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How to play 'Failed Failures'

Twisted logic can devise very profitable trading strategies. For example, we're taught early in our careers to buy breakouts and sell breakdowns. But market contrarians pay their bills doing the exact opposite. They wait for a move to fail, and then sell the breakout or buy the breakdown. These mind-bending tactics don't end there. Many smart traders take it one step further and buy when the failure fails.

Let's back up and examine this way of thinking one step at a time. Most of us follow a common path -- we pile into stocks because they break out of resistance. But contrarians know exactly how you'll react when your pretty breakout drops like a rock. So they guess where your stops are hidden and enter short sales at the same price to capitalize on your misfortune. Now twist your brain a little more and take this reasoning to the next level. The stock breaks out -- you sit on your hands. The stock fails the breakout -- you wait and do nothing. But when the stock jumps back above the breakout price - you buy. Got it?

Modern markets try to burn everyone before they launch definable trends. My friend Bo Yoder calls this action a "rinse job." Whether through manipulation or mechanics, price gets drawn like a magnet through common support and resistance levels. This whipsaw movement cleans out the stops before a market ramps higher or lower. Not a pleasant experience when you're caught holding the bag, but an excellent opportunity when you come off the sidelines.

How does price action "know" where the stops are hidden? The answer is quite devious. Retail traders are well-versed in the basics of technical analysis. They take positions using common methods already deconstructed by the smart money. The result: Price passes through support and resistance far more easily than in the past. But keep your chin up. Whenever someone comes up with a new way to take your money, they also give you a new way to make it. Let's look at failed failures on several stocks we've discussed in recent weeks. We made the case for a bounce play on Concord EFS (CEFT) on Dec. 10. Using the intersection of two key Fibonacci retracements, we suggested Concord would reverse near $29 and start a run back toward its high. But things didn't work out that way.

Four days later Concord gapped down through the entry target and made a mad dash to the 50-day moving average. It tagged it early in the session and reversed, closing back above $29. The next morning, price gapped above the entry target and completed an "abandoned baby," a significant one-bar reversal pattern. Concord then rallied to test the old high. Fortunately, the gap down should have kept swing traders on the sidelines. Most effective trading strategies limit entries after unusual gaps. But those already positioned had stops in the middle of that rinse job because it looked like a safe level on the price chart. There's a diabolical trading lesson here: Safe prices are also the most dangerous ones. How twisted is that? On Nov. 8, we looked at Oxford Health Plans (OHP:NYSE - news - commentary - research - analysis) and made the following prediction: "The intraday bars of the last two trading days draw a bullish pattern that looks close to breaking out."

As someone else around this organization likes to say -- Wrong! Oxford Health decided to go in the opposite direction the same day the column was published. Look at how the two-day rinse job filled the gap, before price jumped back into the resistance line. What happened next is even more interesting. Oxford spent a week gathering into a tight little ball. In fact, the last bar before the breakout printed a "NR7," the swing trader's term for the narrowest range bar of the last seven bars. This quiet signal often precedes major price expansion and is a telltale sign of a market ready to move.

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