Futures Trading Lesson on the Psychology of Price Breakouts

Futures prices are not all that different from general human behavior. And I suppose since market prices reflect the collective thoughts of countless investors, then that explains it. Being aware of this fact does offer the investor a few advantages in futures trading, as understanding human psychology will often pay off when trading.

All of us get into certain thought patterns. Sometimes we feel like everything is going our way and we're on cloud nine. Other times we feel like the world is out to get us. And other times still we feel complacent, like we're moving nowhere and have no direction. And the odd thing about this is that the law of thermodynamics, that an object in motion tends to stay in motion unless acted upon by an outside force, is just as applicable to psychological patterns and futures prices as it is to physics.

Momentum is created in our psychological outlook so that a good mood begets good actions begets good feedback begets a good mood. And likewise, if we're bitter and angry the world reciprocates that. We wind up in cycles, or more appropriately perhaps, trends we carry on until something causes us to change. When something does cause us to change, it is often very meaningful and powerful, and can cause a full about change in behavior that lasts for an extended period of time.

Price ranges in stocks and commodities are areas bound by a high and low price for an extended period of time that keeps prices from finding a trend. This is similar to a person caught in a rut, where nothing seems to be happening in life. But when prices move beyond the upper or lower limits of that range, then we can assume that the battle of forces that kept prices range bound has shifted, and that one of these forces has become more powerful, and will likely dominate the trade for some time to come.

Despite the fact that many traders love ranges, buying the lows and selling the highs for a little profit here and there, the big money will forever be in the trend. So for those looking for long term and large profits, a better approach to trading is to wait for prices to leave a range, and then get on board. This is a difficult method of trading for investors who believe they must buy at the lowest price possible. This method is more of a buy high and sell higher philosophy. We want to ride the force capable of breaking the range because it's probably strong enough to carry prices into a trend.

So if you find a market that is range bound, the ideal entry would be to place a buy stop just above the range. If prices break out, then you are stopped in to a long position. At this point, prices should not reenter the range; otherwise it's a false signal. So you will be able to place a tight stop loss just under the upper edge of the range, which was resistance, and has now become support for prices. This is perhaps the single best low risk high reward trade entry in futures trading, and ought to be carefully considered by all traders.

Tom Fazio is an independent investor and commodities analyst who provides free information on coffee futures and seasonality and gold investment strategies. He also discusses the investment benefits of living abroad.


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