Past Performance Predicts the Future
11/14/2012 9:00 am EST
Previous memories of good or bad trades very often will be a cause of future moves in price, writes Rick Wright of Online Trading Academy, which is why traders need to be discriminating when it comes to what trades they take.
Hello traders! Now that the US presidential election is finally over and we can stop being bombarded with half-truth commercials every 30 seconds, we can now fully concentrate on trading. Whether or not your candidate won is irrelevant. Neither showed the slightest interest in addressing the true economic problems of the US government, namely that we spend much more than we take in. So let’s talk about some charts, ok?
In every Online Trading Academy class that I teach, the statements “What was support becomes resistance” and “What was demand becomes supply” are thoroughly discussed. Many new traders have at least heard this statement before, yet are unsure why it is the case. This week’s newsletter will demonstrate why.
In the following EUR/USD chart, I have marked a demand zone that didn’t hold, thereby becoming a supply zone.
At point labeled 1, in a current uptrend price action pulled back and regained strength defining a new demand zone. But what caused this move up? Obviously greater demand than supply, but even more basic than that is the fact the people (or computers) bought here. If you bought at that point, you were making money quickly and have a fond memory of buying there. As you locked in some of those 100 pips in that move, many traders who have a fond memory of that price level will buy again when price hits that same level in the future—for example at the point labeled 2. As they realized that the next move up only made them half as many pips as the last time they traded this level, many will be reluctant to buy again there, hence lower demand at the next test of that level.
What about the people who sold short at point 1? If you were an Online Trading Academy student, you would have quickly taken your small loss and moved on to the next trade, knowing that small losses are part of the trading business. If you were not an Online Trading Academy student, you may have sat nervously on your hands, hoping that price would come back. Over the next couple of days, imagine the fear of those traders as price went against them 100 pips and slowly moved back down to their level. Finally at break even, these novice traders will very often exit their short trade, which would be another group of buyers at the same level, another layer of demand at point 2.
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What about the people who bought again at point 3? Buying every subsequent retest of the same level is a sure amateur mistake. In our Extended Learning Track education rooms, the retest at point 3 would not have been a good trade. Why not? Many of our Odds Enhancers were not present-for example the distance travelled from the level, arrival to the level, and departure from the level would have kept us from buying there. However, as you can see from the very small pause in price action at point 3, someone was buying there. A few short candles later they were very unhappy with their purchase. Again, an Online Trading Academy student would have taken the small loss (if they had broken several of our rules and bought there anyway) while the new trader would probably have held on to that losing trade.
As price moved sharply down from point 3, many traders will take the breakout entry on the short side making a few quick pips. As price retested the same level at point 4, those traders who have a fond memory of shorting near point 3 will happily short again at point 4, which is a nice layer of supply. Remember those traders who bought at point 3? As they nervously fret about their loss for hours and days, when price hits or even gets close to their break even point, they will happily exit their money losing long trade, another layer of supply.
As price hit the same level at point 5, another retest of the same supply zone, would that have been a good trade? I believe so. Using our Odds Enhancers, the previous departure from the level, distance travelled, and arrival all looked good. Two of the classic mistakes the new traders make is buying at point 5. The mistakes are 1. Buying after price has already moved up, and 2. Buying into a previously defined supply level. Very often we call this “chasing” a trade.
So there you have it. Previous memories of good or bad trades very often will be a cause of future moves in price. If you have a good memory of a price level, I encourage you to take the same trade at that level provided our Odds Enhancers are present. If not, let the amateurs take the trade! Taking every retest is not a good idea, but when you follow our strict rules-based strategy, many can be great trades.
By Rick Wright, Instructor, Online Trading Academy