I am so glad you are keeping a trading diary and creating data that you can analyze. This has helped me so much in my development and probably always will.

I do not reference conspiracy theories, yet the market order flow is such that it naturally seeks pockets of liquidity. I will be exploring this idea through further posts, and data I am working on, but what I have found so far is that market makers and specialists typically are not reading charts the way we think they do. They see order flow and trade towards it, such that if there is a concentration of sell-orders on the book, the specialist – or just normal market action – will drift toward those densities of orders. Specialists and market makers must take the opposite side of retail trades (those we place) and so they see an easy area of liquidity and it doesn’t take much to push the market there to execute these orders and fulfil client orders at favorable, guaranteed prices.

So the result is the market seeks these areas (not even know WHY they exist) and trades at them.

Either way, we must keep losses small and so we must continue using stops (yet I have tried tests of data that do not use them). When you test data without stops, your % winners increase, yet when you lose, they are big and it degrades the system performance and erodes edge and profits. It’s not all about a big win %. So there has to be a balance, but that balance is dependent on your strategy and personal testing, it appears.

Keep me posted! Corey

I’ll have to actually sit down with the data some time and do as you suggest. I keep a trading diary with a lot of data and information in it which I update daily so it’s just a matter of finding the time to sit down and get it done. I am skeptical by nature and try not to be given to conspiracy theories but I have taken so many small losses where I set the stop properly and yet the position could have been held for either break-even or a small gain that it’s very difficult emotionally not to suspect that someone (and by someone I mean someone big) is using what you call the Perversion Pattern. Of course, no pattern works 100% of the time and taking small losses has saved me several times from taking very large losses which is what I keep reminding myself of to minimize my frustration. To paraphrase Todd Harris over at Minyanville.com, “The definition of investment is not nor should ever be a trade gone awry.”

Thank you for sharing your insights and recent example. This example is a perfect picture of the idea I am about to convey through some of my next posts. If we strip all other technical analysis away and simply have our rule “Enter long when price touches the rising 200 daily moving average (simple), place a stop 20 cents (or some number) below the price, and play for $X profit (depending on the stock price or other above level of resistance).” A lot of traders, professional and new, will watch that “Big Bertha 200,” as it has been called the “Line in the Sand” and – right – area of “trend change” (though I have a different definition of trend change).

Anyway, in this example, price did exactly as expected. Traders entered, placed their stops, and then within minutes, all their stop losses were washed by professionals who had BUY orders resting BELOW the average in the same spot where a lot of other traders had their stop-loss orders. This “stop rinse” took two days to complete. Remember, there were people acquiring the positions from those who were stopped out – To put it bluntly, where you wanted OUT, they wanted IN.

And so maybe the natural trend directly simply reasserted itself, maybe those who were stopped out rushed back into the stock angrily and chased the market higher (assisting the move already underway), maybe larger traders (mutual funds, maybe?) had resting buy orders to enter when the price hit that average (but they did not use stops). Whatever the reason, the pattern is the same.

I am developing a trade idea or pattern called the “Perversion Pattern” or something like that (still working on the name). Essentially, it calls for scanning for classic technical decision nodes, entering the market AFTER these “rinse and fade” patterns have occurred, or resting a buy stop where the proper sell stops would be. Still testing my ideas through TradeStation.

Even these Fade or Perversion Patterns don’t work 100%. Just like Joey (DownTown Trader) mentioned, you don’t know when the price will hit the average to the penny, bounce and go as expected, or when it will hit the average, trigger buys, go up a bit, then fall 20 or 30 cents (or more), rinse out those stops to create losses, and then rocket baack to the intended direction. There is no pattern that is 100% – ever.

If 70% of your trades are being stopped out and THEN turn to profit, then that is a huge number and should be a call to action. Review all your trades carefully where that happened and write down 1) Your chosen stop and 2) The number where price reversed and subtract these two and compare across all trades. Next, add that number (plus a few cents) to your naturally (or originally) chosen stop loss level and see if that adds profitability to your trading. See if you can test this mathematically before committing to it as a change in strategy.

I would like to know the results of your testing if you have time to write back. I’m sure it would help other readers as well.
Feel free to email me or contact me, as I would love to keep in touch and hear more.

I wish you the best,
Corey

Mr. Doji: Good job on the profit in JCOM. You had an aggressive fade short entry there and that took some guts to execute. This helps illustrate the point. Most new traders, seeing a gap up and strong momentum, want to jump in and can’t wait to get in to higher profits. Before long, no one is left to buy and the price will decline. Momentum (and buying) declined toward just before noon and then the stock began its decline (to the suprise of many who couldn’t stand it any longer and bought in at the highs of the day). I am looking at the 15 minute chart and would have tried to be patient with the short until it hit the rising 20 period moving average for my target, but I would have had immense problems holding that long with profit on the table. It takes patience and a strong stomach to fade the crowd. It takes time to develop too.

Joey:
I suppose it is a sad reality, but busted chart patterns do work greater than classic patterns provided the public watch for, and play on, classic patterns. But you drove home the point – no trader, professional, novice, OR amateur, knows which patterns or entries will work and which will result in a loss. This is hard for new traders to understand – professionals are not pros because they can read charts and know which way price will move. They are pros because they know the odds of probable price movement and know when to get out when they’re wrong and play for targets that are large enough to cover inevitable losses. I also like your site and chart analysis.

Joey