A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Giving Yourself Time and Room to Be Right (Part 1)
04/27/2009 10:22 am EST
How many times has this happened to you? You waited patiently for the market to show you where it’s going, then bought or sold the breakout to new highs or lows, only to be stopped out when price pulls back against the new trend. And of course, once you were stopped out of the market, the market returned to the trend—without you!
Or maybe you waited patiently for price to approach a prior area of support, then got long at that support area. Once you were in the market, price briefly violated the support area, stopping you out of your position. And of course, once you are stopped out of the market, the market climbed back above the support and headed higher—without you!
You were just “washed and rinsed,” which is a classic trading term for being stopped out of your position on a minor pullback against the trend. Let’s look at a chart showing a classic “wash and rinse” pattern:
The traditional method for buying at prior support would be a limit buy order at the test of the prior multiple bottoms marked by the blue trend line and then putting a stop loss order below the trend line. You can see this method would have resulted in you entering a long position and then quickly getting stopped out as price briefly plunged through the trend line area.
When prices began to trade below the trend line marking the multiple lows, breakout traders began selling “at the market” to enter new short positions. These new entry orders pushed the market lower, executing stop loss orders left by the traders that had been getting long against the support marked by the trend line. But note that once the breakout traders’ orders and the stop loss orders ran their course, price pulled right back above the trend line and headed higher—as the new short positions entered on the break below the trend line began to be stopped out!
Getting “washed and rinsed” is a common occurrence in trading. Is there a way you can avoid it?
I have been working with my students in one-on-one mentoring with a pattern we call the “Lazy Z” that was designed to help avoid being “washed and rinsed” when attempting to enter trades at these critical areas. Let’s look at some charts and see if I can explain how we use this “Lazy Z” pattern to help avoid being “washed and rinsed.”
Price just ran through an area that should have slowed or even stopped and reversed: The red, down-sloping Median Line. In the past, traders who use Median Lines would look to sell a re-test of this down-sloping line as price pulled back to it from below.
But looking at the statistics of trading this patter over the past three years, it has become obvious that many times, this first breakthrough and subsequent pullback is often a trap.
More tomorrow in Part 2.
"Master your tools, Master Yourself."®
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