“How can you know in advance/in real time whether a breakout is real or a trap?”

That’s a question I’m frequently asked at Expos/via email and it’s a very important question.

While there’s no 100% method (I wish there were), knowing how to read market internals gives some of the best clues available – so how did market internals help you side-step Tuesday’s March 1st gap-flap trap?

Easy – let’s take a look:

I intended to do this post mid-day yesterday but was active in the market and did want to document this lesson/example for you – it’s just a day late.

As is the case when I show this same chart, we’re looking at Price – the S&P 500 – with the “Big Three” Market Internals under it:

Breadth (Advancers – Decliners)
TICK (extremes)
VOLD (Volume Difference of Breadth)

Yes, the breakout was a factual breakout and gap above yesterday’s close/short-term resistance.

But before you rush-in to buy just because price crested above a level, take at least one minute to look at the state of market internals and ask a very simple question:

“Are Market Internals generally confirming the breakout with higher readings, moderately high readings, or not at all?”

The answer on the opening session March first was “Not at All.”

Why?

Compared to the closing levels on Monday, we see the following numbers:

Breadth Monday:   1,040
Breadth Tuesday:  959

TICK High Monday (close):  724
TICK High Tuesday (open):  402

VOLD High Monday (close):  335,900
VOLD High Tuesday (open):  30,700

For those of you keeping more detailed stats at home:

Breadth was 7% lower (down 81 issues)
TICK High was 45% lower (down 322 issues)
VOLD was 91% lower (down 305,200)

So price busted to the 1,332 level off the open then performed the infamous “Gap and Crap” or “Gap Trap” maneuver which can also be called a “Finger” (or ‘excess’ to borrow a Market Profile term).

The aggressive short entry – after the failure to maintain the breakout level with weaker internals – was on the break of the little rising trendline at 9:00am CST at the 1,326 index level with a stop above the 1,330 level.

I show a second potential short-sale entry into the newly developing down-move in the morning session on the “Bear Flag” trendline breakdown at 10:30am CST while price broke the 1,324 little support shelf.

Notice also how internals – particularly the TICK highs – moved lower as price moved up then sideways – that’s another little divergence ahead of the official trendline breakdown entry signal.

While I captured this chart in real-time just before 1:00pm, you’ll know now that price moved down even lower on weaker internals for the whole session – or what I like to call a “Type III Trend Day.”

These are the types of daily lessons/examples/concepts I show in the first section of the daily Idealized Trades member reports (the second section is “What might we expect tomorrow?”).

I’m a big proponent of the “Teach a Man to Fish” concept (instead of “Give a Man a Fish”) – and the only way I know how to do that is through showing multiple examples like this of salient concepts of technical analysis and I’m thankful for the opportunity to do so (it helps me organize my thoughts as well).

The more times you see situations/patterns like this, the more confidence you’ll have to recognize them and trade them when they set-up in the future.

Corey Rosenbloom, CMT
Afraid to Trade.com

Follow Corey on Twitter:  http://twitter.com/afraidtotrade

Corey’s new book The Complete Trading Course (Wiley Finance) is now available!