Much of the difficulty with trading is psychological.  Trading doesn’t have the same set of rewards and punishments as many other endeavors.  For example, there’s not necessarily a positive correlation between a trader’s intelligence and his success.  In fact, I’ve often seen smart people have more problems being successful traders-they tend to overanalyze trading. There’s also a tendency to think they’re right, regardless of the evidence at hand.

As so much of trading is about psychology, I’ve often thought that figuring out the psychology of trading patterns and markets could go a long way to being a successful trader.  Behavioral economics attempts to figure out the psychology behind people’s financial decisions.  However, I don’t know of anyone who has come up with a unified trading framework based on psychology.  Maybe I’ll get smart and come up with one some day.

Although there’s no unified filed theory of psychological trading, there are aspects of trading that do seem to “fit” well psychologically.  Failed breakouts are one such pattern; there was a good failed breakout trade in coffee futures today.

Coffee futures have been rallying for the past two weeks, while trading within a defined triangle for the past months. Yesterday was an especially exciting day as it traded and closed over the upper line of the triangle on the fourth try to breach it.

Yesterday’s close above the trendline got the attention of breakout traders interested in buying an upside breakout. As I pointed out in this morning’s watch list, the 9/21 high of 138.20 was the last resistance point before an extension of the rally.

Broke above the trendline yesterday

Broke above the trendline yesterday

So last night Dec. coffee futures closed above the trendline resistance, which got the interest of traders looking at the day charts.  This morning it rallied over 138.20.

This is where it got interesting. After an early morning rally, the buying dried up.  Likely there wasn’t much professional participation in the early rally.  As the buying stopped, prices started to fall.

It’s here that a contrarian could trade.  By recognizing who participated in the rally and the psychology of the participants, you would know that the morning’s new longs were likely:  1. long because of the breakout and 2. Likely long from one or both of the breakout points-the trendline at 137.75 or the old high of 138.30.  As the market sold off below these prices, new longs were seeing losses on their new long positions.

Knowing this gave you a trade setup. As these new longs started to face losses, the more likely it was that they would sell to liquidate.  For us, selling short when the market moved back under these support points would let us profit at the new longs expense!

The strategy for trading failed breakouts is to do just that-to take a trade when the pattern fails.  Today we would look to sell coffee when it broke back under the two support points.  Stop losses could have gone above the high of the day or back above the trendline after the final break under it.  A move from the 138.30 high to the close of 135.55 was worth $1031.25; a good profit for a day trade.  If you wanted to stay short, you could tighten up stops and look for downside followthrough for more trapped longs for Monday.

Big selloff as the breakout failed

Big selloff as the breakout failed

Trading psychology can be a valuable tool for traders; it especially helps you find a market’s pain points and exploit them.

This is the morning update to my Swing Trader’s Insight advisory service. For information on STI, and to sign up for a free two week trial, visit here.

The information contained here includes information from sources believed to be reliable and accurate, but no guarantee is made as to accuracy, nor do they purport to be complete. Opinions are subject to change without notice. Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

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