The “Loop” That Trips Up Traders

01/30/2012 12:10 pm EST

Focus: TRADING

Corey Rosenbloom

Founder and President, Afraid to Trade

Emotional, news-driven markets often give rise to manic price action and an event called a “feedback loop,” whereby bulls and bears take the same action, albeit for different reasons.

One of the main activities that trip up traders—especially new traders—is the concept of continual price movement in one direction without meaningful pullbacks, also known as “powerful trends,” “creeper trends,” or “positive feedback loops.”

Let’s take a look at the current situation and put it in the context of prior S&P 500 day-over-day one-directional movement.

First, the hourly S&P 500 pure price chart:

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Let’s first define a “positive feedback loop” and see how that concept explains these situations.

A positive feedback loop occurs when one action leads to continual (or more) of the same action, such as higher prices resulting in higher prices, with these new higher prices resulting in even higher prices, and so on.

A real-world example includes situations of alarm or panic in a crowd, where a small number of people initially exhibit panic behavior (perhaps screaming or rushing for the exits), which leads to more people exhibiting panic behavior, which in turn leads to even more people in the crowd exhibiting panic behavior until everyone in the crowd is sufficiently panicked or else has escaped the building or situation.

By contrast, a negative feedback loop (using the above example) would be when there is initial activity of panic, yet an authoritative announcement is made where people respond to the announcement and cease panicking.

Thus, negative feedback loops occur when an initial situation is cross-checked by an opposite force that results in stability (or a return to normal) instead of increased activity that develops from un-checked activities in positive feedback loops.

In price, positive feedback loops develop from an initial price movement—often on a breakaway from a range or period of consolidation/contraction (negative feedback)—and then are sustained due to both sides (buyers and sellers) taking the same action for different reasons (one to make money; the other to stop losing money).

In the case of price moving higher in a positive feedback loop, an initial price breakout…

  • Causes those who are short to cover, which is a buying activity
  • This triggers buy signals for bulls who either add to existing positions or else put on new positions
  • That triggers those “stubborn” short-sellers (with wider stops) to buy back to cover
  • That in turn excites more buyers to step in, again adding to positions or putting on new ones

All of which leads to a perpetual upside trend or impulsive rally that develops a positive feedback loop.

The feedback loop tends to end in one of two ways:

  • All bulls who wanted to buy have all been filled (and are long)
  • All bears who needed to buy back to cover have exited their positions

That’s an oversimplification, but it’s a good starting point for thinking about feedback loops in price.

NEXT: See Past Feedback Loops on the S&P 500

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Here are three prior daily chart examples of persistent feedback loops in the S&P 500:

I’m showing three smaller positive feedback loop (trend) periods from the recent action. Keep in mind that positive feedback loops develop to the downside as well. The panic example above is a good illustration how some buyers initially rush for the exits, which emboldens short sellers, and as price falls lower, more buyers rush for the exits.

This impulse took the S&P 500 from 1,350 to 1,100 in about 12 days, and all but one of those days was a down day.

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October 2011 and January 2012 show us classic examples of positive feedback loops in impulsive, one-directional, day-over-day rallies.

Two other periods show similar characteristics, though on a larger scale:

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During the second round of quantitative easing (announcement and official implementation), price developed an initial impulse beginning in September that ended in November, and a second sustained trend move developed from December.

This was a similar situation to what occurred during the first round of quantitative easing in 2009:

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From the March 2009 low, price developed a sustained positive feedback loop that propelled price from 666 to 950.

We can see a slight negative feedback loop (consolidation) that developed in the middle of 2009, which also gave way in August to another positive feedback loop on the break to new recovery highs above 950 and then 1,000.

Those who were short above these levels were forced to buy back to cover, which emboldened more bulls to put on new positions or else add to existing positions in the context of a sustained, upward march higher.

One of the basic principles of technical analysis is that trends, once established, tend to have greater odds of continuing than of suddenly reversing, which builds on the concept of positive feedback loops.

Keep in mind that feedback loops occur on all time frames as different traders interact with various trading tactics and strategies.

In general, it tips the odds to make it easier for traders to trade in the direction of feedback loops instead of against them.

Continue to study this topic for additional insights on how you can apply it to your own trading.

See also: Learn to Trade “Feedback Loops”

By Corey Rosenbloom, CMT, trader and blogger, AfraidToTrade.com

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