Trading failed breakouts by shorting?

Quote of the day:

A failed signal is among the most
reliable of all chart signals. When a market fails to follow through in the
direction of a chart signal, it very strongly suggests the possibility of a
significant move in the opposite direction.

--Jack Schwager, from Schwager on Futures: Technical Analysis (1996, John Wiley & Sons, New York).

I have heard and observed over the years that some of the best easiest risk/reward trades are found going contrary in a play that fails for the majority if you reasonably know the direction (long/short) of their holdings.

Failed chart patterns give some of the most reliable trading signals possible, rivaling the returns of even  successful plays involving shop worn methods that every trader knows. 

It is useful to reflect on why that might be so.

Consider that popular chart patterns and their widespread use causes the herd of wannabe daytraders to jump at the chance to go long on what appears to be a predictable potential breakout setup according to technical analysis. Everyone has the same charting packages, looking for same tired old patterns that they are told "work" according to the experts. You are not the only guy who can read a chart and follow theory rules.

As the old saying goes, the ultimate purpose of the market is to fool as many people as possible from profiting over the obvious. Some time back a recent market wide "head and shoulders" breakdown became a bear trap. Even the folks on CNBC were expecting a fall to line the pockets of shorts with banked coin.

When everyone expects and can obviously predict what is *supposed* to happen, it often does not.

But I have an additional take, which I believe is a very simple and instructive point.

Simply stated, often those that act first have a disadvantage. They show their hand, they take risk in assuming new, and unseen...buyers will come in to keep driving prices up when long.

What happens if they do not? What happens if some big holder or MM tests the old resistance, now new support by share flooding on a pullback?

If stop losses are taken out, predictably set just below new support, a domino effect can induce further selling.

The big advantage in trading a failed breakout rests in knowing that investors are already in the equity and are likely to perceive the play as a failure, so they will sell, and because human nature is somewhat universal, others in the herd do likewise, particularly if enough stop losses are taken out to induce a panic.


A short seller can take advantage of the fact they do not depend on new holders arriving to bank more coin, they need only rely on the predictable actions betrayed by human nature to book a profit.

Just one of many reasons to be an evil short seller!

For further reading, visit: http://www.investopedia.com/articles/trading/06/FailedBreaks.asp

Also see the chapter on  "The true value of failed signals" in The Technical Analysis Course by Thomas A. Meyers.

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