The Sucker Trade: Why Traders Fail?
Can you recognize the sucker trade before you buy a breakout? What is the sucker trade? Why do traders fail? That’s what happens when you blindly buy or sell a stock that is breaking out because you followed a traditional technical analysis trade signal, such as volume, candlesticks, stock indicators, pattern breakouts, etc… without taking into account the dynamics of the broader market.
Taking the sucker trade means your trade will get faded or traded against by smart money leaving you holding the bag.
1. Traditional Breakout Stop Loss Strategies Don’t Work
Problem: Traditional technical analysis theory essentially argues that when resistance is broken it becomes new support. Thus, when most traders buy a stock breakout, they place a stop below broken resistance assuming that the new support level will find buyers. As often as not, stops get swept before the price makes a significant move in the direction of the breakout. This is why traders fail.
Solution: More than 50% of all breakouts experience a throwback pattern, which is a retest of the new support level. Support and resistance levels are not rigid and prices can and do often return inside or outside these levels temporarily. Since it is impossible to tell if a throwback inside a breakout support line is a retest or a breakout failure, you can improve the performance of your breakout trades by buying only after the price has follow through higher out of a throwback.
2. Chart Pattern Breakouts Usually Fail When the Market is Not Trending; the Market is not Trending 70% of the Time
Problem: Traders following traditional technical analysis strategies get traded by smart money all the time. Below is an example of a stock that produced a false breakdown. The breakdown would surely have triggered technical analysis adherents to sell or sell short on the downside breakout only to be badly burned when the price gapped higher the following day. (Read here for a statistical study reviewing the success rates of various chart pattern breakouts)
Solution: Once again, buying or selling only after follow through out of a pullback would have saved this trader. However, you can really increase your odds by trading breakouts only in the direction of the broader market trend. If the market is not trending, you will likely do better fading the breakout, which means buying when others are selling or selling when others are buying.
3. Japanese Candlesticks are Poor Chart Indicators
Problem: Japanese candlestick buy and sell signals are commonly recognizable chart indicators due to the fact that so many books and websites are dedicated to this particular chart theory. In our experience, most signals have lost their predictive power and as often as not, smart money either ignores these signals or fades them by buying when others are selling or vice versa.
Solution: Once again, paying attention to the market trend and other factors such as market sentiment is far more important to the success or failure of a breakout than Japanese candlestick signals. With that said, if the market is not trending, candlestick signals reversal signals can often be a good point to fade the breakouts when others are taking the sucker bet.
4. Overbought and Oversold Indicators Can Remain Overbought and Oversold For Extended Periods of Time
Problem: Oscillators, such as stochastic indicators and MACD can remain in overbought and oversold conditions for extended periods of time when the market is trending. In the chart below, the overbought stochastic indicator proved to be a very poor sell indicator. Sellers would have paid a heavy price. When a stock is trending up, stock indicators can sometimes bounce in the overbought area through the duration of the trend.
Solution: Some traders fear buying the breakout when they see an overbought indicator on their charts. If the market is in an uptrend, overbought indicators need to be ignored or at best used to confirm the trend. Contrarily, if the market is not in a trend, using indicators can help you find the best entry points when fading the sucker bet buyers.
Make Money Consistently in the Markets
Now we’ve reviewed why traders fail. Buying, selling and fading breakouts are three of the most profitable types of stock trades you can make. However, in order to profit consistently over time, you need to have a good money management system in place. In this article we explain how we employ a simple risk or money management system with our trades in order to ensure we keep our client’s trading accounts growing and never slipping back.