Profit from the “Feedback Loop”

01/18/2012 10:20 am EST

Focus: TRADING

Corey Rosenbloom

Founder and President, Afraid to Trade

Widely watched price levels can often be the site for panic selling and failed trades, a phenomenon Corey Rosenbloom calls the "feedback loop." Here, he explains how to trade it.

What should you do when a good trade goes bad? Let’s ask Corey Rosenbloom. Well, Corey, what should I do?

Don’t panic; do not panic when a good trade goes bad. 

Let’s take something simple like a support level that many people are watching. We expect—and the news says—this level should balance. Let’s say it’s 10,000 on the Dow or 1100 on the S&P, whatever the level is.

So the market goes to that level and then begins to rally initially. A lot of traders enter positions at that spot and that is perfectly logical. That’s what we do as traders. We take risk, we have a tighter or smaller stop in relation to a larger target. So that’s fine. The market may rally as a result of that. 

But what if the sellers are in control? Or sellers take over and the market dips under that support level? Or breaks a pattern or whatever the signal that breaks may be? Now those traders are trapped. What do they do? 

Some of the ones that are more fearful, they exit immediately. They don’t want to ask questions. They’ll sell first, and that can lead to a break of support, a downside impulse.

Well, there are other traders, too. We’re not all bulls; some of us are bears. So we’re looking for that to break. So the bears will actually enter on the break of support. 

What happens can be considered a "feedback loop" where those that entered at the support level, or at the break of a flag or head-and-shoulders, or whatever the simple trade was, will trigger their stop losses, which enters the other side of the market. So you have both sides of the market doing the exact same behavior for different reasons. 

This can lead to really good moves when traders can look outside the fact that the market is not personal; it didn’t see you and say "Hey, get in this position and make a fool of you." That’s not what the market does. 

It’s a support level probability. The probabilities were higher on the upside, but that did not work out as the outcome. Then it becomes up to the trader to either exit the position quickly, or for professionals or for those going a step beyond that, to go short. 

We have this saying if the market should do something, but does the opposite where that thing does not happen, then expect a bigger move in the opposite direction because of the feedback loop of popped stops.

See related: Stay Safe While Trading Feedback Loops

So advanced traders, they can almost play these failure patterns for better-than-expected moves when they fail, or if they fail.

How can a trader be aware of the psychology of other traders or realize that that feedback loop is running?

A lot of things now, Twitter, for example; Stocktwits; all these wonderful things on the Internet; blogs; CNBC; any kind of financial show that talks about widespread patterns. 

We’re not talking about a little intraday five-minute triangle. We’re talking about a major level on a major index or gold and oil. Oil is at $100 now, so if something happens there, like a major level that traders are talking about, Twittering about, posting about, we can see that and we can interact with others. 

If we have colleagues we trade with, we can talk to them. If the market tends to get way in one direction, if everybody thinks this level has to hold, watch out, it might not hold.

Related Reading:

Related Articles on TRADING