Friday I wrote about A Broken Stick and how I thought of an analogy with trading. The analogy might not be clear to everyone and there could be multiple analogies possible so I thought I’d share mine and if you have a different one, feel free to share yours.
As I kept swinging the stick around, unknowingly to me, it was getting weaker and weaker until it finally broke. When it broke, I had a shorter stick that was still working. And while swinging the shorter stick, it was getting weaker and weaker until it finally broke. And then there was nothing left.
The stick is like a support/resistance level. Let’s use resistance in this case. As price tests resistance it can get weaker. As price continues testing it, buyers are buying up the supply and diminishing supply makes the resistance level weaker. I say it “can” get weaker because resistance will also attract more supply as traders see a top and expect it to hold. However if buyers keep testing the level then it’s more likely the level will break. In fact professionals will purposely break the level just to trigger the stops. When it does break, price will usually advance. This is due to several reasons:
- The supply has been removed so the market has to go higher to find more supply.
- The “breakout” brings in breakout traders who jump on board.
- The shorts will need to cover by buying back their contracts, often via stop loss orders
All of the above sets off a chain reaction. So price goes up until it hits the next level. And then the scenario repeats.
Think of a double top. Many chart pattern traders will see a double top and expect it to hold and will fade a retest. However each retest is making the supply causing the top weaker.
This can also be seen in the triangle patterns. The general rule is the horizontal edge of the triangle is more likely to be broken. This is the same reason – as it’s tested more it gets weaker. There is a contradiction here as in the double/triple top is expected to hold but the triangle edge is expected to fail. It’s the same thing. Does it really matter if it makes a pretty triangle or not?
I don’t fade double/triple tops. I don’t fade any level that’s tested several times because I know the stick can break at any moment, and when it does, watch out.