How to Deal with Failed Trading Signals - dummies

How to Deal with Failed Trading Signals

By Michael Griffis, Lita Epstein

All trading signals are subject to failure. Sometimes, things just don’t work out as planned. However, even a failed signal provides additional information that you can use to revise your trading plans. In fact, sometimes the best trading signals are the direct result of a failed signal.

Bull and bear traps

Breakouts from trading ranges and cup and handle patterns sometimes fail. These failures happen to bullish and bearish signals, and when they fail, it is called a trap. The two kinds of traps are

  • Bull traps: Bull traps occur after an upside breakout. The stock breaks out of its trading range to the upside but then reverses back into the trading range and ultimately breaks out to the down side.

  • Bear traps: These traps occur after a downside breakout. This opposite scenario often is very bullish. The stock reverses course and reenters the trading range. If a bear trap occurs within a trading range that’s preceded by a long period of declining prices, it often represents an excellent buying opportunity, because it’s a sign that selling pressure has evaporated and is likely to attempt an upside breakout.

Whenever you see a potential bear trap taking place and the stock meets all of your fundamental criteria, you may want to enter a long position as soon as the stock price reenters the trading range.

Fill the gaps

A developing gap is usually interpreted as a signal that the prevailing trend will continue. If a stock reverses and retraces prices within the gap, that means the gap has been filled. A gap that’s filled negates the trading signal that it generated.

When dealing with a breakout gap, a stock price that falls back through the trading range resistance zone and fills the gap is likely to be a bearish development. Similarly, when a continuation gap is filled, you need to consider it a failed signal and exit your position.

The same is true for an island gap. If prices trade back into the area of the isolated island, the trading signal has failed and you need to exit your position.

How to decide whether to reverse directions

A bear trap shows an example of where taking a position based on a failed signal makes sense. If, however, you already have a position, and the signal fails, exiting your position is a wise choice, because you’re letting the market sort out its psychosis without risking your money.

You also need to consider economic and fundamental factors when deciding how to handle a failed signal. Acting on a contrary signal makes sense only if economic and fundamental conditions support the decision.

For example, if a bullish signal fails and becomes a bearish signal, selling a stock short makes sense only if it’s fundamentally weak and the stock’s sector is in decline. Conversely, if a bear trap occurs and generates a buy signal, taking a position in the stock makes sense only if its earnings are strong and growing, its sector is performing well, and the economy is on an upswing.