Failed Breakouts II

Following last month’s article on the ‘curse of the breakout’, we thought it prevalent to discuss one technical pattern synonymous with a failed breakout as well provide some insight in regards to trading around key levels.

The name Cat’s Whisker describes a candle which opens within a level, then breaks though it before it failing and eventually closing within the level. It is the actual wick of this candle poking through the level we describe as the Cat’s Whisker. The subsequent price action is likely a sharp correction as the market aggressively rejects the breakout. This pattern is extremely common because large traders are aware of the significance of key levels and will therefore squeeze the market through this price to:

1 Hunt for stops, or
2 Trap trend following traders (the large part of the retail market) as they play the breakout.

Once the breakout has failed, all the traders playing for the market to continue must unwind their positions. This action, combined with many professional traders vying for a rejection, usually leads to an accelerated change in market direction. Unfortunately, once you recognise this technical pattern, it may be too late to act. Which brings us to the question; how should you trade around key levels?

Louis Borsellino, the revered S&P trader, has been quoted saying that in the pit you could sense when a breakout of the market was going to be genuine. You could hear it. If the market was going to breakout, the noise volume in the pit would rise, as the big traders moved the market and the smaller guys screamed to get a piece of the action. Conversely, if the market was trading at a level and the pit was quiet, it was likely the market would reject this level.

Unfortunately, the modern day trader does not have this luxury; however, what he does have access to is the order flow. A trader purely looking at charts and the bid/ask spread has no idea of the games being played at each price, the level of buying/selling or the intentions of the big traders. Using a product such as Trading Technologies X-Trader to read the order flow, a trader can see the market interact at every price. Like the increase in noise was a potential signal of a breakout for the pit trader, a screen based trader gains an edge over the rest of the market who only see the final product on a chart, once the opportunity has passed.

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