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This phenomenon occurs in the realms of day trading as well as longer-
term investing. In both areas, the masters of the market try
to "shake" other traders out of promising long or short positions by
precipitating quick reversals in the prevailing trend.
For example, news plays are the foundation of day trading where speed
is essential. A positive headline for stock ABCD is usually followed
by a spike in buy volume that shoots the price higher. This can last
five minutes or less. The spike is often followed by a shake in which
the price falls sharply as the surge in volume subsides and early
birds sell and pocket their profits. A typical retracement is 50%. So
if ABCD jumps from 10 to 11, it tends to drop to around 10.50.
This is usually enough to scare out traders who came late to the
party and bought ABCD around 11. The shake is usually followed by
another substantial move higher, and that's where savvy traders jump
back into the stock for further profits.
In longer-term positions, a shake often triggers the stop losses that
wise investors place below their entry price (or above in the case of
a short). They "trail" the stop behind the stock as the price
advances. We usually recommend using a 10% stop loss; if you buy ABCD
at 10, you place the stop loss at 9. If ACBD rises to 11, you adjust
the stop to 10 or so. If it hits 12 you adjust to around 11, and so
on. Using a stop protects your position against severe loss and locks
in profits.
But market makers have an uncanny ability to judge where the majority
of stops are sitting for a particular stock. If ABCD is at 12 and
loads of stops are at 11, it's not unusual to see enough selling hit
the stock to take in down to 11 and trigger all those stops. That
shakes investors out of their position as the stock is sold.
It is frustrating to be shaken out of a good position only to watch
the stock resume its winning move, but it is the way the game is
played. It's no reason to quit using stops, because all too often a
reversal can whack 20 or 30% off the price of a stock before it
regains its footing. We don't want to be around for that.
http://clix.to/wallmann
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