Wendell, Online Trading Academy
Whenever I happen to watch business television, I can't help but notice how the pundits keep mentioning the stocks or other securities that have moved the most for the day or week. They seem to get more excited the higher prices have already moved. I have also noticed that most novice traders and investors seem to share that same enthusiasm and buy these same securities at elevated levels.
I have read many books on trading and investing for both professional advancement as well as an attempt to improve my personal skills. In the majority of these books, they expound on the virtue of buying breakouts to new highs.
This is silly and completely contrary to what we do in our day to day lives. Could you imagine going to an electronics store, (ok, I know we buy things online now) and not buying a TV because it was on sale. Instead, you wait until the price not only goes back to regular price, but actually rises! I'm sure you are shaking your head at this point because you know that you wouldn't do this. But you probably have in the markets.
Professionals know that novice traders do this and they love to separate them from their money. Look at the following chart of Apple. Novice traders bought the breakout of the intraday high. The high volume confirms this. Immediately after the novice buying pressure was absorbed by the market, prices dropped to the open of the breakout candle to trigger the novices' fear and stop loss orders. Once those novices are out, price begins to rise with the professionals having bought the pullback. The novices who were stopped out are likely to jump back in again and help the pro's long positions.
Sometimes the climb will occur the following day instead of the same day. On the chart of SPY, the ETF that tracks the S&P 500, you see the novices again with their signature high volume accompanying their chasing the breakout of the day's high. The end of the day was profitable for the professionals as they sold short to the novice traders.
Those novices who were stopped out likely lamented the move as price gapped up the next day without them.
Investors are not immune to chasing price and may even be more susceptible. Many investors will jump into fast rising stocks for fear of missing out. They will even buy in front of an earnings release expecting to make a quick fortune on a favourable release.
Recently, the retailer Bed Bath and Beyond (BBBY) released their fourth quarter earnings report. On the day of the release investors and traders bought the stock as it climbed and broke above its 52 week high. Once more you can see the increase in volume as their buying frenzy reached a climax. Unfortunately, the report was not what they would have liked and prices gapped down about five percent the next day.
This could have easily been avoided. An educated trader or investor knows to look back in price to find quality demand zones in which to buy and quality supply zones where they sell or short. One year prior to this earning release, there was another earnings release that caused a large gap down and a supply zone. This would have told you not to buy BBBY. You may have even wanted to have shorted the stock instead.
You must remember that trading a stock into an earnings release is incredibly risky and is more akin to gambling than trading. In this case the supply is a warning sign not to buy or to exit a long position, not to short. But it highlights some key mistakes that novices make in the markets. They often buy in front of a supply zone and they sell in front of a demand zone.
In Online Trading Academy's courses we teach our students to look back in time on their charts before entering a position for this very reason. I have been writing a book on trading called, "Look Left and Be Right," that addresses this very concept. Without looking left on our charts, we will not see the signs that tell us where prices will turn and will be doomed to repeat the same novice mistakes.