Have you ever really considered who is on the other side of your trade? Most beginning to intermediate level traders are totally consumed with lagging indicators. They look at MACD, Stochastic, ADX, RSI and on and on. As we advance we become more sophisticated and become attracted to Gann, Andrews, Geometry and even study Financial Astrology. No doubt about it, these are outstanding methodologies to help us analyze the trend and alert us to any changes. However, it was even Gann who warned us to stay grounded and play close attention to the current price action.

At the end of the day, trading is really a zero sum game. In an ideal world, everyone gets paid. Certainly the market maker and broker make a living off every trade. However, if you are to make money, unfortunately someone is going to have to lose as funds transfer from their account to yours. Who is on the other side of your trade? For the most part it’s likely an institutional trader. That being said it would seem like your odds are daunting. You are trading against some of the best traders in the world. However, institutions are not infallible and hedge funds do make mistakes. Fund managers also make mistakes, especially in years with greater volatility. Characteristically, they’ll miss the early part of good moves and chase performance such as the 4th quarter of 2011. That opens opportunity for you, if you know how to recognize it. In this article I’ll show you some simple patterns you can follow and exploit. The good news is you’ll be able to find patterns like this in some timeframe materializing almost every day of the week.

(Click images to enlarge)

We’ve all been taught the trend is your friend but don’t be the last man in. Being the last man in sets off a chain reaction of events that isn’t so hard to recognize. For example, this Market Analyst chart of AMAT early in 2011 shows exactly what the last man in looks like.  

In order to exploit this opportunity, think about all of the mistakes you’ve made in your career. Everyone has bought a top at some point in time. When you have and found yourself under water, what was your main objective? Wasn’t it just to breakeven? All you wanted was a chance to get out without losing any money, right? I know many of you have seen patterns like this your whole career. What ends up happening here are those players who bought the last leg up thinking they were buying a continuation of the bull market ended up getting trapped. In Elliott terminology they bought the end of a 5th wave and had to sit through the 1st or A wave down. Once the price action came close to where they entered they gave up. Other smart traders who recognized this tendency combined to go short. In other words, those who sold on the retest of the last leg up combined with those who sold short in the same place creating selling pressure which drove prices lower. What a lot of new to intermediate level traders don’t realize is it takes a bull to fuel a bear and likewise it requires bears to fuel a new bull.

In this sequence on a daily chart of Intel we see how the last man in syndrome creates a whole sequence of unwinding. The first bounce off the high is likely the last group in exiting their positions. Sometimes there will also be groups of traders who think they are buying a dip in a continued bull phase that end up on the wrong side. As you can see, in each phase they ride it down to the next level and have to exit as they get close to breakeven. In technical terms, this is called a polarity flip where former support becomes resistance. The main difference in these first 2 charts is that in the AMAT chart, there weren’t many if any people buying what they thought was a dip. The reason for that was this was a top fueled by the start of the Libyan conflict in February 2011, and the low in March came as a result of the Japanese earthquake and tsunami. The people who bought AMAT before the top had no idea the market would react to a Libyan crisis. The Intel sequence from 2008 was characterized by a 4 month bear market rally when social mood was still in the denial phase prior to the Lehman meltdown. The psychology at the time was such that most people who thought they saw the light at the end of the tunnel didn’t realize it was an oncoming train.
That being said, let’s look at similar patterns on an intraday basis you are bound to see every day if not every week.

This is a 5 minute EUR-USD chart. On a 5 minute chart all you really need to do is recognize a secondary high and look for bounces that allow polarity to flip. Conditions usually start unwinding as the last man in gets trapped. It sets off a butterfly effect of conditions where each successive group is looking to breakeven. Combine that with smart traders who can recognize the setup and eventually it leads to selling pressure that creates the big bear bar. Once the big bear bar materializes, the best part of the move is usually over.

The next example is a bit more complex and requires the combination of several methodologies. In this recent sequence in the EUR-USD one must think a little deeper to figure out why those who thought they were buying the dip were wrong. First of all, the move up to this high was an 18dg move on a Gann square of 9 off the low from November 25. If you have a good software package like Market Analyst you may have known that. If you don’t know Gann you still could’ve figured it out because the larger pattern on the next chart shows the same high as polarity flip failure from a series of lows in late November.

It’s very important to recognize the next higher timeframe from the one you are trading.  There’s still another reason why buying the dip in this scenario is the wrong thing to do. Look at the pattern on the way up. It’s a parabolic move without any real support. In Andrews work this is considered to be the action reaction sequence and what goes straight up usually comes straight down. As you’ve seen in the other charts, the higher probability result materializes as continued unwinding results in ultimate downward selling pressure. You can also see from the larger timeframe that selling pressure subsides once the action reaction sequence subsides. In the larger timeframe you can’t even see the attempts at buying the dip that is apparent on the 5 minute chart. Ultimately, there are 3 excellent reasons why buying the dip was wrong in this situation. The Gann reading, polarity flip and action reaction were all leaning the other way.

Many traders who use lagging indicators have no idea why their trades don’t work out. In fact they don’t work out simply because they are using lagging indicators. One could not spot these kinds of opportunities on indicators alone. The most important thing to do is place yourself in the shoes of the person who is trapped and think about what they would do. Think about the times you’ve been in that situation. Then look for the higher probability point and do the opposite.

Finally, in my installment I discussed range and time squaring, Gann’s greatest discovery. Understand that I’m not suggesting you abandon advanced methods like that. What I am suggesting are those kinds of tools are excellent to put you in the proper instrument. For instance, if XYZ were to bottom at the 60 handle in 60 days you would know something important may be brewing, but that’s the macro picture. Once you have that problem solved it’s important to look at the micro picture which represents your personal opportunity. Looking at the action as described here will put you in a position to combine the macro and micro which places you at the right place and the right time.